Special features of imperfect markets

Price Discrimination & Deadweight loss

What is price
discrimination?
 Price Discrimination

Price discrimination happens when a firm

charges a different price to different
groups of consumers for an identical
good or service, for reasons not
associated with costs of supply.
 Price Discrimination

• Price discrimination occurs in all imperfectly competitive markets

• It is most common in monopoly and oligopoly
• Requires a supplier to have some pricing power
• Involves selling the same product at different prices to different
groups of consumers
• It has potentially important welfare and distribution effects
• Consider the impact on consumer/producer surplus & social welfare
 CONDITIONS FOR USING PRICE DISCRIMINATION

• Monopolists have something called "market power" - the ability to

influence prices without worrying about competition.
• This allows them to charge different prices to different customers because
there's no one else offering the same product or service.
• Without competition, consumers have fewer options, so they're more likely
to pay higher prices if they need or want the product.
• Also, a monopolist can use their market power to keep new firms out of the
market, further increasing their ability to discriminate.
• Basically, a lack of competition lets the monopolist call the shots on pricing.

PRICE DISCRIMINATION
 What are the main
aims of price
discrimination?

PRICE DISCRIMINATION
 Main Aims of Price Discrimination

Increased Revenue Higher profits Using Spare Capacity

Extracting consumer surplus and Total profit will rise providing the Price discrimination can help a
turning it into increased producer marginal profit from selling to business make more efficient use
surplus for the seller extra customers is positive of their supply capacity.

PRICE DISCRIMINATION
 What are the main
types of price
discrimination?

PRICE DISCRIMINATION
 Types of Price Discrimination

1st Degree 2nd Degree 3rd Degree

Charging each individual Charging different prices Charging different prices to

consumer, the maximum price depending upon quantity bought, groups of people with a different
that they are willing to pay. time period, use of coupons price elasticity of demand (PED)

PRICE DISCRIMINATION
 How does 2nd degree price discrimination
work for a supplier?

Charging different prices depending upon

quantity bought, time period, use of coupons

PRICE DISCRIMINATION
Second-degree Price Discrimination
▪ Practice of charging different prices per unit for different
quantities of the same good or service from the same
consumer.
▪ block pricing: Practice of charging different prices for different
quantities or “blocks” of a good.
Different prices are charged for
different quantities, or “blocks,”
of the same good. Here, there
are 3 blocks, with prices P1, P2,
and P3.
There are also economies of
scale. when AC & MC are
declining 2nd degree price
discrimination make consumers
better off by expanding output &
lowering cost 9
 3rdDegree Price
Discrimination (3)

What are some good examples of

3rd degree price discrimination?
 Examples of 3rd Degree Price Discrimination
Amusement park
STUDENT DISCOUNTS CAR INSURANCE
pricing

Ticket prices vary by age, time of
film showing and (in some cases)
by location of the park.
PRICE DISCRIMINATION
Many venues offer price Price walking - long-standing or
discounts for students who have a loyal customers faced higher
more price sensitive demand prices when renewing their
policies.
 To what extent is price
discrimination harmful
for social welfare?

PRICE DISCRIMINATION
 Negative Effects on Consumer Welfare

1. Higher prices for many people reduces their consumer surplus – an example is “dual
pricing” in insurance where loyal customers were charged more than new customers.
This form of pricing exploits imperfect information in the market and consumer inertia.
2. Price discrimination reinforces monopoly power of firms which can then lead to higher
prices in the long run and a loss of allocative efficiency
3. Algorithms increase the potential to discriminate between consumers – there is now
widespread use of artificial intelligence driven price discrimination leading to certain
groups in society consistently paying more (such as online hotel bookings).
4. Multi-purchase or volume discount purchasing favours higher-income, larger families
at expense of single people. It can encourage food waste which creates external costs

PRICE DISCRIMINATION
 How might price
discrimination be
justified on welfare
grounds?

PRICE DISCRIMINATION
 Arguments Supporting Price Discrimination
1. It makes fuller use of spare capacity leading to less waste. There are potential
environmental benefits from this – an example, less food waste.
2. Helps generate extra cash flow for businesses which can ensure survival during a
recession – this supports jobs and maintains choice for consumers.
3. Can fund cross-subsidy of goods and services – premium prices for some can fund
discounts for other groups living on lower incomes. (Consider means-tested college
fees). It can allow continuation of loss-making services such as rural bus & train routes.
4. Higher monopoly profits can finance investment & research and development
spending which then drives improved dynamic efficiency in the long run
5. Can be seen as a progressive policy – an example, charging different prices for drugs
such as vaccines between advanced and developing nations.

PRICE DISCRIMINATION
PRICE DISCRIMINATION
 The welfare effects of price discrimination can be judged
on a case-by-case basis. The impact depends on how a
business chooses to use their extra profits. The cross-
subsidy argument is potentially important particularly
applied to health care and education.

PRICE DISCRIMINATION
Examples of Price Discrimination
Movie Tickets Many movie theaters charge a lower price for children and senior
citizens than for other patrons. This fact is hard to explain in a competitive
market. In a competitive market, price equals marginal cost, and the marginal cost
of providing a seat for a child or senior citizen is the same as the marginal cost of
providing a seat for anyone else. Yet the differential pricing is easily explained
if movie theaters have some local monopoly power and if children and senior
Citizens have a lower willingness to pay for a ticket. In this case, movie theaters
raise their profit by price discriminating.
Airline Prices Seats on airplanes are sold at many different prices. Most airlines
charge a lower price for a round-trip ticket between two cities if the traveler stays
over a Saturday night. At first, this seems odd. Why should it matter to the airline
whether a passenger stays over a Saturday night? The reason is that this rule
provides
a way to separate business travelers and leisure travelers. A passenger on
a business trip has a high willingness to pay and, most likely, does not want to stay
over a Saturday night. By contrast, a passenger traveling for personal reasons has
a lower willingness to pay and is more likely to be willing to stay over a Saturday
night. Thus, the airlines can successfully price discriminate by charging a lower
price for passengers who stay over a Saturday night.
Discount Coupons Many companies offer discount coupons to the public in
newspapers, magazines, or online. A buyer simply has to clip the coupon to get
$0.50 off her next purchase. Why do companies offer these coupons? Why don’t
they just cut the price of the product by $0.50?
The answer is that coupons allow companies to price discriminate. Companies
know that not all customers are willing to spend time clipping coupons. Moreover,
the willingness to clip coupons is related to the customer’s willingness to pay for
the good. A rich and busy executive is unlikely to spend her time clipping discount
coupons out of the newspaper, and she is probably willing to pay a higher
price for many goods. A person who is unemployed is more likely to clip coupons
and to have a lower willingness to pay. Thus, by charging a lower price only to
those customers who clip coupons, firms can successfully price discriminate.
Financial Aid Many colleges and universities give financial aid to needy
students.
One can view this policy as a type of price discrimination. Wealthy Students have greater financial
resources and, therefore, a higher willingness to pay than needy students. By charging high tuition
and selectively offering financial aid, schools in effect charge prices to customers based on the value
they place on Going to that school. This behavior is similar to that of any price-discriminating
monopolist.
Deadweight loss
 Review of Consumer and Producer Surplus

Consumer and Producer Surplus

Consumer A would pay $10 for a good whose
market price is $5 and therefore enjoys a benefit
of $5. Consumer B enjoys a benefit of $2, and
Consumer C, who values the good at exactly
the market price, enjoys no benefit. Consumer
surplus, which measures the total benefit to all
consumers, is the yellow-shaded area between
the demand curve and the market price.

Producer surplus: measures the total profits of

producers, plus rents to factor inputs. It is the
green-shaded area between the supply curve and
the market price. Together, consumer and
producer surplus measure the welfare benefit of a
competitive market.
Deadweight loss
Consumer Surplus : area below dd curve and
above market equilibrium price. (A+B)

Producer Surplus: Area above Supply curve and

below market equilibrium price.

If Monopoly is existing in market , it results in

the reduction of certain consumer surplus and
producer surplus. Because producer and
consumer cannot absorb all surplus from
market. That loss part of consumer surplus and
producer surplus when monopoly exists is
known as Deadweight loss (B+C).

Also shows the inefficiency of market.

Depreciation
 What is depreciation?

A reduction in the value of an asset over time, due to wear and tear.

Depreciation is an accounting technique used to allocate the cost of an asset over time, usually
its useful life, which is defined as an estimate of how long in years the asset is likely to remain in
service—or useful—and generate revenue.

Depreciation shows the expense of using an asset over time and is unrelated to its physical condition. An
example would be if you purchased a piece of machinery for a company at a total cost of $1,000. The
average useful life of that piece of machinery is 10 years, so it would decrease in value by 10% each year.
How to calculate depreciation
• Straight-line
• Declining balance
• Sum of years digits (SYD)
• Units of production
Straight-line depreciation

1. Subtract the salvage value from the asset cost.

2. Divide that number by its useful life.
salvage value: The estimated resale value of an asset at the end of its useful life.

The formula:
(Asset cost - salvage value) / useful life = depreciation value per year

Example of using straight-line depreciation:

An office buys an office cubicle system for $15,000. The salvage value of the system is $500, and it has a
useful life of 10 years.
To find out how much you can deduct in taxes each year, you use the formula:

(15,000 - 500) / 10 = $1,450

You can deduct $1,450 per year for the 10 years of the system's useful life.
Double-declining balance depreciation
If you want to recover more of an asset's early value, you may choose to use the double-declining
balance method of depreciation. To calculate using this method:

The formula: (2 x straight-line depreciation rate) x book value = declining balance per year

Where depreciation rate = 1 / useful life of asset x

Example of using double-declining balance depreciation:

A $15,000 office cubicle system depreciates over 10 years, so its straight-line depreciation rate is 10%.
For the first year of the system's life:

(2 x .10) x 15,000 = $3,000

You can deduct $3,000 of the system's value in its first year. For year two, the value is now $12,000 so for year two:

(2 x .10) x 12,000 = $2,400

You then can deduct $2,400 from the first-year value of $12,000 to find the second-year value of $9,600. You
would continue the process for years three through 10.
Sum-of-the-year digits depreciation

(Remaining lifespan / SYD) x (asset cost - salvage value) = SYD depreciation the first year

Example of using SYD:

An office cubicle system costs $15,000, has a salvage value of $500, and depreciates over a 10-year
useful life.
Adding the digits for the system's useful life would be: 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 = 55

(10 / 55) x (15,000 - 500) = $2,636.36 for the first-year deduction

Each year, the system's lifespan reduces by one, so the second-year equation would be:

(9 / 55) x (15,000 - 500) = $2,372 for the second-year deduction

Units of production depreciation

The formulas are:

(Asset cost - salvage value) / hours of useful life = units of production depreciation cost per hour

Cost per hour x hours of useful life = total depreciation

Example of using units of production depreciation:

Jonathan's House of Tabletops purchases a material-cutting machine for $75,000.

It has a salvage value of $6,000 and a useful life of 90,000 hours.

To find the units of production cost per hour:

(75,000 - 6,000) / 90,000 = $.76 cost per hour

To find the total depreciation of the machine:

.76 x 90,000 = $69,000

The machine depreciates by $69,000 during its useful life.