Industrial Economics

Dushyant Kumar
BITS Pilani, Hyderabad Campus
 Monopoly Practices
Price Discrimination

Dushyant Kumar
BITS Pilani, Hyderabad Campus
Non-Linear Pricing and Price Discrimination

I So far we assumed that the monopolies charge a single,

uniform price..
I Consumers’ surplus: can monopoly appropriate a part of it
through price discrimination?
I Examples:
1. Firms typically charge different prices at different locations..
2. Students’ discounts, senior citizen discounts etc- transport
sector, restaurants, entertainment industry etc...
3. Books, paperback and hardcover, library vs individuals..
4. Discounts on bulk buying..
Price Discrimination Mechanisms

I Market segmentation: mainly geographical separation,

prohibitive transportation costs or tariffs/taxes..
I Two-part pricing: fixed fee plus variable price.. sports club,
amusement parks etc..
I Non-linear pricing
I Tying and bundling: either through technological
compatibility manipulations or through explicit legal contracts,
firms often try to tie and bundle their products..
I Quality discrimination: economy ticket vs business class
tickets, windows home basic vs windows enterprise..
sometimes firms deliberately push down the quality of ‘base’
product so that those who can offer move to ‘premium’
products..
Price Discrimination

I Motivations:
I Necessary conditions for price discrimination: market power
and arbitrage.
I Firms should be able to block arbitrage or resale.. Firm’s can
adopt different strategies to achieve it:
1. Warranties: global warranty vs local warranty..
2. High transaction costs: can take various forms.. firms can
lobby for rules like one can’t carry sealed packages, more than
certain number of items during the travel! discount coupons
with conditions on applicability restricted to locations.. taxes
on ownership transfer..
3. Contractual remedies: ‘not for resale’ tags- ownership
non-transferable..
4. Vertical integration
5. Adulteration: blue kerosene..
6. Legal restriction
Types of Price Discrimination

I Pigou (1920)
I First-degree price discrimination: perfect price
discrimination, firms have perfect information about the
consumers’ willingness to pay, all the consumers’ surplus is
appropriated by the firm..
I Second-degree price discrimination: self-selection
mechanisms... Firms don’t have information about the
consumers’ attributes but they can use self-selection
mechanisms to capture parts of consumers’ surplus..
I Third-degree price discrimination: market segmentation...
First-Degree Price Discrimination

I Firms have the perfect information about the demand

function- for every consumer, firm knows maximum
willingness to pay for every unit!
I Firms can extract all the consumers surplus- one option:
take-it-or-leave-it offer to the consumers..
I Since firms’ profit equals maximum possible social surplus (CS
+ PS), so the outputs, like quantity and quality, are socially
efficient! Zero dead-weight loss!
I The firms can also use the two-part tariff plan to extract all
the consumers’ surplus.. Set the entry (fixed) fee at the
CS(P = MC ) and per unit price at MC!
First-Degree Price Discrimination
Third-Degree Price Discrimination
I The information requirement for the first-degree price
discrimination is quite unpractical, the producer need to know
‘everything’..
I We move on the third-degree price discrimination where the
producer work with market segmentation..
I Typical example is a multinational firm selling in different
countries..
I Constant marginal cost case:
Third-Degree Price Discrimination
I Non-constant marginal cost case..
I The third-degree price discrimination is quite widely practiced-
geographical locations, senior citizens’ discount, students’
version of softwares, gender based discounts..
I The seller should be able to categorize customers in different
brackets, different category customers have different ‘demand
functions’..
I In third-degree price discrimination case, the monopoly profit
increases (relative to no price discrimination). Obvious, why?
I Consumers in the market with the lower elasticity are worse
off. (?)
I Consumers in the market with the higher elasticity are better
off. (?)
I However, in general we can’t say anything about the total
social welfare.
Third-Degree Price Discrimination

I If the price discrimination decreases total output, social

welfare must decrease..
I This is the case with linear demand curves and constant
marginal costs (total output remains same)..
I Suppose without price discrimination one category is unserved,
then price discrimination increases the social welfare..
I Example:
TC = 20000 + 15Q, Q1 = 5500 − 100P, Q2 = 2000 − 50P.
with price discrimination:

Q1∗ = 2000, P1∗ = 35, Q2∗ = 625, P2∗ = 27.50,

CS1 = 20000, CS2 = 3906.25, π = 27812.50, SW = 51718.75

(verify..)
Third-Degree Price Discrimination

without price discrimination:

Q1∗ = 2625, P∗ = 32.50, Q2∗ = 375,

CS1 = 25312.5, CS2 = 1406.25, π = 25937.5, SW = 52656.25

(verify..)
I Non-linear cost function..
Second-Degree Price Discrimination

I Next we move on to the second-degree price discrimination..

I Here knows that consumers differ in their willingness to pay,
but firm can’t identify them or, can’t enforce ‘direct’ price
discrimination (unlike third-degree price discrimination)..
I Sometime legal compulsion also forces firm to use
second-degree price discrimination instead of first-degree or
third degree..
I Here basically firm ‘smartly’ design its pricing so that
consumers themselves pick the targeted pricing..
I So firms need to design a price schedule- different (average)
price depending on the characteristics of the purchase
decision..
Second-Degree Price Discrimination
I Examples:
I Business class travelers vs economy travelers: not possible for
the airline to distinguish between these two types of travelers-
add/subtract some characteristics to the service which is more
valuable to business travelers..
I Softwares, automobiles, etc.: premium vs basic version..
I Bulk discounts
I Participation constraints or individual rationality constraint for
each type..
I Incentive compatibility constraints between different types..
I One interesting kind of second-degree price discrimination is a
two-part tariff..
I With a fixed fee and variable price, it discriminate
automatically among consumers with different usage or
willingness to pay- different average price!
Second-Degree Price Discrimination: Two-Part Tariff

Here the maximum fixed fee that can be charged is the area B, the
consumer surplus of low type consumer..
Second-Degree Price Discrimination: Two-Part Tariff

I In particular, for any variable price P, the maximum fixed fee

that can be charged is CS1 (P), that is consumer surplus of
the low-type consumer at the price P.
I Now what is profit maximizing fixed fee F and the variable
price P?
I Example: Suppose someone is planning to open a
bar/ice-cream parlour/fun park/sport complex.. Cost
structure: fixed cost per day- 1000, variable cost 0.5 per unit..
I Demand- Initially lets take the case where there are just one
type on (500) customers, each has a demand function

Q1 = 10 − 2P.
Second-Degree Price Discrimination: Two-Part Tariff

I Without two-part tariff, constant per unit charge case:

P ∗ = 2.75, Q1∗ = 4.5 per individual, π = 4062.5

I Two part tariff: entry fee per individual = 20.25, per unit
variable price = MC = 0.50, Q1∗ = 9 per individual, total
profit = 9125.
I So, two part tariff improves the profit significantly.
I Now suppose we have another 500 customers of different
type, each have a demand function of

Q2 = 5 − P.
Second-Degree Price Discrimination: Two-Part Tariff

I For these customers the entry fee of 20.25 is too high.. Verify
that at this entry fee, none of these second types will
subscribing.
I If the seller want to serve these customers, the entry fee need
to be lowered..
I We need to find the optimal two part tariff if all 1000
customers are served, compare the profit with that of the
case when just ‘high’ type customers are served..
I At any per unit price, whats the maximum that can charged
as the entry fee (EF) from everyone- consumer surplus of the
second type at that price-

P2
12.5 − 5P + .
2
Second-Degree Price Discrimination: Two-Part Tariff

I Total revenue:

π = (1000 × EF ) + {P(500(10 − 2P) + 500(5 − P))}.

I Total cost:

1000 − 0.5 × {500(10 − 2P) + 500(5 − P)}.

I Replacing for EF and maximising the profit with respect to

price, we get
P ∗ = 1.625, EF = 5.70.
I Each type 1 customer is going to demand 6.75 units and, each
type 2 customer is going to demand 3.375 units..
I Total profits = 10391. So its better to have this pricing
mechanism and serve both types..
Second-degree Price Discrimination

I By using a two-part tariff, the firm is able to charge different

average price to different customers!
I Yet Another Example: Lets say that an airline knows that
some of the customer are business travelers who are ready to
pay more..
I How should the firm arrive at a pricing schedule such that
business travelers opt for business class and economy travelers
opt for economy class; and firm’s profit is maximized..
I Device a pricing scheme and let consumers self-select
themselves..
Second-degree Price Discrimination

I For simplicity, suppose there are 2 travelers: a business

traveler (b) and a tourist (t).
I The airline has 2 seats: one first class (F) and one economy
(E).
I Utilities: Ub (F ) = 1000, Ub (E ) = 400 and,
Ut (F ) = 500, Ut (E ) = 300.
I Ideally the airline will like to charge 1000 from the business
travelers and book him for the first class and, charge 300 from
the tourist and book him for the economy class.
I But at these prices, the business traveler will prefer to travel
by the economy class (net utility of 0 vs. 100)..
Second-degree Price Discrimination

I Let PF and PE denote the prices of the first class and

economy class respectively..
I The airline has to keep following constraints in mind:

1000 − PF ≥ 0 (1)

300 − PE ≥ 0 (2)
1000 − PF ≥ 400 − PE (3)
300 − PE ≥ 500 − PF (4)
I First two- individual rationality constraints, last two- incentive
compatibility constraints..
I Using all these inequalities, we have PE = 300, PF = 900.
Second-degree Price Discrimination

I In general, the monopoly firm announces a (nonlinear) price

schedule with the intention that group 1 (economy class) pick
x1 and pays total r1 and, group 2 (business class) pick x2 and
pays total r2 ..
I High type and low type customers: u2 (x) > u1 (x) and
u20 (x) > u10 (x)
I The monopoly has to ensure that
1. both type are wiling to participate- participation constraint or
individual rationality constraints..

u1 (x1 ) − r1 ≥ 0
and,
u2 (x2 ) − r2 ≥ 0.
Second-degree Price Discrimination

2. one type doesn’t want to consume the ‘bundle’ intended for

the other type:

u1 (x1 ) − r1 ≥ u1 (x2 ) − r2

and,
u2 (x2 ) − r2 ≥ u2 (x1 ) − r1
these are known as self-selection constraints or incentive
compatibility constraints..

I Rearranging the inequalities above:

r1 ≤ u1 (x1 ) (5)

r1 ≤ u1 (x1 ) − u1 (x2 ) + r2 (6)

Second-degree Price Discrimination

r2 ≤ u2 (x2 ) (7)
r2 ≤ u2 (x2 ) − u2 (x1 ) + r1 (8)

I We have to check which of these equations are going to bind..

using our starting restriction on the utility functions:
u2 (x) > u1 (x) and u20 (x) > u10 (x)
I Lets suppose equation 7 binds i.e. r2 = u2 (x2 ). Using this in
equation 8, we have u2 (x1 ) ≤ r1 .
or, u1 (x1 ) < u2 (x1 ) ≤ r1 .
Second-degree Price Discrimination

this contradicts equation 5, so equation 7 is not going to

bind.. equation 8 is going to bind, we have

r2 = u2 (x2 ) − u2 (x1 ) + r1 .

I Next consider equation 5 and 6. Suppose equation 6 binds i.e.

r1 = u1 (x1 ) − u1 (x2 ) + r2 .
substituting the value of r2 from above,

u2 (x2 ) − u2 (x1 ) = u1 (x2 ) − u1 (x1 ).

or, Z x2 Z x2
u10 (t)dt = u20 (t)dt
x1 x1
Second-degree Price Discrimination

I But this clearly violates u10 (x) < u20 (x). So here equation 5
binds i.e.
r1 = u1 (x1 ).
I So for the ‘low type’ customer, the participation constraint is
going to bind.
I The monopoly is going to extract all the surplus from the low
type customer and leave him with just ‘zero’ utility.. He will
be just indifferent between consuming and not consuming..
I For the ‘high type’, the participation constraint is not going to
bind, he will be enjoying strictly positive utility..
Second-degree Price Discrimination
I Now using this the monopoly’s profit function becomes:

π = (r1 − cx1 ) + (r2 − cx2 )

or,

π = (u1 (x1 ) − cx1 ) + (u2 (x2 ) − u2 (x1 ) + u1 (x1 ) − cx2 )

I FOC for maximisation w.r.t x1 and x2 ,

u10 (x1 ) − c − u20 (x1 ) + u10 (x1 ) = 0

or,

u10 (x1 ) = c + (u20 (x1 ) − u10 (x1 )) > c

and,

u20 (x2 ) = c
Second-degree Price Discrimination

I So the low type consumer’s consumption is distorted

downwards; high type continue to consume at the efficient
level!
I These results are quite general..
I It can be extended to a more general setup..
I Yet another very widely practiced second-degree price
discrimination is tying and bundling..
Second-Degree Price Discrimination: Tying and Bundling

I Tying of 2 goods (or services) occurs when the sale (or

provision) of one good (service) is conditioned on the
purchase of another one.
I Suppose a producer (A) is only producer of a certain good, say
a computer.. But there are many producers of another related
goods and services, say softwares.. Then the producer might
impose a condition that in order to buy the computer from
him, one needs to purchase the softwares from him as well..
I Base good and variable goods: printer and ink, cell phone and
service plans, kindle and amazon..
I Base goods are usually priced reasonably but the variable
goods are often costly..
Second-Degree Price Discrimination: Tying and Bundling

I Printer and ink: often one can’t use ink cartridges from
another companies (technical compatibility, warranties).. ink
are priced at a quite high margin..
I Suppose someone has a high willingness to pay for prints, and
they are heavy users as well.. So these pricing schemes are
successful at extracting more from them!
I Tying typically increases ‘social welfare’ because it increases
overall output..
I In the absence of tying, printer would have been expensive
and ink cheaper..
I So heavy users would have been better off and occasional
users won’t buy at all..
I With a quite large number of occasional users, output (and
social welfare) would have been lower..
Second-Degree Price Discrimination: Tying and Bundling

I Bundling typically refers to a situation where two more

products (or services) need to purchased together..
I Microsoft Office, Cable TV, Journal subscriptions,
Newspapers (bundle of sections- business, sports, politics)..
I Difference between tying and bundling- tied goods are sold in
variable proportion, one-to-many (metering) whereas bundled
goods are sold in fixed proportion..
I Pure bundling..
I Demand for individual products are highly variable across
individual and hard to predict.. In many cases, at aggregate
level, its even out (less variation)...
I Negative correlation between the willingness to pay for
different products: movie channels and sports channels..
Second-Degree Price Discrimination: Tying and Bundling

I Negative correlation is helpful but not essential for profitability

of bundling..
I Crucial one is less variability at the aggregate level.
I Also, zero (or, very low) marginal costs helps greatly..
I Zero marginal cost insures that the producer is not selling a
particular component of the bundle at lower than the
production (marginal) cost which is never a good idea.
I Bundling increases profit..
I Overall consumer welfare might go up or down..
Second-Degree Price Discrimination: Tying and Bundling

I Zero marginal cost- information goods..

I Goods with zero or low marginal cost often have very high
fixed costs- R & D, softwares, movies...
I Spotify vs. iTunes.
I So an increase in profits from bundling helps huge
expenditures on R & D and overtime increases efficiency and
consumer welfare..
I Price discrimination allows high fixed cost to spread over large
base of consumers..
Second-Degree Price Discrimination: Damaged Products!

I Intel used to sell 486 chip and 486SX chip.. 486SX chip was
lower capacity one..
I In order to lower the computing capacity, Intel used to disable
the integrated math coprocessor from the 486 chip. Otherwise
it was exactly same..
I Disabling the coprocessor was costly and still the 486SX chip
was sold at a lower price!
I This is a quite common business practice.. How does it make
sense?
I The producer often damage (maybe even at some cost) a
good to price discriminate!
I This kind of ‘damaging’ activity can actually be Pareto
improving!
Second-Degree Price Discrimination: Damaged Products!

I The low demand customer gets the product (damaged one),

often the price original product is reduced due to incentive
consideration and, the profit increases.. EVERYONE
BENEFITS..
I Consider the following example: the high-value users are
willing to pay $ 600 for the 486 chip, but would pay only $
300 for the chip without a math coprocessor.
I The low-value users are willing to pay $400 for the 486 chip,
but would pay only $350 for the chip without a math
coprocessor.
I The firm does not know consumer’s type, so only
second-degree price discrimination is possible..
Second-Degree Price Discrimination: Damaged Products!
Second-Degree Price Discrimination: Damaged Products!

I Upward slope of the ‘indifference curves’..

I The number of high value consumers are high relatively.. so in
the absence of ‘damaged products’, its profit maximizing to
serve just high value consumers at price $ 600..
I Now suppose the firm is exploring the damaged good (486SX)
option..
I Whats the maximum price that can be charged for 486SX so
that high value customer is not tempted to switch to it?
I For any price lower than 300 (given that chip 486 is priced at
600), high value customer is going to switch..
I So the price of 486SX should increase and/or the price of chip
486 should decrease..
Second-Degree Price Discrimination: Damaged Products!

I The firm considering damaged good strategy must have

significant market power.. there should be enough mark-up to
incur the cost of damaging the good and selling it at a lower
rate..
I Other example: IBM LaserPrinter E- introduced in 1990 as a
low cost alternative to already existing LaserPrinter. IBM
(literally!) attached a chip in its LaserPrinter to decrease the
printing speed..
Price Discrimination: Conclusion

I Optimal Nonlinear Pricing..

I Price discrimination and social welfare: no sure-shot result..
Output change is the best predictor however..
I If price discrimination increases output, typically it increases
social welfare..
I If price discrimination decreases output, typically it reduces
social welfare..