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Second-Degree Price Discrimination Example In class on Monday and Tuesday (9/17-18) we went through the second degree price discrimination example involving a company selling airline tickets to tourists and businesspeople. The following slide, included in your handouts, laid out the example: [pic] As the solutions to the problem set explain, the way to approach these problems is to think through possible pricing strategies the company might want to use, such as selling to all consumers, selling only to the high willingness to pay consumers or selling to both consumers using a second degree price discrimination strategy.
Strategy 1 involves setting one price (a simple, as opposed to advanced, pricing strategy) low enough so that both types of consumers would buy the tickets. Since tourists’ maximum willingness to pay is $300, this is the maximum the company could charge them, hence the maximum they could charge for the ticket under this strategy. Strategy 2 also involves setting one price but ignoring the tourists (pricing them out of the market) and only selling to the businesspeople.
If the company is going to do this, it should offer the high quality product (the unrestricted ticket) and charge the business people their maximum willingness to pay for it, $800. Strategy 3 is a set up to get you to think about the constraints a company faces in trying to do second-degree price discrimination. The key here is to see that if the company tried to offer an unrestricted ticket for $800 and a restricted (Saturday-night-stay) ticket for $300, the businesspeople would buy the restricted ticket because that gives them the most consumer surplus ($100 versus $0 for the unrestricted ticket).
You should think of consumers as deciding between spending money on the good in question (here an airline ticket) and saving their money. That’s one way to think of consumer surplus???money they would have been willing to spend on the good in question, but are happy to save to spend on something else. Here, the businesspeople are willing to spend up to $400 for a Saturday-night-stay ticket and up to $800 for an unrestricted ticket. For instance, if the only option were a $900 ticket, they would not buy anything (and, for instance, hold the client meeting by phone).
You can think of the difference between the businesspeople’s willingness to pay for restricted and unrestricted as the maximum amount they are willing to spend to be back on Saturday (e. g. , the value they would place on seeing a youth soccer game). Given that the prices offered under Strategy 3 would require them to spend more than $400 extra to be back on Saturday, they would opt for the restricted ticket, so Strategy 3 would be identical to Strategy 1. Here is the slide that was omitted from your handout: [pic]
Strategy 4 is the second-degree price discrimination strategy. Since $300 is the maximum the company can charge for the restricted ticket and still be ensured that the tourists will buy it, and the maximum the businesspeople are willing to pay to be back on Saturday is $400, the maximum the company can charge for the unrestricted ticket under a price discrimination strategy is $700 (I’ve made it $699 to ensure that the businesspeople get MORE consumer surplus, by $1, from the restricted ticket, so that they will clearly buy that rather than the restricted ticket).
The basic message is that companies need to be careful not to make the low price, low quality option too attractive (i. e. they can’t make its quality too high or price too low), because otherwise, too many consumers who would have bought the high price, high quality option will buy it instead. On the other hand, if offering a low price, low quality option forces the company to reduce the price of the high quality, high price option by too much, the company may give up on serving the consumer group with the lower willingness to pay. For instance, MAXjet offers all business class service to Europe from Washington and New York.