JC Economics Essay Price Discrimination & Cartel Model Answers
In the Market Structures topic, one of the frequently tested question is on the concept of price discrimination. Even if you can skip this essay question, in your “A” Levels H2 Economics, you cannot afford to do if it appears in the H2 Case Study Question. And definitely not able to skip it in your JC1 Promos exams as there is easily one question for Market Structures. Worse, it may be a compulsory section on its own.
The theory says that any firm can price discriminate, as long as it fulfils 3 conditions, including possessing market power. Hence, even oligopoly firms can conduct price discrimination strategy to earn more revenue. Thus, firms in a collusion (ie cartel) can do even more damage to the market than when they are in competition mode.
(a) Air fares on Singapore Airlines (SQ) from Singapore to UK will cost more during peak period travelling seasons. Explain whether charging higher air fares during peak season is an example of price discrimination.
(b) The higher are fares are mutually arranged and agreed among the 26 members of Star Alliance. Discuss the possible impacts on SQ consumers If the arrangement among the Star Alliance members ended and fares are then left to competitive market forces.
JC Economics Essay – Price Discrimination
Definition: Price discrimination happens when a firm sells the same product to different groups of consumers at different prices when the price difference cannot be explained by differences in the cost of production.
Why PD: Increase total revenue
1st Deg: charging at reservation price of the consumer: auction
2nd Deg: charging the same consumer for different quantities purchased: car parking rates differ for first hour and subsequent hours
3rd Deg: charging different consumers different prices
(Question: for the new syllabus 9757, which of the type(s) of PD can we ignore?)
1: Explain how price discrimination can occur
Necessary Conditions for Price Discrimination
a. Firm must be price setter
For the firm to be price setter, it must have substantial market power. A perfectly competitive firm will not be able to price discriminate because consumers will have perfect information on the prices charged by other firms. In this context, the airline industry is one where firms are price setters. Legal barriers, need licence to operate. Enjoys EOS, natural BTE. This is consistent with the necessary conditions for PD as such market power allows airline group to determine the profit – maximizing price to charge the different time period.
b. Different PED for various submarkets
Different PED makes it profitable for the firm to charge different prices to maximize TR. In the market which is more price elastic, the firm can charge a lower price that qty dd will rise more than proportionately. Increasing price in market that is lower in PED will increase TR from that market. [note this is the practice of 3rd degree PD.]
The PED may differ during peak and non- peak season. During the peak season (such as June & December school holidays), demand for air travel is likely to be relatively price inelastic as passengers during this period are likely to be leisure travellers who has little alternatives to travel outside the holiday period. On the other hand, PED for air travel during non-peak season is likely to be more price elastic as travellers during the non-peak period may choose to travel any time of the year. Hence airfares are likely to be higher during peak period while during non-peak, the prices of air tickets are lower.
c. No resale between markets / individual possible
Such that the goods bought at a lower cost cannot be sold at a higher price (known as arbitrage). This maintains the ability of firms to sell their produces at different prices. Market segmented into peak & non-peak travel seasons. Resale between the 2 markets is not possible in this case as the tickets sold in during the peak period is only valid for travel within that time and not applicable for travel during the non-peak season.
The ability to price discriminate depends on certain conditions available. In this case, there is strong evidence that indicate the practice of PD in the long haul flight industry. While costs may be higher during peak period as airline companies may need to employ more staff and more frequent aircraft maintenance to handle the increased number of travellers during the peak period, this is non-conclusive. We do not have information on costs. Thus price differentials due to cost differences would be likely to justify.
Remarks by H2 Econs tutor:
1. The above is charging different price to different markets (3rd Deg). Do we need to highlight what type of PD is it?
2. As suggested in the signpost: Market segmented into peak & non-peak travel seasons. Resale between the 2 markets is not possible in this case as the tickets sold in during the peak period is only valid for travel within that time and not applicable for travel during the non-peak season.
JC Economics Essay – Cartel Breakdown
Suggested Answer for (b)
The change in market structure / behaviour. from cartel in collusion mode to cartel in competition mode
(Qn: can the change be to monopolistic competition mode?)
Airline companies in agreement form a cartel behaving like monopolist firms. However, when they end their agreement, the resultant market structure is likely to be one of a competitive oligopoly
How consumers may be affected depends on i) Prices and hence consumer surplus, ii) Non-price development such as product variety and improvements, leading to consumer welfare
Benefits to consumers
Lower airfares in SR
With the ending of collusion, competition heightens and each airline would try to reduce the airfares in an attempt to capture a larger market share. A simultaneous reduction by all airlines will trigger a price war and the result of this is an increase in consumer surplus as shown by fig. 1. When price falls from PO to P1, consumer surplus increases from AP C to AP,Y
(Sketch typical DD curve)
Variety in SR
As airline companies become a competitive oligopolistic market, competition increases and they would resort to non-price competition in order to gain market share. They might engage in product and process development such as the provision of more unique cabin services. As such, consumers may hence benefit through an increase in consumer welfare. Or more frequent flights, different timings, etc.
No Benefits to consumers
Prices may not fall cos of Price Rigidity
Prices may be stable under a competitive oligopoly due to the mutual interdependent nature of the companies, hence a reluctance to change equilibrium price. Each company would face a kinked demand curve (as below), with a range of changes in costs over which the company will not change its price. As a result of price rigidity, consumers may not necessarily benefit through the increase in consumer welfare brought about by a fall in prices of air fares, as illustrated previously.
(Not necessary, although you may sketch the Kinked-demand curve DIAGRAM)
Although airline companies ended their agreement (i.e. cartel has been broken), the resultant market structure may not be a competitive oligopoly but remain collusive through price leadership instead. Airline companies may follow the pricing decisions of a dominant company which seeks to set a price which will maximize its own profits. In this case, consumer surplus may not rise.
(Again for 9757 syllabus, price leadership or barometric firm models are not required.)
The collusive oligopoly that the airline industry took on previously provided a bigger scope for reaping EOS as the few dominant companies could gain from cost advantages of combined, large scale production. Now that agreement has ended, there is a smaller scope for reaping EOS – costs may rise resulting in higher prices → fall in consumer surplus. [Diagram, and you can even specify one type of internal EOS]
In the long run, the market concentration will increase as less efficient airlines close down. Also, the govt may intervene to save the national carrier resorting to protectionism – making many local destinations a monopoly of the local carrier and many limit international flights by other airlines into its own airports. Increased mkt power and lowered scope for EOS translate to higher airfares – lowers consumer surplus.
As for non-price competition,
Rising advertising costs Stiff competition amongst firms that result for the need to advertise excessively increases operating costs. Advertising serves as a fixed cost that will increase the unit cost of production. In turn, prices will be increased if firms seek to pass on the higher costs, reducing consumer surplus.
Long Run: Less product/process development Increased mkt power with exit of inefficient firms or protectionism of national carriers + lowered scope for cost savings + → less choice + lower profitability and weakened incentive to engage in product development, innovation and even R&D→ loss of welfare, quality
EV: depends on
– tendency of behaviour, conditions of collusion..
– The characteristics of the market or the economy may also determine the impact on consumers / society ( For example, Singapore, being small and open, will it matter if we have a few dominant firms in the market?)
– ( What are evaluation options can you come up with? More evaluation ideas in our Post-Prelims Econs intensive lessons.)