CHAPTER 9: Price Discrimination

This chapter considers nonlinear pricing and price discrimination. Price Discrimination: Nonuniform pricing in which a firm 1. charges different categories of consumers different unit (uniform) prices for the identical good, or 2. charges each consumer a nonuniform price on different units of the good

Price difference due to different cost is not price discrimination. Which differences in price is due to price discrimination?

1.

Price of gasoline in Onalaska

Price of gasoline near downtown La Crosse Price of gasoline in La Crescent Price of gasoline in Minneapolis 2. Is a quantity discount for large purchases price discrimination?

Purpose: Practice of setting different prices for the same good so as to capture as much Consumer Surplus (CS) as possible. Incentive: Maximize profits.

Conditions for Price Discrimination: 1. Market power 2. Identifying different willingness-to-pay For individuals For groups of individuals 3. Prevent or limit resales (no arbitrage) Cost Test for Price Discrimination: Price discrimination exists if the ratio of prices across markets is different from the ratio of marginal costs. (In perfectly competitive market the law of one price holds) When is Price Discrimination a Problem? When used to lessen competition

Predatory pricing impacting direct competitors (primary-line price discrimination)

Types of Price Discrimination Perfect Price Discrimination or 1st Degree Price Discrimination: Also called personalized pricing. Set different prices (at maximum willingness-to pay) for each buyer and for each unit sold, extracting all the CS. Examples: small town doctor, auto sales Case 1: Each consumer buys one unit. Charge the maximum willingness-to-pay for each consumer and capture all the CS. The price to the marginal consumer = MC and output sold is identical to perfect competition. No efficiency loss, but income distribution is impacted. Case 2: Each consumer buys more than one unit. 1. Quantity dependent prices that extracts all the CS
2.

Two-part tariff: Lump-sum fee for right to purchase product equal to CS and price equal to MC

3rd Degree Price Discrimination [group pricing]: Seller separates consumers into two or more groups by distinguishing different buyer characteristics (demand elasticities must differ). The market is segmented with different prices charged to different groups. Examples: Senior discount, student discount, geographical location Note: MR = P [ 1 + (1/D)]

In each market segment, i, profit maximizing firm wants MRi = MC So, MC = P1 [ 1 + (1/D1)] = P2 [ 1 + (1/D2)] P1 / P2 = [ 1 + (1/D2)] / [ 1 + (1/D1)] Charge lower price in those market segments with greater price elasticity. Segmenting the market may be difficult: Student or senior discount Airline travel (tourist discount) Discount coupons or rebates Queuing or waiting Informed versus uninformed or

2nd Degree Price Discrimination [menu pricing or nonlinear pricing]: (see Chapter 10 under Nonlinear Pricing) Two cases: 1. Consumers self-select from a menu since the seller can only distinguish buyers indirectly. Examples include airline price discrimination (get lower fare if selecting a Saturday night stay over) or quantity discounts (get lower prices if selecting higher quantities). Two-Part Tariff charges a customer a lump-sum fee for the right to purchase and a usage charge per unit. Ideally, the firm would like the usage charge or price to be MC (if MC is constant) and the lump-sum fee to be Consumer Surplus (CS). The average price will vary (hence nonlinear). In special cases the two-part tariff can extract all the CS. Examples: Club memberships (e.g. golf club), car leasing, Polaroids instant-picture camera

2.

Welfare Effects

P m m m
M

C A MC

Perfect Price CS PS Welfare Deadweight Loss Competition MC A+B+C 0 A+B+C 0

Monopoly
Uniform price

1st Degree P.D. Final unit = MC 0 A+B+C A+B+C 0

Two-Part Tariff Fixed = CS Price = MC 0 A+B+C A+B+C 0

P B C B+C A

Comparisons with non-discriminating monopolist

1.

No deadweight loss with PC, 1st Deg PD, or 2-part tariff. In 1st Deg PD and 2-part tariff: CS (fairness ) ?

2. Welfare and efficiency

3.

4. Consumers pay different prices, but more consumers are served

Welfare and 3rd Degree Price Discrimination More complicated in analyzing welfare implications.
1.

Within each group P > MC

2. With no arbitrage, lose gains from trade 3. Consumers expend resources to obtain lower prices 4. Welfare may be higher than non-discriminating monopolist if the deadweight loss is smaller

Price Discrimination and Antitrust Price discrimination was originally outlawed by section 2 of the Clayton Act in 1914 if it lessened competition. This law was weak and strengthened by the Robinson-Patman Act of 1936 in response to political pressure from small grocery stores. Predatory pricing that harms direct competitors also called primary-line price discrimination
2.

1.

Secondary-line price discrimination, leads to harm among the customers Tie-in sales

3.

Tie-in Sales (see Chapter 10 and 19) May increase efficiency May also be used strategically to harm rivals

1.

Bundling (package tie-in sales): Two or more products are sold in fixed proportions Requirements tie-in: In order to purchase one product, you are required to purchase another product

2.

Bundling Pure Bundling: Must buy package deal Mixed Bundling: Choice between package deal and separate items Example: 1. Movie distribution package bad movie in with good. 2. Software suite of wordprocessor (WP) and spreadsheet (SS) Consider the case where MC = 0, so firm wants to max Revenue Willingness-to-Pay User Type Writer Number Cruncher Generalist Strategies Sell each at $30 Sell each at $50 Sell Package @ $50 # 40 40 20 WP $50 0 $30 Revenue 40($30) + 40($30) + 20($30+$30) = $3600 40($50) + 40($50) 40($50) + 40($50) + 20($50) = $4000 = $5000 = $5200 SS 0 $50 $30

Ea.@$50 or Package@$60 40($50) + 40($50) + 20($60) Pure bundle yields $5000. Mixed bundle yields $5200.

Example of Profitable Package Tie-in (MC = 0) Type 1 Consumers Amount ($) Willing-to-pay for A Amount ($) Willing-to-pay for B Willing-to-pay for A & B together 9,000 3,000 12,000 Type 2 Consumers 10,000 2,000 12,000 = $22,000 = $24,000

Max Revenue selling A @ $9,000 and B @ $2,000 Max Revenue selling Package @ $12,000 Note the Price Discrimination 1 pays $9,000 for A and $3,000 for B 2 pays $10,000 for A and $2,000 for B Example of Unprofitable Package Tie-in (MC = 0) Type 1 Consumers Amount ($) Willing-to-pay for A Amount ($) Willing-to-pay for B Willing-to-pay for A & B together 9,000 500 9,500

Type 2 Consumers 10,000 2,000 12,000 = $20,000 = $19,000

Max Revenue selling A @ $9,000 and B @ $2,000 Max Revenue selling Package @ $9,500

Requirements Tie-in Consumers (or businesses) buy one good and are then required to make all of their purchases of some related good from the same manufacturer. Company IBM AB Dick Amer Can Others High users of the tied good are in effect paying a high price for the machine. This raises profit for the monopoly. Problem: Foreclosure. Monopolist may extend monopoly to the tied good. Good keypunch mimeograph can closing Tied good at above competitive price tabulating cards ink can requirements

Distribution Effects Trade-offs: Efficiency (favors PD) Making good accessible To many consumers (favors PD) vs vs. Consumer Welfare (favors uniform pricing) Fairness (no arbitrage) (favors uniform pricing)

Distributional effects from PD are that producers gain, consumers lose. Likely to increase inequality (negative), but may increase welfare (CS + PS) over uniform monopoly pricing (positive).

Effect on Competition: 1. If done by small, fringe firms, PD may be positive by keeping competitors in business. 2. Systematic PD by dominant firms may lead to predation or foreclosure and therefore harmful to competition.