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CHAPTER 9: Price Discrimination

This chapter considers nonlinear pricing and price discrimination.

Price Discrimination : Nonuniform pricing in which a firm

1. charges different categories of consumers different unit

(uniform) prices for the identical good, or

2. charges each consumer a nonuniform price on different units of

the good

Price difference due to different cost is not price discrimination.

1. Which differences in price is due to price discrimination?

Price of gasoline in Onalaska

Price of gasoline near downtown La Crosse

Price of gasoline in La Crescent

Price of gasoline in Minneapolis

2. Is a quantity discount for large purchases price discrimination?

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Purpose :

Practice of setting different prices for the same good so as to capture

as much Consumer Surplus (CS) as possible.

Incentive: Maximize profits.

Conditions for Price Discrimination:

1. Market power

2. Identifying different willingness-to-pay

For individuals

For groups of individuals

3. Prevent or limit resales (no arbitrage)

Cost Test for Price Discrimination:Price discrimination exists if the ratio of prices across markets is

different from the ratio of marginal costs. (In perfectly competitive

market the law of one price holds)

When is Price Discrimination a Problem?When used to lessen competition

Predatory pricing impacting direct competitors ( primary-line

price discrimination )

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Types of Price Discrimination

Perfect Price Discrimination or 1 st Degree Price Discrimination:

Also called personalized pricing. Set different prices (at maximum

willingness-to pay) for each buyer and for each unit sold, extracting

all the CS.

Examples: small town doctor, auto sales

Case 1: Each consumer buys one unit.

Charge the maximum willingness-to-pay for each consumer and

capture all the CS. The price to the marginal consumer = MC and

output sold is identical to perfect competition. No efficiency loss, but

income distribution is impacted.

Case 2: Each consumer buys more than one unit.

1. Quantity dependent prices that extracts all the CS

2. Two-part tariff : Lump-sum fee for right to purchase product

equal to CS and price equal to MC

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3rd Degree Price Discrimination [group pricing]:

Seller separates consumers into two or more groups by distinguishing

different buyer characteristics (demand elasticities must differ). The

market is segmented with different prices charged to different groups.

Examples: Senior discount, student discount, geographical location

Note: MR = P [ 1 + (1/ D)]

In each market segment, i, profit maximizing firm wants MR i = MC

So, MC = P 1 [ 1 + (1/ D1)] = P 2 [ 1 + (1/ D2)] or

P 1 / P 2 = [ 1 + (1/ D2)] / [ 1 + (1/ D1)]

Charge lower price in those market segments with greater priceelasticity.

Segmenting the market may be difficult:

Student or senior discount

Airline travel (tourist discount) Discount coupons or rebates

Queuing or waiting

Informed versus uninformed

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2nd Degree Price Discrimination [menu pricing or nonlinear pricing]:

(see Chapter 10 under Nonlinear Pricing)

Two cases:

1. Consumers self-select from a menu since the seller can only

distinguish buyers indirectly. Examples include airline price

discrimination (get lower fare if selecting a Saturday night stay

over) or quantity discounts (get lower prices if selecting higher

quantities).

2. Two-Part Tariff charges a customer a lump-sum fee for the right

to purchase and a usage charge per unit. Ideally, the firm would

like the usage charge or price to be MC (if MC is constant) andthe lump-sum fee to be Consumer Surplus (CS). The average

price will vary (hence nonlinear). In special cases the two-part

tariff can extract all the CS.

Examples: Club memberships (e.g. golf club), car leasing,Polaroids instant-picture camera

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Welfare Effects

Perfect

Competition

MonopolyUniform price

1st Degree

P.D.

Two-Part

Tariff Price MC P Final unit =

MC

Fixed = CS

Price = MCCS A+B+C B 0 0PS 0 C A+B+C A+B+CWelfare A+B+C B+C A+B+C A+B+CDeadweight

Loss

0 A 0 0

Comparisons with non-discriminating monopolist

A

B

C

MC

Pm

m

m

M

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1. No deadweight loss with PC, 1 st Deg PD, or 2-part tariff.

2. Welfare and efficiency

3. In 1 st Deg PD and 2-part tariff: CS (fairness ) ?

4. Consumers pay different prices, but more consumers are served

Welfare and 3 rd Degree Price Discrimination

More complicated in analyzing welfare implications.

1. Within each group P > MC

2. With no arbitrage, lose gains from trade

3. Consumers expend resources to obtain lower prices

4. Welfare may be higher than non-discriminating monopolist if the

deadweight loss is smaller

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Price Discrimination and Antitrust

Price discrimination was originally outlawed by section 2 of the

Clayton Act in 1914 if it lessened competition. This law was weak and

strengthened by the Robinson-Patman Act of 1936 in response to

political pressure from small grocery stores.

1. Predatory pricing that harms direct competitors also called

primary-line price discrimination

2. Secondary-line price discrimination , leads to harm among the

customers

3. Tie-in sales

Tie-in Sales (see Chapter 10 and 19) May increase efficiency

May also be used strategically to harm rivals

1. Bundling (package tie-in sales):

Two or more products are sold in fixed proportions2. Requirements tie-in :

In order to purchase one product, you are required to

purchase another product

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Bundling

Pure Bundling: Must buy package deal

Mixed Bundling: Choice between package deal and separate items

Example: 1. Movie distribution package bad movie in with good.

2. Software suite of wordprocessor (WP) and spreadsheet (SS)

Consider the case where MC = 0, so firm wants to max Revenue

Willingness-to-Pay

User Type # WP SS

Writer 40 $50 0

Number Cruncher 40 0 $50Generalist 20 $30 $30

Strategies Revenue

Sell each at $30 40($30) + 40($30) + 20($30+$30) = $3600

Sell each at $50 40($50) + 40($50) = $4000Sell Package @ $50 40($50) + 40($50) + 20($50) = $5000

Ea.@$50 or Package@$60 40($50) + 40($50) + 20($60) = $5200

Pure bundle yields $5000. Mixed bundle yields $5200.

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Example of Profitable Package Tie-in (MC = 0)

Type 1 Type 2

Consumers Consumers

Amount ($) Willing-to-pay for A 9,000 10,000

Amount ($) Willing-to-pay for B 3,000 2,000

Willing-to-pay for A & B together 12,000 12,000

Max Revenue selling A @ $9,000 and B @ $2,000 = $22,000

Max Revenue selling Package @ $12,000 = $24,000

Note the Price Discrimination

1 pays $9,000 for A and $3,000 for B

2 pays $10,000 for A and $2,000 for B

Example of Unprofitable Package Tie-in (MC = 0)Type 1 Type 2

Consumers Consumers

Amount ($) Willing-to-pay for A 9,000 10,000

Amount ($) Willing-to-pay for B 500 2,000

Willing-to-pay for A & B together 9,500 12,000

Max Revenue selling A @ $9,000 and B @ $2,000 = $20,000

Max Revenue selling Package @ $9,500 = $19,000

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Requirements Tie-in

Consumers (or businesses) buy one good and are then required to

make all of their purchases of some related good from the same

manufacturer.

Company Good Tied good at above competitive price

IBM keypunch tabulating cards

AB Dick mimeograph ink

Amer Can can closing can requirements

Others

High users of the tied good are in effect paying a high price for the

machine. This raises profit for the monopoly.

Problem: Foreclosure . Monopolist may extend monopoly to the tied

good.

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Distribution Effects

Trade-offs:

Efficiency vs. Consumer Welfare

(favors PD) (favors uniform pricing)

Making good accessible vs Fairness

To many consumers (no arbitrage)

(favors PD) (favors uniform pricing)

Distributional effects from PD are that producers gain, consumers

lose. Likely to increase inequality (negative), but may increasewelfare (CS + PS) over uniform monopoly pricing (positive).

Effect on Competition :

1. If done by small, fringe firms, PD may be positive by keepingcompetitors in business.

2. Systematic PD by dominant firms may lead to predation or

foreclosure and therefore harmful to competition.