Question

Suppose that an airplane basic operating cost is c per a passenger. However, it can price add-ons (better sits, extra beverages, wi-fi) to generate extra fees averaging p̄ from naive type of passangers. A fraction α of customers are naive, and do not foresee these add-ons. The remaining fraction (1 − α) are sophisticated, and can avoid the add-ons at an effort cost of e. For simplicity, assume that the add-ons do not cost anything for the airlines to provide.

1. (a) Assuming that the flight industry is competitive - so an airline earn zero profits at equilibrium. Calculate the basic price p that the airline will charge.

2. (b) Calculate the total cost to a sophisticate if he incurs the effort cost e to avoid add-ons, and compare this to the cost if he does not. Under what condition will he put in the effort to avoid add-on charges? Assume for the rest of the question that this condition holds.

3. (c) Now suppose that the airline decides to stop pricing add-ons separately, and instead adds a compulsory “service fee” of $x that includes free access to beverages, wi-fi, carry-on baggage etc. How much in total will each airline client now pay?

4. (d) Explain why the sophisticates may not be happy about the new service fees, particularly if the fraction α of naive passengers is large.

Answer 1