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Airline Fares:Elasticities of Demand for Air Travel, The Two-Part Tariff

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Microeconomics ­ECO402
VU
­
Lesson 36
Airline Fares
Differences in elasticities imply that some customers will pay a higher fare than others.
Business travelers have few choices and their demand is less elastic.
Casual travelers have choices and are more price sensitive.
Elasticities of Demand for Air Travel
Elasticity
First-Class
Economy Plus Economy
Price
-0.3
-0.4
-0.9
Income
1.2
1.2
1.8
The airlines separate the market by setting various restrictions on the tickets.
­  Less expensive: notice, stay over the weekend, no refund
­  Most expensive: no restrictions
Intertemporal Price Discrimination and Peak-Load Pricing
Separating the Market With Time
­  Initial release of a product, the demand is inelastic
­Book
­Movie
­Computer
­  Once this market has yielded a maximum profit, firms lower the price to appeal to a
general market with a more elastic demand
­Paper back books
­Dollar Movies
­Discount computers
Consumers are divided
$/Q
into groups over
Over time, demand
time.Initially, demand  becomes more elastic
P1
is less elastic resulting  and price is reduced
in a price of P1 .
to appeal to the mass
market.
P2
D2 = AR2
AC = MC
MR2
D1 = AR1
MR1
Q1
Q2
Quantity
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Microeconomics ­ECO402
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Peak-Load Pricing
­  Demand for some products may peak at particular times.
­Rush hour traffic
­Electricity - summer season
­Restaurants on weekends
­  Capacity restraints will also increase MC.
­  Increased MR and MC would indicate a higher price.
­  MR is not equal for each market because one market does not impact the other market.
$/Q
MC
Peak-load
price = P1 .
P1
D1 = AR1
Off- load
price = P2 .
P2
MR1
D2 = AR2
MR2
Q
Q
Quantity
How to Price a Best Selling Novel
What Do You Think?
1) How would you arrive at the price for the initial release of the hardbound
edition of a book?
2) How long do you wait to release the paperback edition? Could the
popularity of the book impact your decision?
3) How do you determine the price for the paperback edition?
The Two-Part Tariff
The purchase of some products and services can be separated into two decisions, and
therefore, two prices.
Examples
1)Amusement Park
­Pay to enter
­Pay for rides and food within the park
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Microeconomics ­ECO402
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2)Tennis Club
­Pay to join
­Pay to play
3) Safety Razor
­Pay for razor
­Pay for blades
4) Polaroid Film
­Pay for the camera
­Pay for the film
Pricing decision is setting the entry fee (T) and the usage fee (P).
Choosing the trade-off between free-entry and high use prices or high-entry and zero use
prices.
Two-Part Tariff with a Single Consumer
$/Q
Usage price P*is set
where
T
MC = D. Entry price T*
is equal to the entire
consumer surplus.
M
P
D
Quantity
The price, P*, will be
T*
$/Q
greater than MC. Set T*
at the surplus value of D2.
š = 2T  * + (P* - MC) x(Q1 + Q2 )
A
š more than twice ABC
P*
MC
B
C
D1 = consumer 1
D2 = consumer 2
Quantity
Q2
Q1
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Microeconomics ­ECO402
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Two-Part Tariff with Two Consumers
The Two-Part Tariff With Many Different Consumers
­  No exact way to determine P* and T*.
­  Must consider the trade-off between the entry fee T* and the use fee P*.
­Low entry fee: High sales and falling profit with lower price and more entrants.
­  To find optimum combination, choose several combinations of P,T.
­  Choose the combination that maximizes profit.
š =ša +šs =n(T)T +(P-MCQ(n)
)
Profit
n=entrants
Total profit is the sum of the
profit from the entry fee and
the profit from sales. Both
depend on T.
š Total
ša: entry fee
šS: sales
T
T*
Rule of Thumb
­  Similar demand: Choose P close to MC and high T
­  Dissimilar demand: Choose high P and low T.
Two-Part Tariff With A Twist
­  Entry price (T) entitles the buyer to a certain number of free units
­Razors with several blades
­Amusement parks with some tokens
­On-line with free time
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Table of Contents:
  1. ECONOMICS:Themes of Microeconomics, Theories and Models
  2. Economics: Another Perspective, Factors of Production
  3. REAL VERSUS NOMINAL PRICES:SUPPLY AND DEMAND, The Demand Curve
  4. Changes in Market Equilibrium:Market for College Education
  5. Elasticities of supply and demand:The Demand for Gasoline
  6. Consumer Behavior:Consumer Preferences, Indifference curves
  7. CONSUMER PREFERENCES:Budget Constraints, Consumer Choice
  8. Note it is repeated:Consumer Preferences, Revealed Preferences
  9. MARGINAL UTILITY AND CONSUMER CHOICE:COST-OF-LIVING INDEXES
  10. Review of Consumer Equilibrium:INDIVIDUAL DEMAND, An Inferior Good
  11. Income & Substitution Effects:Determining the Market Demand Curve
  12. The Aggregate Demand For Wheat:NETWORK EXTERNALITIES
  13. Describing Risk:Unequal Probability Outcomes
  14. PREFERENCES TOWARD RISK:Risk Premium, Indifference Curve
  15. PREFERENCES TOWARD RISK:Reducing Risk, The Demand for Risky Assets
  16. The Technology of Production:Production Function for Food
  17. Production with Two Variable Inputs:Returns to Scale
  18. Measuring Cost: Which Costs Matter?:Cost in the Short Run
  19. A Firm’s Short-Run Costs ($):The Effect of Effluent Fees on Firms’ Input Choices
  20. Cost in the Long Run:Long-Run Cost with Economies & Diseconomies of Scale
  21. Production with Two Outputs--Economies of Scope:Cubic Cost Function
  22. Perfectly Competitive Markets:Choosing Output in Short Run
  23. A Competitive Firm Incurring Losses:Industry Supply in Short Run
  24. Elasticity of Market Supply:Producer Surplus for a Market
  25. Elasticity of Market Supply:Long-Run Competitive Equilibrium
  26. Elasticity of Market Supply:The Industry’s Long-Run Supply Curve
  27. Elasticity of Market Supply:Welfare loss if price is held below market-clearing level
  28. Price Supports:Supply Restrictions, Import Quotas and Tariffs
  29. The Sugar Quota:The Impact of a Tax or Subsidy, Subsidy
  30. Perfect Competition:Total, Marginal, and Average Revenue
  31. Perfect Competition:Effect of Excise Tax on Monopolist
  32. Monopoly:Elasticity of Demand and Price Markup, Sources of Monopoly Power
  33. The Social Costs of Monopoly Power:Price Regulation, Monopsony
  34. Monopsony Power:Pricing With Market Power, Capturing Consumer Surplus
  35. Monopsony Power:THE ECONOMICS OF COUPONS AND REBATES
  36. Airline Fares:Elasticities of Demand for Air Travel, The Two-Part Tariff
  37. Bundling:Consumption Decisions When Products are Bundled
  38. Bundling:Mixed Versus Pure Bundling, Effects of Advertising
  39. MONOPOLISTIC COMPETITION:Monopolistic Competition in the Market for Colas and Coffee
  40. OLIGOPOLY:Duopoly Example, Price Competition
  41. Competition Versus Collusion:The Prisoners’ Dilemma, Implications of the Prisoners
  42. COMPETITIVE FACTOR MARKETS:Marginal Revenue Product
  43. Competitive Factor Markets:The Demand for Jet Fuel
  44. Equilibrium in a Competitive Factor Market:Labor Market Equilibrium
  45. Factor Markets with Monopoly Power:Monopoly Power of Sellers of Labor