Price Discrimination

1
 Introduction

• Price Discrimination describes strategies used by firms

to extract surplus from customers
• Examples of price discrimination
– presumably profitable
– should affect market efficiency: not necessarily adversely
– is price discrimination necessarily bad – even if not seen as
“fair”?

2
 Mechanisms for Capturing Surplus

• Market segmentation
• Non-linear pricing
– Two-part pricing
– Block pricing
• Tying and bundling
• Quality discrimination

3
 Feasibility of price discrimination
• Market power

• Two problems confront a firm wishing to price

discriminate
– identification: the firm is able to identify demands of different
types of consumer or in separate markets
• easier in some markets than others: e.g tax consultants, doctors
– arbitrage: prevent consumers who are charged a low price from
reselling to consumers who are charged a high price
• prevent re-importation of prescription drugs to the United States

• The firm then must choose the type of price

discrimination
– first-degree or personalized pricing
– second-degree or menu pricing
– third-degree or group pricing

4
 Third-degree price discrimination

• Consumers differ by some observable characteristic(s)

• A uniform price is charged to all consumers in a
particular group – linear price
• Different uniform prices are charged to different groups
– “kids are free”
– subscriptions to professional journals e.g. American Economic
Review
– airlines
• the number of different economy fares charged can be very large
indeed!
– early-bird specials; first-runs of movies

5
 Third-degree price discrimination 2

• The pricing rule is very simple:

– consumers with low elasticity of demand should be
charged a high price
– consumers with high elasticity of demand should be
charged a low price

6
 Third degree price discrimination: example

• Harry Potter volume sold in the United States and Europe

• Demand:
– United States: PU = 36 – 4QU
– Europe: PE = 24 – 4QE
• Marginal cost constant in each market
– MC = $4

7
 The example: no price discrimination

• Suppose that the same price is charged in both markets

• Use the following procedure:
– calculate aggregate demand in the two markets
– identify marginal revenue for that aggregate demand
– equate marginal revenue with marginal cost to identify the
profit maximizing quantity
– identify the market clearing price from the aggregate demand
– calculate demands in the individual markets from the
individual market demand curves and the equilibrium price

8
 The example (cont.)

United States: PU = 36 – 4QU Invert this:

QU = 9 – P/4 for P < $36
Europe: PU = 24 – 4QE Invert At these prices
QE = 6 – P/4 for P < $24 only the US
market is active
Aggregate these demands Now both
Q = QU + QE = 9 – P/4 for $36 < P < markets are
$24
active
Q = QU + QE = 15 – P/2 for P < $24

9
 The example (cont.)

Invert the direct demands $/unit

P = 36 – 4Q for Q < 3 36

P = 30 – 2Q for Q > 3
30
Marginal revenue is
MR = 36 – 8Q for Q < 3 17

MR = 30 – 4Q for Q < 3
MR Demand
Set MR = MC MC

Q = 6.5
6.5 15
Quantity

Price from the demand curve P = $17

10
 The example (cont.)

Substitute price into the individual market demand curves:

QU = 9 – P/4 = 9 – 17/4 = 4.75 million
QE = 6 – P/4 = 6 – 17/4 = 1.75 million
Aggregate profit = (17 – 4)x6.5 = $84.5 million

11
 The example: price discrimination

• The firm can improve on this outcome

• Check that MR is not equal to MC in both markets
– MR > MC in Europe
– MR < MC in the US
– the firms should transfer some books from the US to Europe
• This requires that different prices be charged in the
two markets
• Procedure:
– take each market separately
– identify equilibrium quantity in each market by equating MR
and MC
– identify the price in each market from market demand

12
 The example: price discrimination 2

$/unit
Demand in the US:
36
PU = 36 – 4QU
Marginal revenue:
20

MR = 36 – 8QU Demand
MR

MC = 4 4 MC

Equate MR and MC 4 9
Quantity
QU = 4
Price from the demand curve PU = $20

13
 The example: price discrimination 3

$/unit
Demand in the Europe:
24
PE = 24 – 4QU
Marginal revenue:
14

MR = 24 – 8QU Demand
MR

MC = 4 4 MC

Equate MR and MC 2.5 6 Quantity

QE = 2.5
Price from the demand curve PE = $14

14
 The example: price discrimination 4

• Aggregate sales are 6.5 million books

– the same as without price discrimination
• Aggregate profit is (20 – 4)x4 + (14 – 4)x2.5 =
$89 million
– $4.5 million greater than without price discrimination

15
 No price discrimination: non-constant cost

• The example assumes constant marginal cost

• How is this affected if MC is non-constant?
– Suppose MC is increasing
• No price discrimination procedure
– Calculate aggregate demand
– Calculate the associated MR
– Equate MR with MC to give aggregate output
– Identify price from aggregate demand
– Identify market demands from individual demand curves

16
 The example again

Applying this procedure assuming that MC =

0.75 + Q/2 gives:
(a) United States (b) Europe (c) Aggregate
Price Price Price
40 40 40

30 30 30
DU
24
20 20 DE 20 D
17 17 17
MR
10 MRU 10 10
MC
MRE

0 0 0
0
4.75 5 10 0 1.75 5 10 0 5 6.5 10 15 20
Quantity Quantity Quantity

17
 Price discrimination: non-constant cost

• With price discrimination the procedure is

– Identify marginal revenue in each market
– Aggregate these marginal revenues to give aggregate marginal
revenue
– Equate this MR with MC to give aggregate output
– Identify equilibrium MR from the aggregate MR curve
– Equate this MR with MC in each market to give individual
market quantities
– Identify equilibrium prices from individual market demands

18
 The example again

Applying this procedure assuming that MC = 0.75 +

Q/2 gives:
(a) United States (b) Europe (c) Aggregate
Price Price Price
40 40 40

30 30 30
DU

24
20 20 DE 20
17
14 MR
10 MRU 10 10
MC
4 4 MRE 4
0 0 0
0 5 10 0 1.75 5 10 0 5 6.5 10 15 20
Quantity Quantity Quantity

19
 Some additional comments

• Suppose that demands are linear

– price discrimination results in the same aggregate
output as no price discrimination
– price discrimination increases profit
• For any demand specifications two rules apply
– marginal revenue must be equalized in each market
– marginal revenue must equal aggregate marginal
cost

20
 Third-degree price discrimination 2
• Often arises when firms sell differentiated products
– hard-back versus paper back books
– first-class versus economy airfare

• Price discrimination exists in these cases when:

– “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.” (Phlips)

• The seller needs an easily observable characteristic that

signals willingness to pay

• The seller must be able to prevent arbitrage

– e.g. require a Saturday night stay for a cheap flight

21
 Product differentiation and price discrimination

• Suppose that demand in each submarket is Pi = Ai – BiQi

• Assume that marginal cost in each submarket is MCi = ci
• Finally, suppose that consumers in submarket i do not
purchase from submarket j
• Equate marginal revenue with marginalItcost inunlikely
is highly eachthat the
difference in prices will equal
submarket the difference in marginal
costs

Ai – 2BiQi = ci  Qi = (Ai – ci)/2Bi  Pi = (Ai + ci)/2

 Pi – Pj = (Ai – Aj)/2 + (ci – cj)/2

22
 Other mechanisms for price discrimination

• Impose restrictions on use to control arbitrage

– Saturday night stay
– no changes/alterations
– personal use only (academic journals)
– time of purchase (movies, restaurants)
• Damaged goods
• Discrimination by location

23
 Discrimination by location

• Suppose demand in two distinct markets is identical

– Pi = A = BQi
• But suppose that there are different marginal costs in
supplying the two markets
– cj = ci + t
• Profit maximizing rule:
– equate MR with MC in each market as before
–  Pi = (A + ci)/2; Pj = (A + ci + t)/2
–  Pj – Pi = t/2  cj – ci
– difference in prices is not the same as the difference in costs

24
Third-degree rice discrimination and welfare

• Does third-degree price discrimination reduce welfare?

– not the same as being “fair”
– relates solely to efficiency
– so consider impact on total surplus

25
 Price discrimination and welfare

Suppose that there are two markets: “weak” and “strong”

The discriminatory The discriminatory
Price Price
price in the weak price in the strong
market is P1 market is P2

D2 The minimum
The maximum
The uniform loss of surplus in
gain in surplus MR2
price in both the strong
D1 in the weak P2
market is PU market is L
market is G
PU PU
P1
G L
MR1
MC MC

ΔQ1 Quantity ΔQ2 Quantity

26
 Price discrimination and welfare

Price Price Price

Pricediscrimination
discrimination
cannot
cannotincrease
increase
surplus
surplusunless
unlessitit D2
increases
increasesaggregate
aggregate MR2
output
output
D1 P2

PU PU
P1
G L
MR1
MC MC

ΔQ1 Quantity ΔQ2 Quantity

It follows that ΔW < G – L = (PU – MC)ΔQ1 + (PU – MC)ΔQ2

= (PU – MC)(ΔQ1 + ΔQ2)

27
 Price discrimination and welfare 2

• Previous analysis assumes that the same markets are

served with and without price discrimination
• This may not be true
– uniform price is affected by demand in “weak” markets
– firm may then prefer not to serve such markets without price
discrimination
– price discrimination may open up weak markets
• The result can be an increase in aggregate output and
an increase in welfare

28
 New markets: an example

Demand in “North” is PN = 100 – QN ; in “South” is PS = 100 - QS

Marginal cost to supply either market is $20

North South Aggregate

$/unit $/unit $/unit

100

100
Demand
MC MC MC

MR
Quantity Quantity Quantity

29
 New Markets: the example 2

Aggregate demand is P = (1 + )50 – Q/2

Aggregate
provided that both markets are served $/unit

Equate MR and MC to get equilibrium

output QA = (1 + )50 - 20
Get equilibrium price from
P Demand
aggregate demand P = 35 + 25
MC

MR
QA Quantity

30
 New Markets: the example 3

Aggregate
Now consider the impact of a $/unit
reduction in 
Aggregate demand changes
Marginal revenue changes
PN
It is no longer the case that both
Demand
markets are served
MC
The South market is dropped
D'
MR
Price in North is the monopoly
price for that market Quantity
MR'

31
 The example again

Previous illustration is too extreme Aggregate

$/unit
MC cuts MR at two points
So there are potentially two
equilibria with uniform pricing
At Q1 only North is served at the
monopoly price in North
At Q2 both markets are served PN
at the uniform price PU PU Demand

Switch from Q1 to Q2: MC

decreases profit by the red area
increases profit by the blue area MR

If South demand is “low enough” or Q1 Q2 Quantity

MC “high enough” serve only North
32
 Price discrimination and welfare Again

In this case only North is $/unit Aggregate

served with uniform pricing

But MC is less than the
reservation price PR in South
So price discrimination will PN
lead to South being supplied PR
Demand
Price discrimination leaves
MC
surplus unchanged in North
But price discrimination generates
profit and consumer surplus in South MR

Q1 Quantity
So price discrimination increases welfare

33
 Introduction to Nonlinear Pricing

• Annual subscriptions generally cost less in total than one-off

purchases
• Buying in bulk usually offers a price discount
– these are price discrimination reflecting quantity discounts
– prices are nonlinear, with the unit price dependent upon the quantity
bought
– allows pricing nearer to willingness to pay
– so should be more profitable than third-degree price discrimination
• How to design such pricing schemes?
– depends upon the information available to the seller about buyers
– distinguish first-degree (personalized) and second-degree (menu)
pricing

34
 First-degree price discrimination 2

• Monopolist can charge maximum price that each

consumer is willing to pay
• Extracts all consumer surplus
• Since profit is now total surplus, find that first-degree
price discrimination is efficient

35
 First-degree price discrimination 3

• First-degree price discrimination is highly profitable

but requires
– detailed information
– ability to avoid arbitrage
• Leads to the efficient choice of output: since price
equals marginal revenue and MR = MC
– no value-creating exchanges are missed

36
 First-degree price discrimination 4

• The information requirements appear to be

insurmountable
– but not in particular cases
• tax accountants, doctors, students applying to private universities
• But there are pricing schemes that will achieve the
same outcome
– non-linear prices
– two-part pricing as a particular example of non-linear prices
• charge a quantity-independent fee (membership?) plus a per unit
usage charge
– block pricing is another
• bundle total charge and quantity in a package

37
 Two-part pricing

• Jazz club serves two types of customer

– Old: demand for entry plus Qo drinks is P = Vo – Qo
– Young: demand for entry plus Qy drinks is P = Vy –
Qy
– Equal numbers of each type
– Assume that Vo > Vy: Old are willing to pay more
than Young
– Cost of operating the jazz club C(Q) = F + cQ
• Demand and costs are all in daily units

38
 Two-part pricing 2

• Suppose that the jazz club owner applies “traditional”

linear pricing: free entry and a set price for drinks
– aggregate demand is Q = Qo + Qy = (Vo + Vy) – 2P
– invert to give: P = (Vo + Vy)/2 – Q/2
– MR is then MR = (Vo + Vy)/2 – Q
– equate MR and MC, where MC = c and solve for Q to give
– QU = (Vo + Vy)/2 – c
– substitute into aggregate demand to give the equilibrium price
– PU = (Vo + Vy)/4 + c/2
– each Old consumer buys Qo = (3Vo – Vy)/4 – c/2 drinks
– each Young consumer buys Qy = (3Vy – Vo)/4 – c/2 drinks
– profit from each pair of Old and Young is U = (Vo + Vy – 2c)2

39
 Two part pricing 3

This example can be illustrated as follows:

(a) Old Customers (b) Young Customers (c) Old/Young Pair of Customers
Price Price Price

a Vo
Vo

V e
y
d b f Vo+V y + c h i
g 4 2

c k j MC

MR

Vo+V y Vo + V y
Quantity Vo Quantity Vy - c Quantity
2

Linear pricing leaves each type of consumer with consumer surplus

40
 Two part pricing 4

• Jazz club owner can do better than this

• Consumer surplus at the uniform linear price is:
– Old: CSo = (Vo – PU).Qo/2 = (Qo)2/2
– Young: CSy = (Vy – PU).Qy/2 = (Qy)2/2
• So charge an entry fee (just less than):
– Eo = CSo to each Old customer and Ey = CSy to each Young
customer
• check IDs to implement this policy
– each type will still be willing to frequent the club and buy the
equilibrium number of drinks
• So this increases profit by Eo for each Old and Ey for
each Young customer

41
 Two part pricing 5

• The jazz club can do even better

– reduce the price per drink
– this increases consumer surplus
– but the additional consumer surplus can be extracted through
a higher entry fee
• Consider the best that the jazz club owner can do with
respect to each type of consumer

42
 Two-Part Pricing

$/unit
Vi The entry charge
Set Using
Usingtwo-part
Setthe
theunit
unitprice
priceequal
equal converts consumer
two-part
totomarginal pricing increases
intothe
marginalcost
cost pricingsurplus
increases profit
the
monopolist’s
monopolist’s
profit
profit
This
Thisgives
givesconsumer
consumer
2
surplus
surplusof (Vi --c)c)2/2/2
of(V i c MC
MR
Set
Setthe
theentry
entrycharge
charge
2
(Vi --c)c)2/2/2
toto(V
i Vi - c Vi
Quantity

Profit from each pair of Old and Young now d = [(Vo – c)2 + (Vy – c)2]/2

43
 Block pricing

• There is another pricing method that the club owner

can apply
– offer a package of “Entry plus X drinks for $Y”
• To maximize profit apply two rules
– set the quantity offered to each consumer type equal to the
amount that type would buy at price equal to marginal cost
– set the total charge for each consumer type to the total
willingness to pay for the relevant quantity
• Return to the example:

44
 Block pricing 2

$ Old $ Young
Willingness to
Vo pay of each Willingness to
Old customer pay of each
Quantity Young customer
Quantity
Vy
supplied to supplied to
each Old each Young
customer customer

c MC c MC

Qo Vo Qy Vy
Quantity Quantity
WTPo = (Vo – c)2/2 + (Vo – c)c = (Vo2 – c2)/2

WTPy = (Vy – c)2/2 + (Vy – c)c = (Vy2 – c2)/2

45
 Block pricing 3

• How to implement this policy?

46
 Second-degree price discrimination

• What if the seller cannot distinguish between buyers?

– perhaps they differ in income (unobservable)
• Then the type of price discrimination just discussed is
impossible
• High-income buyer will pretend to be a low-income
buyer
– to avoid the high entry price
– to pay the smaller total charge
• Take a specific example
– Ph = 16 – Qh
– Pl = 12 – Ql
– MC = 4

47
 Second-degree price discrimination 2

• First-degree price discrimination requires:

– High Income: entry fee $72 and $4 per drink or entry plus 12
drinks for a total charge of $120
– Low Income: entry fee $32 and $4 per drink or entry plus 8
drinks for total charge of $64
• This will not work
– high income types get no consumer surplus from the package
designed for them but get consumer surplus from the other
package
– so they will pretend to be low income even if this limits the
number of drinks they can buy
• Need to design a “menu” of offerings targeted at the
two types

48
 Second-degree price discrimination 3

• The seller has to compromise

• Design a pricing scheme that makes buyers
– reveal their true types
– self-select the quantity/price package designed for them
• Essence of second-degree price discrimination
• It is “like” first-degree price discrimination
– the seller knows that there are buyers of different types
– but the seller is not able to identify the different types
• A two-part tariff is ineffective
– allows deception by buyers
• Use quantity discounting

49
 Second degree price discrimination 4
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8 12 16 8 12
Quantity Quantity
50
 Second degree price discrimination 5

A high-income consumer will pay

High-Income
up to $87.50 for entry and 7
The monopolist does better by
drinks
So buying the ($59.50, 7) package Suppose each low-income
reducing
gives him $28 consumerthe number of units
surplus consumer is offered 7 drinks
offered
So entry plus to low-income
Can
Can
12 drinks thebeclub-
the
can club-
sold consumers
Each consumer will pay up to
$ since this Low-Income
for $92
Profit from each ($120 12) allows
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owner28
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($92, = $92)
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16
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$87.50
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4 MC 4 MC
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$48 $28

7 12 16 7 8 12
Quantity Quantity

51
 Second-degree price discrimination 6

• Will the monopolist always want to supply both types

of consumer?
• There are cases where it is better to supply only high-
demand types
– high-class restaurants
– golf and country clubs
• Take our example again
– suppose that there are Nl low-income consumers
– and Nh high-income consumers

52
 Second-degree price discrimination 7

• Suppose both types of consumer are served

– two packages are offered ($57.50, 7) aimed at low-income and
($92, 12) aimed at high-income
– profit is $31.50xNl + $44xNh
• Now suppose only high-income consumers are served
– then a ($120, 12) package can be offered
– profit is $72xNh
• Is it profitable to serve both types?
– Only if $31.50xNl + $44xNh > $72xNh  31.50Nl > 28Nh
This requires that Nh
< 31.50 = 1.125
Nl 28
There should not be “too high” a fraction of high-demand consumers

53
 Second-degree price discrimination 8

• Characteristics of second-degree price discrimination

– extract all consumer surplus from the lowest-demand group
– leave some consumer surplus for other groups
• the incentive compatibility constraint
– offer less than the socially efficient quantity to all groups other
than the highest-demand group
– offer quantity-discounting
• Second-degree price discrimination converts consumer
surplus into profit less effectively than first-degree
• Some consumer surplus is left “on the table” in order
to induce high-demand groups to buy large quantities

54
 Non-linear pricing and welfare 1

• Pricing policy affects

– distribution of surplus Price
– output of the firm
• First is welfare neutral Demand
• Second affects welfare
• Does it increase social welfare?
Total
• Price discrimination increases Surplus
social welfare of group i if it
increases quantity supplied to
c MC
group i

Qi Q’i Qi(c) Quantity

55
 Non-linear pricing and welfare 2

• First-degree price
discrimination always
increases social welfare
– extracts all consumer surplus
– but generates socially
optimal output
– output to group i is Qi(c)
– this exceeds output with
uniform (non-
discriminatory) pricing

56
 Non-linear pricing and welfare 3

• Menu pricing is less straightforward

– suppose that there are two markets
• low demand
• high demand

• Uniform price is PU
• Menu pricing gives quantities Q1s, Q2s
• Welfare loss is greater than L
• Welfare gain is less than G

57
 Non-linear pricing and welfare 4

Price
• It follows that
ΔW < G – L
= (PU – MC)ΔQ1 + (PU – MC)ΔQ2
PU
= (PU – MC)(ΔQ1 + ΔQ2) L
MC
• A necessary condition for second- Qls QlU Quantity
degree price discrimination to Price
increase social welfare is that it
increases total output
• “Like” third-degree price discrimination
• But second-degree price discrimination PU
G
is more likely to increase output MC
QhU Qhs Quantity

58
 The incentive compatibility constraint

• Any offer made to high demand consumers must offer them

as much consumer surplus as they would get from an offer
designed for low-demand consumers.
• This is a common phenomenon
– performance bonuses must encourage effort
– insurance policies need large deductibles to deter cheating
– encouragement to buy in bulk must offer a price discount

59
 Tying

• Tying is a seller’s conditioning the purchase of

one product on the purchase of another
– Technological ties
• Printer cartridges
– Contractual ties
• Car dealer and car parts

• Why tying?

60
 Quality Discrimination

• Why is Quality Discrimination a form of Price

Discrimination?
– First / business class airfare vs economy class
• Reduction in quality of the lower-quality good to
reduce the incentive of people with high
willingness to pay to switch from the high-quality
good when the firm increases its price
– “Damaged goods”

61