Economics 161: Industrial Organization

Lecture 3
 Feasibility of price discrimination
 Third degree price discrimination
 Implementing 3rd degree PD
 Price and elasticity of demand
 Product variety and group pricing
 Differentiation by location
 3rd degree PD and welfare
 Standard def’n of price discrimination – seller sells the same
product to different buyers at different prices

 Use of price discrimination raises two questions

▪ What market conditions make price discrimination feasible
▪ What makes price discrimination profitable

 Welfare implications of price discrimination

 How can price discrimination affect market competition

 Textbook monopoly which charges one price
▪ Firm lowers its price not only to the consumer who buys the additional
unit but to all its other consumers as well.
▪ Constrains the firm’s ability to convert consumer surplus to profit, in
particular, from those who are willing to pay more for the product.

 Two obstacles to price discrimination

▪ Identification problem – must be able to identify who is who on its market
demand curve
▪ Arbitrage – being able to prevent those who are offered a low price from
reselling to those charged a high price.
 Identification problem
▪ Common assumption in the textbook monopoly model- firm knows
the quantity demanded at each price, and therefore the MR curve
▪ For discrete goods (where consumers just consume one unit of the good) -
market demand curve is an ordering of consumers by their reservation prices
▪ For continuous goods –consumer is expected to purchase an increasing
(decreasing) amount of the good as the price decreases (increases).
▪ With uniform pricing all that is required is how willingness to pay in
the overall market varies with the quantity of the goods sold
 To price discriminate –monopolists should know how different
kinds of consumers differ in their demand for its good.

▪ Easier for some sellers than others, e.g., those with personal
knowledge of their clients, but not for others – e.g, retail market
▪ Some techniques – weekend sales or offering coupons that take time
to collect
▪ identification problem is not easy to overcome.
 Arbitrage
▪ More easily accomplished for some goods than others.

 Expect firms with monopoly power to try to price discriminate →

firms develop techniques to identify the different consumers and
prevent arbitrage among them.
 Three broad classes of price discrimination
▪ First degree, aka personalized pricing
▪ Second degree, aka menu pricing
▪ Third degree, aka group pricing
 Three key features
▪ An easily observable characteristic by which monopolists can group
consumers according to wtp
▪ Monopolist can prevent arbitrage across the different groups
▪ Different prices to different groups, but all consumers within a particular
group are quoted the same price

 Commonly referred to as linear pricing.

▪ Consumers within a group are free to buy as much as they like at the
quoted price → average price per unit paid by each consumer = marginal
price for the last unit bought.
▪ Observable characteristic proxy for differences in willingness to pay.
▪ Once groups have been identified, consumers for whom the
elasticity of demand is low should be charged a higher price than
those for whom elasticity of demand is high.
Example
 Inverse demand in the US : 𝑃𝑈 = 36 − 4𝑄𝑈
 Inverse demand in the Europe : 𝑃𝐸 = 24 − 4𝑄𝐸
 Marginal cost is $4 per book
 With non-discriminatory pricing
▪ Aggregate market demand at each price = add the two market demands horizontally
𝑃
▪ Inverting → 𝑄𝑈 = 9 − , provided that 𝑃 ≤ 36
4
𝑃
▪ Inverting → 𝑄𝐸 = 6 − , provided that 𝑃 ≤ 24
4
▪ Aggregate demand equation:
𝑃
𝑄 = 𝑄𝑈 + 𝑄𝐸 = 9 − for $36 ≥ 𝑃 ≥ $24
4𝑃
𝑄 = 𝑄𝑈 + 𝑄𝐸 = 15 − for 𝑃 < $24
2
▪ in more normal inverse form
𝑃 = 36 − 4𝑄 for $36 ≥ 𝑃 ≥ $24
𝑃 = 30 − 2𝑄 for 𝑃 < $24
▪ marginal revenue curve follows the twice as steep rule
𝑀𝑅 = 36 − 8𝑄 for 𝑄 < 3
𝑀𝑅 = 30 − 4𝑄 for 𝑄 > 3
▪ Profit maximizing quantity and price:
▪ Q= 6.5 million,
▪ Price = $ 17
▪ Sold in US = 4.75 million, sold in Europe = 1.75 million
▪ Aggregate profit = (17-4)*6.5= 84.5 million
▪ At this price, MR of last book sold in Europe > MR in the US
▪ Transferring some of the books sold in US to the EU market will lead to
an increase in profit
 With discriminatory pricing
▪ Necessary condition for profit maximization under third degree price
discrimination → MR = MC in each market.

▪ With MR equal to MC in each market, then:

▪ 𝑄𝑈∗ = 4 and 𝑃𝑈∗ = $20, with profits $64 million
▪ 𝑄𝐸∗ = 2.5 and 𝑃𝐸∗ = $14, with profits $25 million
▪ Aggregate profit is $ 89 million,
 Price and elasticity of demand
▪ Important property of linear demand curves- elasticity of
demand falls smoothly from infinity to zero as we move
along the demand curve, and it is equal to 1 midway

▪ For any price less than $ 24, the elasticity of demand in the
US is lower than the elasticity of demand in the EU.
 What if MC is not constant
𝑄
▪ Suppose: 𝑀𝐶 = 0.75 + , where Q = total number of books printed
2
▪ Next figure illustrates the profit maximizing behavior without price
discrimination: Underlying process
▪ Calculate aggregate demand as above
▪ Identify MR function for this aggregate demand
▪ Equate MR=MC
▪ Identify equilibrium price from aggregate demand function
▪ Calculate demand at each price
 With price discrimination mechanism is different
 Derive MR in each market and add these horizontally to give aggregate
𝑀𝑅 = 36 − 8𝑄𝑈 for 𝑀𝑅 𝑏𝑒𝑙𝑜𝑤 $36
𝑀𝑅 = 24 − 8𝑄𝐸 for 𝑀𝑅 𝑏𝑒𝑙𝑜𝑤 $24

 Summing gives an aggregate MR:

𝑄 = 𝑄𝑈 + 𝑄𝐸 = 4.5 − 𝑀𝑅/8 for 𝑄 ≤ 1.5
𝑄 = 𝑄𝑈 + 𝑄𝐸 = 7.5 − 𝑀𝑅/4 for 𝑄 > 1.5

 Equate aggregate MR with MC to identify the equilibrium aggregate quantity and

marginal revenue
30 − 4𝑄 = 0.75 + 2𝑄
 which yields 𝑄∗ = 6.5 and equilibrium 𝑀𝑅 = $4 (marginal cost of the last unit
produced)
 Identify the equi. quantities in each market by equating individual market MR with
equi. MR and MC
 US → 𝑀𝑅 = 36 − 8𝑄𝑈 = $4 𝑜𝑟 𝑄𝑈∗ = 4
 EU → 𝑀𝑅 = 24 − 8𝑄𝐸 = $4 𝑜𝑟 𝑄𝐸∗ = 2.5

 Identify the equi. price in each market from the ind’l market demand curves →
price of $20 for the US and $14 in EU.
 Two simple rules to guide monopolist pricing behavior
(irrespective of what the shape of the cost functions)
▪ MR must be equal for the last unit sold in each market
▪ MR =MC, where MC is measured at the aggregate output level

 When both markets are active, aggregate MR is identical with the

two pricing policies, so equating MR with aggregate MC must give
the same aggregate output

 However, price discrimination is more profitable in that it allocates

the output more profitably in the two markets to ensure that
marginal revenue on the last unit sold in each market is equal.
 Recall - MR in market i in terms of price and point elasticity of demand in that price.
1
𝑀𝑅𝑖 = 𝑃𝑖 (1 − )
𝜂𝑖
where 𝜂𝑖 is the absolute value of the elasticity of demand

 Recall that the profit-maximizing aggregate output must be allocated such that the MR is equalized across
each market (and equal to marginal cost).
 Suppose two markets, 𝑀𝑅1 = 𝑀𝑅2
1
𝑀𝑅1 = 𝑃1 (1 − )
𝜂1
1
𝑀𝑅2 = 𝑃2 (1 − )
𝜂2
 Solve for the ratio of two prices to get: 1
𝑃1 (1−𝜂 ) 𝜂1 𝜂2 −𝜂1
2
= 1 =
𝑃2 (1−𝜂 ) 𝜂1 𝜂2 −𝜂2
1

 The price will be lower in the market with the higher elasticity of demand. When consumers are price sensitive,
the strategy of lowering price can actually raise the monopolists’ surplus because it brings many additional
purchases.
 Many examples of what looks like price discrimination or group pricing arise when the
seller offers differentiated products, i.e., selling different varieties of the same good.
 Phlips (1983) defines group pricing allowing for product differentiation:
“Price discrimination should be defined as implying that two varieties of a commodity are sold (by
the same seller) to two buyers at different net prices, the net price being the price (paid by the
buyer) corrected for the cost associated with the product differentiation”.

 A firm with market power increase its ability to price discriminate by offering different
varieties of the product
 By offering versions of the product, the monopolist is able to solve the identification and
arbitrage problem.
▪ Different consumers may buy different versions of the good and therefore reveal who they are
through their purchase decisions.
▪ Because they are purchasing different varieties, the resale problem is solved.
 Example of group pricing with varieties
▪ Suppose three types of travelers
𝑃𝐹 = 18500 − 1000𝑄𝐹 ,
𝑃𝐵 = 9200 − 250𝑄𝐵 ,
𝑃𝐶 = 1500 − 5𝑄𝐶 ,
 Marginal costs are the following, $100 for coach passenger, $200 for business class and $500 for first
class
 Equating the MR for each class of passenger with the corresponding MC:
𝑀𝑅𝐹 = 18500 − 2000𝑄𝐹 = 500
𝑀𝑅𝐵 = 9200 − 500𝑄𝐵 = 200
𝑀𝑅𝐶 = 1500 − 10𝑄𝐶 = 100
 Equilibrium prices and quantities are:
𝑄𝐹∗ = 9, 𝑎𝑛𝑑 𝑃𝐹∗ = 9,500,
𝑄𝐵∗ = 18, 𝑎𝑛𝑑 𝑃𝐵∗ = 4,700
𝑄𝐶∗ = 140, 𝑎𝑛𝑑 𝑃𝐶∗ = 800
 Airlines’ ability to exploit the difference in willingness to pay faces a potentially severe
arbitrage problem, business travelers may declare themselves as holiday travelers
 Suppose we just have two types of travelers, business travelers and vacationers.
𝑉 𝐵 = 𝑟𝑒𝑠𝑒𝑟𝑣𝑎𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑟 𝑊𝑇𝑃 𝑓𝑜𝑟 𝑏𝑢𝑠𝑖𝑛𝑒𝑠𝑠 𝑡𝑟𝑎𝑣𝑒𝑙𝑒𝑟𝑠, assumed to be high
𝑉 𝑉 = 𝑟𝑒𝑠𝑒𝑟𝑣𝑎𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑟 𝑊𝑇𝑃 𝑓𝑜𝑟 𝑣𝑎𝑐𝑎𝑡𝑖𝑜𝑛 𝑡𝑟𝑎𝑣𝑒𝑙𝑒𝑟𝑠, assumed to be low.
𝑉 𝐵 > 𝑉 𝑉 and this would like to be exploited by charging business travelers a higher price than
vacationers.
 Policy of explicitly charging business travelers more may backfire since business travelers
could claim to be holiday travelers and airline may just resort to charging one monopoly
price
 Suppose that business and holiday travelers differ in other respects as well as their
motivation for flying
▪ Business travelers –would like to return within three days, willing to pay premium to be
guaranteed a return flight within three days
▪ In this case, the airline company can offer two differentiated tickets, one that has no minimum
stay and one without
 Strategy is this:
▪ Set price 𝑉 𝑉 for tickets with a minimum stay of 7 days before returning.
Vacationeers buy but all surplus is extracted
▪ Set a price as close as possible to 𝑉 𝐵 for flights with no minimum stay.
▪ Business people will gladly pay a premium M over the holiday price so long as total
fare is less than 𝑉 𝐵 , 𝑉 𝑉 + 𝑀 < 𝑉 𝐵
▪ Where 𝑀 are limits to ability to stay longer like costs of hotel for extra nights, price of alternative
transportation, etc.
▪ Using such a scheme allows airlines to extract considerable surplus from
business costumers, while extracting all the surplus from holiday travelers
 Companies offer different varieties of the product as a means of
having their customers self-select into different groups.
▪ “screening devices” - they screen or separate customers precisely along
the relevant dimensions of willingness to pay.

 “Crimping of product” – crimping or deliberately damaging a

product to enhance the ability to price discriminate
 Net prices are different – lower quality product sells for a lower
price yet because it starts as a high quality product and then
requires the cost of crimping, the lower quality product is more
expensive to make.
 A product for sale in one location is not the same as the product for sale in
another location. Differences may be due to transport costs

▪ Suppose: identical demands from clam chowder in Boston and Manhattan.

𝑃𝐵 = 𝐴 − 𝐵𝑄𝐵
𝑃𝑀 = 𝐴 − 𝐵𝑄𝑀

▪ Marginal cost is c per unit, but it takes transport cost t to transport to Manhattan.

▪ Profit maximizing conditions:

𝑐 = 𝐴 − 2𝐵𝑄𝐵
𝑐 + 𝑡 = 𝐴 − 2𝐵𝑄𝑀
 Equilibrium would be:
∗ 𝐴−𝑐 ∗ 𝐴+𝑐
𝑄𝐵 = , 𝑃𝐵 = for Boston
2𝐵 2

∗ 𝐴−𝑐−𝑡 ∗ 𝐴+𝑐+𝑡
𝑄𝑀 = , 𝑃𝑀 = for Manhattan
2𝐵 2

 Difference in price between the two markets is only t/2, the

company is absorbing 50 percent of the transport costs in sending
its chowder from Boston to Manhattan.
 Does P.D worsen or reduce the monopoly distortion?
 May reduce efficiency since it amounts to uniform pricing within two or more
separate markets, thus compounding the output-reducing effects of monopoly
power.
 Drawing on the work of Schmalensee (1981), illustrated in the two markets
▪ 𝑃1 and 𝑃2 are the discriminatory prices, 𝑃𝑈 is the nondiscriminatory price.
▪ Market 2 is the strong market:𝑃2 > 𝑃𝑈
▪ Market 1 is the weak market: 𝑃1 < 𝑃𝑈
▪ ∆𝑄1 , ∆𝑄2 are differences between discriminatory vs. nondiscriminatory output, ∆𝑄1 >
0, ∆𝑄2 < 0
▪ ∆𝑊 ≤ 𝐺 − 𝐿 = 𝑃𝑈 − 𝑀𝐶 ∆𝑄1 + 𝑃𝑈 − 𝑀𝐶 ∆𝑄2 = (𝑃𝑈 − 𝑀𝐶)(∆𝑄1 + ∆𝑄2 )
▪ Extending to n markets: ∆𝑊 = (𝑃𝑈 − 𝑀𝐶) σ𝑛 𝑖=1 ∆𝑄𝑖
▪ Necessary condition for third-degree price discrimination to increase welfare is that it
increases output.
▪ With linear demands, non-discriminatory output is equal to
discriminatory output, thus 3rd degree p.d must reduce total welfare.
Increase in profit is more than offset by reduction in consumer
surplus.
▪ Caveat: Price discrimination may make it profitable to serve markets
that will not be served with non-discriminatory prices.
▪ additional welfare from the new markets that 3rd degree p.d. introduces more
than offsets any loss of welfare in the markets that were previously being
served
 Example: demand for AIDS treatment
▪ North America demand: 𝑃𝑁 = 100 − 𝑄𝑁
▪ Sub−saharan Africa demand: 𝑃𝑆 = 𝛼100 − 𝑄𝑆 , with alpha <1
▪ Constant MC, 𝑐 = 20
▪ With no p.d.
▪ Invert demand equations:
𝑄𝑁 = 100 − 𝑃
𝑄𝑆 = 𝛼100 − 𝑃
▪ Aggregate demand is:
𝑄 = 1 + 𝛼 100 − 2𝑃
or
𝑄
𝑃 = 1 + 𝛼 50 − and 𝑀𝑅 = 1 + 𝛼 − 𝑄
2
 Example: demand for AIDS treatment
▪ Equating MR=MC → 𝑀𝑅 = 1 + 𝛼 − 𝑄 = 20
▪ gives the equilibrium output and price:
𝑄 = 30 + 𝛼50
𝑃 = 35 + 25𝛼
▪ For the two markets to be served:
35 + 25𝛼 < 𝛼100
▪ For both markets to be active without price discrimination:
35
𝛼> 𝑜𝑟 𝛼 > 0.466
75
 With P.D.

▪ For the monopolist to be willing to supply the African market, all that
is needed is that the reservation price 𝛼100 be greater than marginal
cost of 20 or 𝛼 > 0.20 =→ 100 ∗ .20 = 20

▪ If this condition is satisfied, then third-degree price discrimination

increases welfare because a market has opened.
Pepall, L., D. Richards and G. Norman [2014] Industrial
Organization:Contemporary Theory and Practice, 5th ed. New
Jersey: John Wiley and Sons