Model:

The XYZ airline company has two types of customers business travellers and non- business
travellers/ Tourists. We assume that the Non- business travellers, tourists are in the ratio of 60: 40.

The table below shows the maximum willingness to pay based on the time of booking along with the
cost of providing the two services and potential profits available

Time of Airline’s Cost Reservation Price Potential profits

booking Tourists Business Tourists Business
Early booking 200 240 330 40 125

Last minute 200 275 400 75 200

booking

Solution:

Calculations before Screening:

Profit incurred for the airlines = (240-200) *60+(400-200) *40 = 2400+8000 = 10,400

Different Ticketing Versions:

In the above table there is no discrimination to detect if the customers are tourist or business class.
In such a case airline can`t charge 400 from business class customers for the last-minute booking of
business class. There should be some incentive in place for the business class customers to go for
last minute bookings, as of now it appears that the business class customers will prefer to book early
since the price is lower when they book early.

Business class people buy on time tickets and also will be willing to pay 330 and get an extra benefit
of (330-240) =90. Therefore, they would be switching to book on time rather than last minute
booking.

So, the last-minute booking fare for the business class should be changed to 400-90 = 310.

Airlines can`t charge more than 400 for the business class. Since airlines will not have any surplus,
prompting customers to shift to on time booking resulting in screening failure.

For 150 customers profit would turn out to be = 240-200*150 = 6000

After the Screening:

Time of Airline’s Cost Reservation Price Potential profits

booking Tourists Business Tourists Business
Early booking 200 240 330 40 125

Last minute 200 275 310 75 200

booking

Airlines can at max charge 310 from the business class customers. Airlines can still charge 240 from
economy who looks to book early on time.

In this case the total profit turns out to be = (240-200) *60+(310-200) *40=2400+4400=6800
This profit of 6800 is greater than 6000. Airlines need to ensure they don`t defect to making the
choice that it intends for tourists.

Such a requirement or constraint in screening strategy arises on all problems of mechanism design
and is called incentive compatibility constraint.

Only way airlines can charge more than 310 without inducing their defection would be to increase
the on time booking price.