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Asia-Pacific Journal of Accounting &
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Production efficiency, input price
discrimination, and social welfare
Kuo-Feng Kao
a
& Cheng-Hau Peng
b
a
Department of Industrial Economics , Tamkang University ,
Taipei , Taiwan
b
Department of Economics , Fu Jen Catholic University , Taipei ,
Taiwan
Published online: 22 May 2012.
To cite this article: Kuo-Feng Kao & Cheng-Hau Peng (2012) Production efficiency, input price
discrimination, and social welfare, Asia-Pacific Journal of Accounting & Economics, 19:2, 227-237,
DOI: 10.1080/16081625.2012.667382
To link to this article: http://dx.doi.org/10.1080/16081625.2012.667382
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and-conditions
Production efciency, input price discrimination, and social welfare
Kuo-Feng Kao
a
and Cheng-Hau Peng
b
*
a
Department of Industrial Economics, Tamkang University, Taipei, Taiwan;
b
Department of
Economics, Fu Jen Catholic University, Taipei, Taiwan
(nal version received 10 September 2010)
This paper re-examines the welfare implications of input price discrimination by
considering the possibility of the structural change in the nal goods market.
When the marginal cost difference is moderate, price discrimination is more
socially desirable as the upstream rm serves more downstream rms under
price discrimination than uniform pricing. Surprisingly, when the marginal cost
difference is sufciently large, although the upstream monopolist serves more
downstream rms and more outputs are produced under price discrimination than
uniform pricing, the social welfare is lower under price discrimination. This
result runs against those prevailing in the literature without market structural
change.
Keywords: production efciency; price discrimination; vertically related markets
JEL Codes: L13, L16, L43
1. Introduction
The relative merits of third-degree price discrimination (discriminatory pricing) and uni-
form monopolistic pricing (uniform pricing) have become issues of much concern, with
numerous studies on this theme having been published and debated ever since the Rob-
insonPatman Act and the so-called price protection policies were enforced by the US
government.
Assuming that the demand curves are linear, Robinson (1933) rst points out that
the total output is unchanged after price discrimination. Along this line, Schmalensee
(1981) re-examines Robinsons results by introducing an N-market model with non-lin-
ear demands. He shows that discriminatory pricing will be welfare enhancing only if
the industry output increases. Varian (1985) extends the ndings in Schmalensee (1981)
by assuming interdependent demands and increasing marginal cost. He derives the
boundary for welfare improvement if the monopolist switches from uniform pricing to
discriminatory pricing.
The aforementioned papers all conclude that, if demands are linear, price discrimi-
nation decreases social welfare. However, this result may not hold if the model is
revised to consider the location of a monopolistic rm, the market structure, or the
trade cost; see, e.g. Holahan (1975), Hausman and MacKie-Mason (1988), and
Hwang and Mai (1990). Holahan (1975) shows that, when the market area is endoge-
nous, a nal good monopolist will serve more consumers under discriminatory pricing
*Corresponding author. Email: chpon@mail.fju.edu.tw.
Asia-Pacic Journal of Accounting & Economics
Vol. 19, No. 2, August 2012, 227237
ISSN 1608-1625 print/ISSN 2164-2257 online
2012 City University of Hong Kong and National Taiwan University
http://dx.doi.org/10.1080/16081625.2012.667382
http://www.tandfonline.com
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than under uniform pricing and the welfare effect of price discrimination is reversed.
Hausman and MacKie-Mason (1988) nd that third-degree price discrimination by patent
holders can raise social welfare if new markets are served. Hwang and Mai (1990)
employ a spatial model (the so-called barbell model) to investigate optimal locations of a
monopolistic rm and nd that, when the monopolistic rms location is endogenous,
the welfare under discriminatory pricing is superior to that under uniform pricing in
some circumstances.
Most of the studies in the early years tended to focus only on a market relating to a
nal good. Nowadays, however, given the growth in global supply chains which has
bound national economies tightly together, the importance of the input markets cannot
be ignored. Katz (1987) rst discusses third-degree price discrimination in input mar-
kets. He concludes that price discrimination is welfare enhancing only if the down-
stream chain stores are inefciently backward integrated. However, if downstream
rms marginal production costs are different and neither downstream rm can integrate
backward, price discrimination in input markets necessarily lowers social welfare as it
distorts market efciency by charging the efcient (inefcient) downstream rms a
higher (lower) input price. DeGraba (1990) also concludes that price discrimination will
suppress the downstream rms incentives to adopt new technology and thus lowers
social welfare. Yoshida (2000) employs a generalized model to show that an increase in
the total output of the nal good is a sufcient condition for deterioration in welfare as
the discriminatory pricing deepens the market inefciency of the downstream produc-
tion. However, these studies examine the welfare effect and the output of industry in a
vertically related market without considering the possibility of the structural change in
the nal goods market.
In practice, the pricing policy of an upstream monopolist may affect the downstream
market structure. Under uniform pricing, the upstream rm sells the intermediate good
to the downstream rms at the same price, which may drive the inefciency rm out of
the nal goods market. However, under discriminatory pricing, the upstream rm is able
to charge the inefcient (efcient) downstream rm a lower (higher) input price, which
may induce inefcient downstream rms to stay in the nal goods market. To ll this
gap in the literature, in this paper, we extend DeGraba (1990) by considering the possi-
bility of the structural change of the nal goods market and set out to examine whether
uniform pricing is superior to discriminatory pricing in terms of social welfare.
The major ndings of this paper are as follows. Whether discriminatory pricing is
superior to uniform pricing is contingent upon the marginal cost difference of the down-
stream rms. More specically, when the marginal cost difference between the two
downstream rms is small and the market structure is not affected by the pricing strat-
egy of the upstream rm, uniform pricing is superior to discriminatory pricing. How-
ever, when the marginal cost difference is moderate, price discrimination is socially
more desirable if more downstream rms are served. This result is similar to the main
contribution of Hausman and MacKie-Mason (1988). More surprisingly, when the mar-
ginal cost difference between the two downstream rms is sufciently large, our result
is sharply against the result of Hausman and MacKie-Mason (1988). We show that
although more downstream rms are served and more output are produced under dis-
criminatory pricing, the social welfare is lower as it distorts the downstream rms pro-
duction efciency. This nding is very striking as it is contrary to the conventional
wisdom in which the welfare under duopoly is necessarily higher than that under
monopoly. We also explore the case in which the nal good markets are separated and
nd that the social welfare under discriminatory pricing is higher than that under uni-
228 K.-F. Kao and C.-H. Peng
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form pricing as long as there are more downstream rms to be served under discrimina-
tory pricing.
The remainder of this paper is organized as follows. In Section 2, we introduce our
basic model. Section 3 examines the social welfare under the two pricing schemes.
Section 4 compares their social welfare. We extend the model and investigate the wel-
fare effect of price discrimination when the downstream markets are independent in
Section 5. Section 6 concludes this paper.
2. The model
Assume that there are two downstream rms, Firms 1 and 2, which purchase an intermedi-
ate good to produce a homogeneous nal good and compete in Cournot fashion in the nal
goods market. There is an upstream monopolist who is the only supplier of the intermedi-
ate good. Under the discriminatory pricing regime, the upstream monopolist sells the inter-
mediate good to Firms 1 and 2 at different prices (w
1
and w
2
). In contrast, under the
uniform pricing regime, the upstream monopolist can only sell the intermediate good to
Firms 1 and 2 at a uniform input price (w). To facilitate our analysis, we assume that the
downstream rms, together with transaction costs c
1
and c
2
, use one unit of the intermedi-
ate good to produce one unit of the nal good. Without loss of generality, we further
assume that xed costs are zero and c
1
is smaller than c
2
, that is, c
2
c
1
= h.
1
The inverse
market demand for the nal goods is set to be linear and can be expressed as:
P = a x
1
x
2
where x
1
and x
2
are the sales of Firms 1 and 2, respectively, and the downstream mar-
ket is integrated.
2
Given this setting, the respective prot functions for Firms 1 and 2,

1
and
2
, can be written as:

i
(x
i
; x
j
) = (P w
i
c
i
)x
i
for i; j = 1; 2 and i ,= j (1)
In addition, the prot function of the upstream monopolist can be specied as
follows:
=
P
2
i=1
w
i
x
i
under discriminatory pricing;
w
P
2
i=1
x
i
under uniform pricing:
8
>
>
<
>
>
:
The game involving the model comprises two stages. In the rst stage, the upstream
monopolist determines its optimal prices (w
1
and w
2
in the discriminatory pricing case,
and w in the uniform pricing case) for the intermediate good. In the second stage, taking
the price(s) of the intermediate good as given, Firms 1 and 2 engage in Cournot competi-
tion in the nal goods market. The sub-game perfect Nash equilibrium is solved through
backward induction by rst considering the second stage (the decisions taken by Firms 1
and 2), followed by the rst stage (the decision taken by the upstream monopolist).
3. The equilibria of the two pricing policies
We proceed to derive the equilibrium for discriminatory pricing and uniform pricing,
respectively, in Sections 3.1 and 3.2.
Asia-Pacic Journal of Accounting & Economics 229
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3.1. The equilibrium under discriminatory pricing
Based on our earlier assumptions, Firms 1 and 2 compete in Cournot fashion in the
nal goods market. By differentiating (1) with respect to x
i
, we can derive the rst-
order conditions for prot maximization as follows:
d
i
dx
i
= P P
/
x
i
w
i
c
i
= 0 for i; j = 1; 2 and i ,= j (2)
To facilitate our analysis and to simplify our notation, we let the marginal cost of
Firms 1 and 2 be c and c h, respectively. By solving (2), we can derive the outputs
of Firms 1 and 2 as follows:
3
x
1
=
1
3
(a 2w
1
w
2
c h) and x
2
=
1
3
(a w
1
2w
2
c 2h) (3)
In the case of price discrimination, the prot of the upstream rm can be expressed
as follows:
= w
1
x
1
w
2
x
2
By taking the rst-order conditions with respect to w
1
and w
2
, we can derive the
optimal input prices as follows:
w
1
=
1
2
(a c) and w
2
=
1
2
(a c h) (4)
Substituting (4) into (3), we can obtain the outputs for the nal goods, the upstream
and downstream rms prots, and the resulting social welfare as follows:
x
1
=
1
6
(a c h) and x
2
=
1
6
(a c 2h)

1
=
1
6
(a c h)

2
and
2
=
1
6
(a c 2h)

2
=
1
6
[(a c)
2
(a c)h h
2
[
SW =
1
72
[20(a c)(a c h) 23h
2
[ (5)
We also assume that the prot of Firm 2 is non-negative to ensure that the structure
of the downstream market to be duopolistic, which requires h\h
+
= (a c)=2. Other-
wise, the nal goods market becomes monopolistic, which changes the prot of the
upstream monopolist as well as the corresponding social welfare. Thus, we make this
result as the following lemma.
230 K.-F. Kao and C.-H. Peng
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Lemma 1
Under discriminatory pricing, the inefcient downstream rm is driven out of the nal
goods market only if the difference in marginal production costs between the two down-
stream rms is sufciently large (i.e. h[h
+
= (a c)=2)
When h is large enough (h[(a c)=2) such that Firm 2 is too inefcient to produce
in the nal goods market, the market structure becomes the one of successive monop-
oly. Under such a circumstance, Firm 1s prot function can be expressed as follows:

M
= (P w
M
c)x
M
where variables with a subscript M indicate that they are associated with the case of
successive monopoly. By taking the rst-order condition with respect to x
M
, we can
derive the optimal output for Firm 1 under the monopoly case as follows:
x
M
=
1
2
(a w
M
c) (6)
Furthermore, the prot function of the intermediate good supplier can be written as:

M
= w
M
x
M
By differentiating the above equation with respect to w
M
, we can derive the optimal
input price as follows:
w
M
=
1
2
(a c)
By substituting w
M
into (6), the equilibrium output, the prot, and the resulting
social welfare can be derived as follows:
4
x
M
=
1
4
(a c)

M
=
1
4
(a c)

2

M
=
1
8
(a c)
2
SW
M
=
7
32
(a c)
2
(7)
3.2. The equilibrium under uniform pricing
We now begin our analysis for the uniform pricing case. By substituting ^ w = w
1
= w
2
into (3), we can derive the output of the downstream rms in the second stage as
follows:
Asia-Pacic Journal of Accounting & Economics 231
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^x
1
=
1
3
(a ^ w c h) and ^x
2
=
1
3
(a ^ w c 2h) (8)
where variables with a hat ^ indicate the equilibrium is associated with the uniform
pricing.
The prot of the upstream rm under uniform pricing is as follows:
^
= ^ w(^x
1
^x
2
)
Taking the rst-order condition with respect to ^ w, we can derive the optimal input
price as follows:
^ w =
1
4
(2a 2c h) (9)
By substituting (9) into (8), we can derive the equilibrium outputs for the nal
goods, the upstream and downstream rms prots, and the resulting social welfare as
follows:
^x
1
=
1
12
(2a 2c 5h) and ^x
2
=
1
12
(2a 2c 7h)
^

1
=
1
12
(2a 2c 5h)

2
and
^

2
=
1
12
(2a 2c 7h)

2
^
=
1
24
(2a 2c h)
2
^
SW =
1
72
[20(a c)(a c h) 41h
2
[ (10)
As the upstream monopolist has the rst-mover advantage, it shall set ^ w = w
M
if

M
[
^
, that is, h[(2

3
_
)(a c) = h
+
. Again, in such a circumstance, Firm 2 is dri-
ven out of market and the nal goods market is monopolized by Firm 1.
5
Given the
above discussion, we can summarize this result in the following proposition.
Proposition 1. If the marginal cost difference between the two downstream rms is
large enough (i.e. h[(2

3
_
)(a c) and price discrimination is not allowed, the
upstream rm tends to raise the input price which expels the inefcient downstream
rm and changes the downstream market structure from duopoly to monopoly.
Proposition 1 shows that the upstream monopolist ousts the inefcient downstream
rm from the nal goods market by raising the input price under uniform pricing when
the marginal cost difference between the two downstream rms is large enough. How-
ever, under discriminatory pricing (Lemma 1), the inefcient downstream rms is dri-
ven out of the nal goods market merely because of its inefciency in production and
not the pricing strategy of the upstream monopolist.
232 K.-F. Kao and C.-H. Peng
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4. The social welfare comparison
By comparing the changes from h
+
to
^
h
+
, it is found that the critical values for the inef-
cient downstream rm to be driven out of the nal goods market under the two pric-
ing schemes are different. Given (5), (7), and (10), the social welfare functions under
price discrimination and uniform pricing are as follows:
SW =
1
72
[20(a c)(a c h) 23h
2
[ h\h
+
if
7
32
(a c)
2
h _ h
+
8
<
:
^
SW =
1
72
[20(a c)(a c h) 41h
2
[ h\
^
h
+
if
7
32
(a c)
2
h _
^
h
+
8
<
:
According to the above equations, we can depict Figure 1 to illustrate how the social
welfare is affected by h under discriminatory pricing and uniform pricing.
From Figure 1, it is clear that SW (
d
SW) is of U shape when 0\h\h
+
(0\h\
^
h
+
).
The intuition behind Figure 1 is as follows: It is straightforward to show that there are
two effects. The rst effect is the output effect. The average production cost for the
downstream industry increases with h, which, in turn, increases the total cost and
reduces the aggregate output as well as the social welfare. The second effect is the real-
location of production. The output of Firm 1 (Firm 2) increases (decreases) with h.
When h is sufciently large, the production of Firm 2 is very inefcient and its market
share is very small. As a result, from the perspective of the social welfare, the efcient
rm produces most of the output and restores the production efciency. The above dis-
cussion explains why SW is U shaped when 0 < h < h
+
. The same intuition can also
be applied to
d
SW when 0 < h <
^
h
+
4.1. Observation: SW (
d
SW) is U shaped if 0 < h < h
+
(0 < h <
b
h
+
):
Given Lemma 1 and Proposition 1, it should be noted that when the marginal cost dif-
ference is sufciently large h > h
+
, the inefcient downstream rm shall never serve
the nal goods market and the market is monopolized by Firm 1 under both pricing

SW
*

SW

SW
Figure 1. Social welfare change with an integrated downstream market.
Asia-Pacic Journal of Accounting & Economics 233
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regimes. Under such a circumstance, the two pricing policies have the same social wel-
fare. In what follows, we shall focus our analysis on the opposite case with h < h
+
. For
0< h <
^
h
+
,
d
SW is necessarily larger than SW although the total output under both pric-
ing schemes are the same. This is because Firm 2 produces more output under discrimi-
natory pricing than under uniform pricing, resulting in a larger efciency distortion.
Therefore, price discrimination shall reduce the social welfare. This result is accordant
with Katz (1987), DeGraba (1990), and Yoshida (2000).
For
^
h
+
_ h < h
+
, the inefcient rm is driven out of the nal goods market under
uniform pricing while it produces a positive output under price discrimination since
the upstream monopolist charges the inefcient downstream rm a lower input price.
That is to say, the downstream market is of monopoly under uniform pricing,
whereas it is of duopoly under discriminatory pricing. As a result, the total output
under discriminatory pricing is necessarily larger than that under uniform pricing.
Comparing SW with
d
SW, it can be shown that SW>
d
SW if
^
h
+
\h\17(a c)=46 =
~
h; otherwise, SW<
d
SW. Given the above discussions, we
make the following proposition.
Proposition 2 If the marginal cost difference is moderate (i.e.
^
h
+
_ h _
~
h), the social
welfare under discriminatory pricing is higher than that under uniform pricing as more
downstream rms are served by the upstream rm.
This nding is similar to Hausman and MacKie-Mason (1988), which considers the
price discrimination in the two different non-substitutable nal goods markets. They
conclude that price discrimination can lead to welfare improvements if new markets are
open. In this paper, we also nd that, when
^
h
+
_ h _
~
h, more downstream rms will be
served under discriminatory pricing, and thus the total output of the nal goods is no
less than that under uniform pricing. Therefore, the social welfare under discriminatory
pricing is higher than that under uniform pricing.
However, the social welfare does not necessarily increase with total output of the
nal goods. If
~
h _ h _ h
+
, the inefcient downstream rm is served only under dis-
criminatory pricing, making the nal goods market more competitive under discrimina-
tory pricing than uniform pricing. Although the output of the nal goods is larger
under discriminatory pricing, the social welfare is lower as the welfare loss from the
efciency distortion overpowers the welfare gain from the competition between the
two rms. Summarizing the above discussions, we can establish the following
proposition.
Proposition 3 If the marginal cost difference is sufciently large (i.e. ) the upstream
monopolist serves more downstream rms and produces more output under
discriminatory pricing than uniform pricing. However, the social welfare is lower under
discriminatory pricing.
In a way that differs from Hausman and MacKie-Mason (1988), in our model, the
social welfare is not necessarily higher even if more downstream rms are served under
discriminatory pricing. This result not only runs against the conventional wisdom, but
also warns us that the criterion for judging the increase or decrease in social welfare
shall not only depend on the structure of the downstream market or the aggregate out-
puts. The relative production efciency also plays an important role.
234 K.-F. Kao and C.-H. Peng
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5. The social welfare comparison under independent downstream markets
In this section, we would like to investigate the welfare effect of price discrimination
when there are two independent downstream markets. The model setup is the same as
in Section 2 except that Firms 1 and 2 now monopolize in Markets 1 and 2, respec-
tively. The inversed market demand for the nal goods is set to be linear and can be
expressed as P
i
= a x
i
, i =1, 2. The prot functions of Firms 1 and 2 are as follows:

i
(X
i
) = (P
i
w
i
c
i
)x
i
for i = 1; 2.
Proceeding as before, we can derive the equilibrium social welfare under discrimina-
tory pricing and uniform pricing as follows:
SW =
7
32
[2(a c)
2
2(a c)h h
2
[ h\a c
if
7
32
(a c)
2
h _ a c
8
<
:
(15)
d
SW =
1
64
[28(a c)
2
28(a c)h 19h
2
[ h\(2

2
_
(a c)
if
7
32
(a c)
2
h _ (2

2
_
(a c)
8
<
:
(16)
Note that
M
_
^
if h _ (2

2
_
)(a c). In such a circumstance, the upstream monopo-
list would raise the input price frofrom ^ w = (2a 2c h)=4 to w
M
= (a c)=2, Firm 2
will be driven out of Market 2. This result is similar to Proposition 1.
We use Figure 2 to illustrate the welfare effect of price discrimination. The same as
before, we ignore the case in which only Market 1 is served under both pricing schemes. In
Figure 2, it is shown that the social welfare under uniform pricing is superior (inferior) to
that under discriminatory pricing if 0\h\(2

2
_
)(a c) ((2

2
_
)(a c)
\h\(a c)). When (2

2
_
)(a c)\h\(a c), Firm 2s output under uniform pricing
becomes non-positive due to its inefcient productivity. However, its output is positive
under discriminatory pricing owing to a lower input price. Given this result, we can make
the following proposition.
Proposition 4. When the downstream markets are independent, price discrimination
improves the social welfare as long as more downstream rms are served.
This result is consistent with the nding of Hausman and MacKie-Mason (1988)
(Proposition 2), which indicates that price discrimination can enhance welfare as long
SW
ac (2 2)(ac)
SW

SW
Figure 2. Social welfare change with independent downstream markets.
Asia-Pacic Journal of Accounting & Economics 235
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as new markets are open (more downstream rms are served). This is true no matter
the marginal cost difference between the downstream rms is high or low. Hence, the
welfare outcome in Proposition 3 is no more robust when the nal goods markets are
independent. The reason is as follows. When the downstream markets are independent,
there is no competition between Firms 1 and 2 as they are monopolist in their own
downstream market. That is to say, there is no production reallocation effect between
Markets 1 and 2. As a result, the social welfare necessarily increases as new markets
are open or more downstream rms are served.
6. Conclusions
This paper re-examines the welfare implications of price discrimination in vertically
related markets by considering the possibility of the market structural change in the
nal goods market. If the number of the downstream rms is xed, the social welfare
under uniform pricing is necessarily larger than that under discriminatory pricing. How-
ever, if the upstream rm is capable of driving out the inefcient downstream rm, and
resulting in a market structural change, whether discriminatory pricing is superior or
inferior to uniform pricing in terms of welfare crucially depends on the marginal cost
difference between the downstream rms. We have shown that, given that the marginal
cost difference is moderate h
+
_ h _
~
h allowing price discrimination is more socially
desirable. However, if the marginal cost difference is sufciently large
~
h _ h _ h
+
,
although the total outputs are larger under discriminatory pricing (duopoly) than that
under uniform pricing (monopoly), the social welfare is necessarily lower under dis-
criminatory pricing owing to the efciency distortion. This tells us that the criterion for
judging the social welfare can not only depend on the structure of the downstream mar-
kets or the total outputs. The relative production efciency also needs to be considered.
In addition, when the downstream markets are independent, the social welfare under
discriminatory pricing is higher than that under uniform pricing if and only if more
downstream rms are served under discriminatory pricing.
Acknowledgement
This paper was presented at the International Trade Workshop, College of Social Sciences,
National Taiwan University.
We would like to thank Hong Hwang, Chin-Sheng Chen, and other participants of the workshop,
as well as an anonymous referee, for their helpful comments. The usual disclaimer applies.
Notes
1. A positive xed cost makes the nal good market more likely to become monopolistic. But it
does not affect our results qualitatively.
2. We shall relax this assumption and discuss the independent nal good markets case in Sec-
tion 5.
3. The second-order condition is necessarily satised given the linear demand function.
4. The prot of the upstream rm under discriminatory pricing is necessarily no less than that
under successive monopoly as it can always set w
1
=w
2
=w
M
under discriminatory pricing.
5. By substituting w
M
=w
1
=w
2
into ^x
2
in (8), the outputs of Firm 2 is negative if
h > (2

3
_
)(a c).
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236 K.-F. Kao and C.-H. Peng
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