Question

Consider an airline trying to sell plane tickets to business travellers and tourists. The airline cannot distinguish between the two at the point of sale, but knows that in general, business travelers have higher willingness to pay for better seats. Let Pf and Pc be the price of first class and coach tickets respectively. Suppose that business travelers are willing to pay $1000 for a first class seat and $400 for a coach seat, whereas tourists are willing to pay $500 for a first class seat and $300 for a coach seat.

(a) If the airline wants to implement second-degree price discrimination so that business travelers buy first class seats and tourists buy coach seats, what are the incentive compatibility constraints they face?

(b) Using your incentive compatibility constraints, find the price that the airline will charge for a coach seat.

(c) What are the information rents that the airline must leave to business travelers? What is the price of a first class seat?

Answer 1

One of the few implementation benefits of second degree price discrimination is that business travellers require comfort and need to be business ready upon arrival hence their spending capacity is a lot higher than the rest of the tourists who would be interested in only the coach seats.

The incentive compatibility constraint ensures that the employees are motivated to act in the owner’s interest.

The airline will sell First class seats to business travellers and coach seats to tourists because it will benefit them in monetary terms.

Tourists can even raise their voice why business seats are not available for them, the company will definitely understand their customers better and can say that you cannot pay as per business traveller and because of this scenario or monopoly they can discriminate in air fare prices.

This helps in solving the implementation of second degree price discrimination between business class and coach passengers