Price Discrimination

• How does someone price discriminate? Age Sex Quantity Patience (lines, express delivery) Flexibility (plane tickets) Ability or willingness to bargain Information Membership Coupons

1st Degree Price Discrimination

• AKA Perfect Price Discrimination

• Charge each person his/her WTP

• Allocatively efficient, no DWL

• Extracts all of the consumer surplus

• Difficult to implement

• Can use a 2-part tariff

Using a Two-Part Tariff to Price Discriminate

Demand = WTP

Supply = MC

Quantity

$

QM

PM

Fixed Fee = (V-PM)/2

V

Even Better - From the Monopolist’s Point of View

Demand = WTP

Supply = MC

Quantity

$

QM

PC

Fixed Fee = (V-PC)/2

V

2nd Degree Price Discrimination

• All consumers face same price “menu”

• Actual price paid depends on consumer’s preferences or type

• Usually used when consumers cannot be distinguished ex ante

• Ex: Quantity discount

3rd Degree Price Discrimination

• AKA Market Segmentation

• Consumers separated into submarkets based on some external characteristic

• Different prices in each submarket

• No arbitrage between submarkets

• Ex: Airlines

Market Segmentation

Demand = WTP

MC

Quantity

$V

QM

PM

MR

PS

Demand of Group 1

Demand of Group 2

Implementing 3rd Degree Price Discrimination

• Must be able to identify different demand and to prevent resale/arbitrage

• Screening: Offering different features to appeal to customers with different WTP– 2 model years of the same car on the same lot

– Different passes at CW and Busch Gardens

• Crimping: Limiting the usefulness of the product to "screen” customers– Prevents resale from low price to high price market

– Shareware versions that aren't fully functional

Consequences of Price Discrimination

• 1st Degree:– Quantity at competitive level– Extracts all of the potential surplus

• 2nd Degree– Expands output, but not to competitive level

• 3rd Degree = Market Segmentation– Doesn’t necessarily expand output, may

redistribute– May lead to loss in total surplus

Antitrust and Price Discrimination

• 1887: Interstate Commerce Act– Prohibited undue discrimination in railroad rates.

• 1914: Clayton Act– Price discrimination illegal if it lessens competition or

tends to create a monopoly.

– OK to discriminate based on grade, quality, or quantity.

• 1936: Robinson-Patman Act– Closed the quantity loophole - no difference in price

allowed when effect is to lessen competition.

Illegal Price Discrimination

• Primary Line– The firm practicing PD injures its own rivals.

• Secondary Line– The injury to competition occurs in the buyers’

market.

Anheuser-Bush Case: Primary Line Discrimination

• AB dropped price of premium brand (Budweiser) in St. Louis only

• Claim was it would hurt AB’s competitors because it would divert consumers from other brands

Morton Salt Case: Secondary Line Discrimination

• Salt sold at a quantity discount

• Only 5 customers bought at the lowest price -- all large chain stores

Commodity Bundling and Tie-In Sales• Techniques used by multi-product firms to

extract additional consumer surplus

• Bundling: Selling two or more products in a single package– Ratio of the products is fixed– Example: Happy Meal

• Tie-In Sales: Purchase of one good conditional on purchase of another– Ratio of the products not fixed– Example: Polaroid cameras

How Bundling Works

Two Types of TV Viewers: Series Lovers and Event Watchers

WTP for Network TV WTP for Sports/Special Interest

Series Lover $15 $10

Event Watcher $8 $12

Selling products separately, maximize revenue by charging $8 for Network TV and $10 for Sports/Special Interest. Total Revenue = $36, Total Consumer Surplus = $9

Selling bundled products, maximize revenue by charging $20 for combined package. Total Revenue = $40, Total Consumer Surplus = $5

General Model of Commodity Bundling

Each consumer will buy at most one unit of each of two good. Consumers have different values (V) for the two goods.

V1

V2

A’s value for good 1

Consumer A

A’s value for good 2

Firm produces goods at different constant marginal costs, c1 & c2.

Without bundling, prices are set at the monopoly level.

With “pure” bundling (can only buy the bundle) sales increase.

PB

PB

PB

P1

P2

c1

c2V1

V2

With “mixed” bundling, consumers can buy products either separately, or together.

PB

PB

c1

c2V1

V2

P1

P2

PB

In both cases, PB > c1 + c2 , but PB < P1 + P2.

Therefore, although sales increase, profit may not. For profit to increase, there must be significant variation in valuations.

How Tie-In Sales Work

1. Amount of each good that must be bought is not specified.

2. Usually complementary goods.

Allows firm to price discriminate. Acts like a 2-part tariff. Everyone pays same amount for camera, but heavy users buy more film than light users, so the two groups will pay different average prices.

Tie-in sales can also be used to get rid of externalities that may exist if the goods are related.

Assume goods 1 and 2 are complements, but are produced by separate firms.

QD (Pair) = A - (P1 + P2 )

There’s an externality, because

QD (good 1) = A - (P1 + P2 ) and

QD (good 2) = A - (P1 + P2 )

Start by focusing on good 1. Assume the mkt is a monopoly.

QD (good 1) = A - (P1 + P2 )

Inverse Demand P1 = A - P2 - Q1 TR = (A - P2 - Q1)Q1

MR1 = A - P2 - 2Q1

If MC = 0, Q1 = (A - P2 )/2 and likewise, Q2 = (A - P1 )/2

So P1 = A - P2 - (A - P2 )/2 = (A - P2 )/2

and likewise, P2 = (A - P1 )/2

Let’s graph this.

P1

P2

A

A/2

A/2 AA/3

A/3

To solve, set the two curves equal:

P1 = (A - P2 )/2

P2 = (A - P1 )/2 P1 = A - 2 P2

(A - P2 )/2 = A - 2 P2 3/2 P2 = 1/2 A

P2 = A/3 (and by symmetry P1 = A/3 )

Now assume that 1 firm makes both goods.

QD (pair) = A - (P for the pair )

Inverse Demand P = A - Q TR = (A - Q)Q

MR = A - 2Q

If MC = 0, Q = A/2 and thus P = A/2

So = (A/2)A/2 = A2 /4

Compare to profit if goods priced independently.

P = 2A/3, Q = A - A/3 - A/3 = A/3, = 2A2 /9

A2 /4 > 2A2 /9