Price Discrimination

Consider the prices airlines charge for a round-trip flight from New York to London. A coach-class ticket for a flight with a 7-day advance purchase is $1,100 if the passenger stays in London over a Saturday night. The ticket is $2,000 if the passenger returns without staying over a Saturday night. Can this price difference be explained by the difference in the cost to the airline of these round-trip flights? No, because it costs the airline the same amount to transport the passenger from New York to London and back, regardless of whether the passenger stays in London over a Saturday night. This difference in price is due to price discrimination.

Price discrimination is the practice of charging different customers different prices for the same product or service. How does price discrimination work in the airline example? The demand for airline tickets comes from two main sources: business travelers and pleasure travelers. Business travelers must travel to conduct business for their organizations, so their demand for air travel is relatively insensitive to price. Airlines can earn higher operating incomes by charging business travelers higher prices. Insensitivity of demand to price changes is called demand inelasticity. Also, business travelers generally go to their destinations, complete their work, and return home without staying over a Saturday night. Pleasure travelers, in contrast, usually don’t need to return home during the week and prefer to spend weekends at their destinations. Because they pay for their tickets themselves, pleasure travelers’ demand is price-elastic; lower prices stimulate demand while higher prices restrict demand. Airlines can earn higher operating incomes by charging pleasure travelers lower prices.

How can airlines keep fares high for business travelers while keeping fares low for pleasure travelers? Requiring a Saturday night stay discriminates between the two customer segments by taking advantage of their differential travel habits.

From a legal standpoint, the Robinson-Patman Act of 1936 and related laws specify that

1. Price discrimination is permissible if differences in prices can be justified by differences in costs.
2. Price discrimination is illegal only if the intent is to lessen or prevent competition.

In the airline situation, there is clearly no difference in cost in serving the two customer segments; however, the price discrimination is legal because the practice does not hinder competition.