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©2005, Southwestern Slides by Pamela L. Hall Western Washington University Price Discrimination Chapter 13.

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Presentation on theme: "©2005, Southwestern Slides by Pamela L. Hall Western Washington University Price Discrimination Chapter 13."— Presentation transcript:

1 ©2005, Southwestern Slides by Pamela L. Hall Western Washington University Price Discrimination Chapter 13

2 2 Introduction Price discrimination is legal unless it substantially limits competition Firms will actively price discriminate in an effort to enhance profits A firm with monopoly power has some control over output price when it is facing a negatively sloping demand curve May be able to increase profits by discriminating among consumers For example, a bar may sell drinks at a lower price per unit during happy hour Generally, a firm desires to sell additional output if it can find a way to do so without lowering price on units it is currently selling By separating market into two or more segments Called price discrimination (or Ramsey pricing) Analogous to a multiproduct firms supplying products in different markets

3 3 Introduction Our aim in this chapter is to illustrate how firms are always probing market for ways to enhance profits For a firms long-run survival, it must constantly devise novel pricing techniques for enhancing profits Firms who first develop such pricing techniques can earn pure profits Firms who do not will, in the long run, fail We first state underlying market conditions required for price discrimination We develop categories of first-, second-, and third-degree price discrimination Evaluate efficiency and welfare effects of each type First-degree price discrimination includes pricing strategies such as two- part tariffs Tie-in-sales and bundling are discussed as an alternative to this type of price discrimination

4 4 Introduction Second-degree price discrimination offers potential social benefits If a firm did not price discriminate it might not be able to produce a desired commodity Third-degree price discrimination segments the market For instance, into a foreign and a domestic market We discuss quality discrimination Generally, same implications associated with price discrimination hold for quality discrimination as well In all large companies, applied economists are actively developing methods for price discrimination For example, after deregulation of airline industry in 1978, airline economists developed price-discriminating techniques for improving profit Such as requiring a Saturday night stay or 14-day advance bookings

5 5 Conditions for Price Discrimination In terms of demand elasticities, if elasticities associated with market segments are the same No incentive on part of a firm to price discriminate Because profit-maximizing output and price are identical in both markets Two necessary conditions for price discrimination are Ability to segment market Exists if resales become so difficult that it becomes impossible to purchase a commodity in one market and sell it in another market When resale is possible, arbitrage will eliminate any price discrepancies and Law of One Price will hold Existence of different demand elasticities for each market segment

6 6 Conditions for Price Discrimination A firm may price discriminate across any category of consumers Such as income level, type of business, quantity purchased, geographic location, time of day, brand name, or age For example, doctors may charge less for treatment of low- income patients, and a defense contractor may charge military $500 for a hammer that costs other costumers only $20 Depending on how a market can be segmented, economists have categorized various types of price discrimination into First-, second-, and third-degree price discrimination

7 7 First-degree Price Discrimination Complete price discrimination, perfect price discrimination, or first- degree price discrimination Occurs when it is possible to sell each unit of product for maximum price a consumer is willing to pay Table 13.1 lists characteristics and examples of first-, second- and third- degree price discrimination First-degree price discrimination involves tapping demand curve Illustrated in Figure 13.1 First unit of commodity is sold to a consumer willing to pay highest price, 0A Second unit to a consumer willing to pay at a slightly lower price And so on until demand curve intersects SMC In this case, demand or AR curve becomes MR curve As firm increases supply, price declines only for additional commodity sold, not for all commodities supplied

8 8 Table 13.1 Characteristics of First-, Second-, and Third-Degree Price Discrimination

9 9 Figure 13.1 First-degree price discrimination

10 10 First-degree Price Discrimination As shown in figure, firm equates MR to SMC and supplies a level of output Q 1 Results in TR being represented by area 0ABQ 1 STC by area 0FEQ 1 Pure profit by area FABE Each consumer who purchases commodity is paying his or her maximum willingness-to-pay, WTP, for commodity Receives zero consumer surplus from purchasing commodity Area FABE contains total consumer surplus, for an output level of Q 1 Which firm captures Since all of consumer surplus is captured by firm, all consumers are indifferent between buying commodity or not Lowest price offered by firm is p 1 = SMC(Q 1 ) Because additional revenue generated by selling an additional unit of output is less than additional cost SMC

11 11 First-degree Price Discrimination Last consumer willing to purchase commodity pays this lowest price, p 1 Consumers who are not willing to pay p 1 do not purchase the commodity All other consumers who do purchase commodity pay a price higher than p 1 equivalent to their maximum WTP Thus, at p 1 and Q 1, what consumers (society) are willing to pay for an additional unit of commodity is equivalent to what it costs society to produce this additional unit, SMC(Q 1 ) Represents a Pareto-efficient allocation With first-degree price discrimination there is no deadweight loss (inefficiency) However, distribution of wealth between consumers and owners of firms may be questionable for maximizing social welfare First-degree price discrimination is difficult to attain One example is a roadside produce stand Prices vary depending on type of automobile consumer is driving and where he is from Person driving a Lincoln with New York plates will probably pay a premium for boiled peanuts at a roadside stand in Georgia

12 12 Intertemporal Price Discrimination Type of first-degree price discrimination Products price is based on different points in time Price is initially set high To capture consumer surplus from those consumers willing to pay high price rather than wait Price is lowered over time To capture further consumer surplus from those consumers unwilling to pay high price and willing to wait

13 13 Two-Part Tariffs Consumers pay for ability to purchase a commodity and possibly again for actual commodity E.g., pay a membership fee for joining a country club in addition to any greens fee E.g., pay an entrance fee to get into a bar and then pay for drinks Firm will price discriminate on entrance fees to extract as much of a consumers WTP as possible Commodity being sold is priced so it will maximize admission Subject to constraint that additional output cannot be sold below cost At p = SMC Will expand number of consumers paying entrance fees compared with no price discrimination condition of MR = SMC

14 14 Two-Part Tariffs Price discrimination on entrance fees is achieved through coupons and discounts by age or for membership in certain organizations For example, in 1955 Disneyland opened in rural Anaheim, California In 1950s and 1960s, Disneyland employed a two-part tariff Admission price was charged along with a cost for each attraction Cost of tickets for attractions varied Rides like Dumbo cost the least (an A ticket) and rides like Pirates of the Caribbean cost the most (an E ticket)

15 15 Two-Part Tariffs A two-part tariff assuming only one consumer is also illustrated in Figure 13.1 Firm sets an entrance fee that takes all consumer surplus Where p = SMC at p 1, area p 1 AB Sets a price of p 1 that results in output Q 1 Firms profit is same as first-degree price discrimination, FABE No deadweight loss exists However, may be social-welfare implications from transfer of surplus from consumers to firms Firms will also use a two-part tariff in pricing tie-in sales Firm with monopoly power will require consumers to purchase two or more commodities that are complementary goods For example, up until late 1960s, IBM required consumers who purchased an IBM computer to also purchase their punch cards Priced computer at a perfectly competitive price Employed monopoly pricing for punch cards, where MR = SMC < p

16 16 Bundling In many cases firms are unable to practice first-degree price discrimination Because consumer preferences are not completely revealed Cost of revealing these preferences may be prohibitive In such cases, difference in consumers willingness- to-pay for commodities and marginal cost of producing commodities can be exploited By selling commodities in bundles Bundling exists when a firm requires consumers to purchase a package or set of different commodities rather than some subset of commodities For example, many portrait studios will sell a package of photos in different sizes and poses rather than each photo separately

17 17 Bundling Effective method for enhancing profit when consumers have heterogeneous demands But firm is unable to effectively separate consumers by their preferences and then price discriminate Specifically, bundling is an alternative when firms are unable to perfectly price discriminate For example, automobile dealers often offer a package containing a number of options, such as leather seats and antilock brakes Consumers can purchase package containing leather seats and antilock brakes Cannot purchase leather seats or antilock brakes separately

18 18 Bundling Suppose Robinson is willing to pay more for leather seats than Friday Friday is willing to pay more for antilock brakes than Robinson As shown in Table 13.2, if options were sold separately, maximum price that could be charged is $1300 for leather seats and $1000 for antilock brakes Revenue would be $2300 from each consumer, with TR = $4600 If dealer could perfectly price discriminate and charge each consumer their maximum WTP for each option First-degree price discrimination would yield TR = = $6800 However, since dealer cannot do this, it bundles leather seats with antilock brakes Robinson is willing to pay $3000 and Friday $3800 By charging each consumer $3000, TR = $6000 Greater than revenue derived from not bundling but lower than revenue from perfect price discrimination

19 19 Table 13.2 Bundling

20 20 Bundling Bundling is most effective when demands of two consumers are highly negatively correlated See Table 13.3 Local governments have recently adopted bundling in an effort to entice voters to pass local-option tax measures Targeting tax revenue to a bundle of specific projects Such as school improvements, a retirement center, a sports complex, and a transit facility improves likelihood of tax passing Negative correlation of these projects makes bundling a very attractive method for funding If voters had to consider each project separately, probability of all projects receiving majority support would decrease

21 21 Table 13.3 Bundling with Positively Correlated Demands

22 22 Second-degree Price Discrimination Cost of a 1-ounce letter is 22.2¢ using Standard Class (bulk mail) Compared with 37¢ for regular First Class mail Bulk rate discount is an example of second-degree price discrimination Commonly used by public utilities For example, per-unit price of electricity often depends on how much is used Second-degree price discrimination (also known as nonlinear pricing) occurs Where a firm with monopoly power sells different units of output for different per-unit prices Every consumer who buys same unit amount of commodity pays same per-unit price Price differs across commodity units and not across consumers Same price schedule is offered to all consumers and consumers self-select which price per unit they will pay Mixed bundling is an alternative type of bundling associated with second-degree price discrimination Firm will offer commodities both separately and as a bundle With bundled price below sum of individual prices

23 23 Second-degree Price Discrimination In some cases it may be possible for a firm with monopoly power to earn a pure profit only if it price discriminates Consider second-degree price discrimination where a monopoly establishes two prices for a commodity A higher per-unit price for the commodity offered in a smaller size and a lower per-unit price for a larger size As illustrated in Figure 13.2, monopoly would be operating at a loss if it offers a single (linear) per-unit price for commodity SATC curve does not cross AR curve at any output level No single price will yield a positive pure profit If firm price discriminates, it will earn a pure profit by selling Q 1 units of commodity in smaller unit size at a price of p 1 and Q 2 - Q 1 units of commodity in larger unit size at a price of p 2

24 24 Figure 13.2 Second-degree price discrimination yielding a pure profit

25 25 Second-degree Price Discrimination Pure profit from selling smaller unit size is represented by area (SATC 2 )p 1 AB Greater than loss (negative pure profit) from selling larger unit size, area EBCD Consumers can now consume a commodity that would not be available if firm did not price discriminate Firm can earn a pure profit Both consumers and firm are better off by price discrimination Implies a Pareto improvement and an associated increase in social welfare One justification for allowing a regulated monopoly to practice price discrimination

26 26 Second-degree Price Discrimination If consumers who are willing to pay for larger size units pay a price in excess of marginal cost Firm could lower p 2 by some amount to induce consumers to buy more Price is still greater than marginal cost Firm will still make a profit on these sales Profit occurs because, given price discrimination, such a policy would not affect profits from any other consumers As indicated in Figure 13.2, we determine optimal price for larger size units, p 2, and total quantity sold of both small and large sizes, Q 2 By setting p = SMC Determine optimal quantity of smaller size units, Q 1, and associated price, p 1 By maximizing revenue from smaller size units minus lost revenue from not quantity at bulk price per unit, p 2

27 27 Second-degree Price Discrimination F.O.C. is MR 1 (Q 1 ) – p 2 = 0 Solving for Q 1 yields optimal quantity for firm to supply in smaller units Firm can sell this level of output at p 1 In Figure 13.2, maximization problem results in additional revenue above bulk price p 2 of [(p 1 - p 2 )Q 1 ], represented by area p 2 p 1 AE

28 28 Self-Selection Constraint One problem with a firm maximizing smaller-unit revenue Consumers rather than firm determine who will purchase smaller versus larger sizes of commodity Nothing to prevent a consumer who usually purchases commodity in bulk from purchasing smaller size unit If firms price/quantity solution of p 1 and Q 1 yields unintended result of consumers shifting from purchasing larger size units to smaller size units Will not be profit-maximizing solution Firm instead must determine optimal price and quantity that will provide incentive for consumers to purchase unit size that maximizes firms profit

29 29 Self-Selection Constraint If consumer surplus for consumers purchasing larger size unit is greater than their surplus from purchasing smaller size unit Consumers will self-select and purchase larger size unit Otherwise, self-selection will not occur and bulk purchasers will switch to purchasing smaller size unit Considering self-selection constraint on determining profit- maximizing price and quantity Maximization problem is Where CS 1 and CS 2 are bulk consumers surplus from instead purchasing smaller size unit and their surplus from purchasing in bulk, respectively

30 30 Self-Selection Constraint If at unconstrained optimal solution, where MR 1 (Q 1 ) - p 2 = 0, self-selection constraint holds Firm will maximize profits by setting MR 1 = p 2 If CS 1 > CS 2 at MR 1 (Q 1 ) - p 2 = 0, firm would further increase price of smaller size unit until CS 1 = CS 2 For a linear demand curve the condition of CS 1 = CS 2 corresponds to revenue-maximizing condition MR 1 (Q 1 ) = p 2 = 0

31 31 Self-Selection Constraint Can demonstrate this condition with Figure 13.2 Let p = a - bq be inverse linear demand function faced by firm Then CS 1 = CS 2 (a – p 1 )Q 1 ÷ 2 = (p 1 – p 2 )(Q 2 – Q 1 ) ÷ 2 Multiplying both sides by 2 and substituting linear demand function for p 1 and p 2 yields Q 1 = Q 2 /2 Result is equivalent to F.O.C. for maximizing revenue MR 1 (Q 1 ) - p 2 = 0 Solving for Q 1 yields this equivalence a – 2bQ 1 – (a – bQ 2 ) = 0 Q 1 = Q 2 /2 Illustrated in Figure 13.2 Area p 1 aA representing CS 1 is equivalent to area EAD representing CS 2 at MR 1 (Q 1 ) - p 2 = 0 Thus, for a linear demand curve, self-selection constraint is always satisfied

32 32 Third-degree Price Discrimination Some managers believe only reason a firm would sell its product at a lower price in its foreign market To drive competing firms out of business and then exercise monopoly power by increasing price However, in many cases, reason is that firm is practicing third-degree price discrimination Common form of price discrimination Examples include senior-citizen discounts, lower prices in foreign versus domestic markets, and happy hours at bars Whenever markets have different demand elasticities and arbitrage among markets is impossible Firm can engage in third-degree price discrimination Occurs when a firm with monopoly power sells output to different consumers for different prices Every unit of output sold to a given category of consumers sells for same price For example, nonprofit rate for Standard Class (bulk) mail is 12.7¢ compared to 22.2¢ charged to for-profit consumers In contrast to second-degree price discrimination, where price differs across commodity unit and not across consumers In third-degree price discrimination price differs across consumers and not across commodity unit

33 33 Third-degree Price Discrimination Consider two markets each with different demand elasticities Assume demand curves are independent, so no leakage exists among markets Thus, consumers in market with a lower price cannot resell product in another market with a higher price For determining optimal selling prices and outputs, let p j (q j ) be inverse demand function in j th market segment and express revenue in j th market segment by TR j (q j ) = p j (q j )q j, j = 1, 2, Where q j is quantity sold in j th market segment Total revenue is TR(Q) = TR 1 (q 1 ) + TR 2 (q 2 ) Where total quantity sold, Q is Q = q 1 + q 2

34 34 Third-degree Price Discrimination Letting STC(Q) be short-run total cost function, firm maximizes profits by Partial differentiation yields F.O.C.s If MR 1 > MR 2, total revenue and profit can be increased by shifting output from market 2 to market 1 Enhancement in total revenue can continue until marginal revenues in both markets are equal

35 35 Third-degree Price Discrimination In general, for k markets MR j (q j *) = SMC(Q*) for all k markets If a monopoly can divide its market into k independent submarkets It should divide overall output among k markets in such a way that it equalizes marginal revenue obtained in all markets MR 1 (q 1 *) = MR 2 (q 2 *) = … = MR k (q k *) This common marginal revenue should be equal to marginal cost of overall output MR 1 (q 1 *) = MR 2 (q 2 *) = … MR k (q k *) = SMC(Q*) Price charged in each market is determined by substituting q j * into markets average revenue function, p j * = AR j (q j *) A graphical illustration for two markets (say, foreign and domestic) is provided in Figure 13.3

36 36 Figure 13.3 Third-degree price discrimination for two markets

37 37 Third-degree Price Discrimination Consider a level of MR = MR* This value of marginal revenue is attained in both markets only if quantities sold in two market segments are q 1 * and q 2 * Remaining F.O.C. requires that this common MR in two market segments be equated to SMC Determines optimal (Q, MR) combination By summing horizontally MR curves in each of two markets, we determine total output for a given level of MR, q j | MR Equating q j | MR with SMC determines optimal level of total output, Q* Optimal quantities and prices in the two markets are q 1 *, q 2 *, p 1 *, and p 2 * Determined by demand curve in each market given optimal output levels

38 38 Third-degree Price Discrimination Price is highest in market segment with more steeply sloped demand function Domestic market with more inelastic demand Can investigate relationship of prices in separate markets and elasticity by recalling that MR j (q j ) = p j [1 + (1/ D j )] Where D j = (q j /p j )(p j /q j ) is own-price elasticity of demand in market j Can relate prices charged in separate markets to own-price elasticities of demand in each of these markets Given that condition for the two markets is

39 39 Third-degree Price Discrimination Relationship indicates that prices in any two markets are equivalent if own-price elasticities of demand are equal If D 2 > D (demand is more elastic in foreign market, market 1), then 1 + (1/ D 2 ) < 1 + (1/ D 1 ) Which implies p 1 /p 2 p 1

40 40 Third-degree Price Discrimination Foreign market is charged lower price More price sensitive due to a greater degree of competition from other firms (more elastic demand) Prices will be lower in market where demand is more elastic and arbitrage is not possible For example, elasticity of demand for movie matinees is more elastic than evening movies Matinee prices are lower because opportunity cost of going to a matinee is higher Working and going to school coincide with matinee time Similarly, senior citizens and college students are groups with relatively lower incomes Resulting in a more elastic demand for commodities If a firm is able to segment its market based on these demographics It can price discriminate and potentially enhance its profits

41 41 No Price Discrimination Figure 13.3 illustrates relationship between ordinary monopoly (no price discrimination, where full arbitrage exists among consumers) and price discrimination A horizontal summation of individual market demand curves, q j | AR Is market demand curve facing firm if no price discrimination exists Note discontinuity of MR curve associated with this market demand curve Due to kink in market demand curve Optimal output is where SMC = MR at output Q' associated with common price p' Common price is between prices charged in the two market segments when price discrimination is practiced At this common price, firm sells q 1 ' in market 1 and q 2 ' in market 2 MR 1 > MR 2 Firm could increase profits by practicing price discrimination

42 42 No Price Discrimination Effect of third-degree price discrimination on social welfare is ambiguous Social welfare could be enhanced or reduced Depending on consumers preferences and wedge between price and marginal costs Sufficient condition for social welfare to decline is If total output from price discrimination does not increase Sufficient condition for a social-welfare gain is If third-degree price discrimination results in satisfying demand in a market where zero output would be supplied with no price discrimination For example, prior to airline deregulation, airlines could not compete in terms of price and were required to service certain routes Resulted in many empty seats on flights and airlines competing for passengers in terms of service and meals Since deregulation, airlines compete in terms of price They generally fill every seat Resulted in greatly expanded airline travel Satisfying markets (particularly vacation traveling) that were small or nonexistent before

43 43 Combination of Discrimination Techniques In an effort to earn short-run pure profits, firms will employ combinations of these three price discrimination techniques Will constantly be devising new methods for price discrimination For example U.S. Post Office uses both second- and third-degree price discrimination in pricing mail delivery In long-run, costs will adjust to any short-run profits from price discrimination Leading to long-run equilibrium with associated normal profits Firms failing to engage in price discrimination will experience declining revenue Be forced out of business

44 44 Combination of Discrimination Techniques Individual consumer can increase her utility by shifting consumption patterns and capturing lower price per unit offered by price-discriminating firms By doing so consumer is able to recoup some of surplus appropriated by firms Unfortunately, firms constantly change their prices or quantity as market conditions change For example, candy manufacturers will alter number of ounces in different sizes of candy bars Changes per-unit price for each size but keeps prices the same Changes in price discrimination have resulted in a whole industry developing for assisting consumers For example, travel agents will assist consumers in finding lowest fares for particular destinations

45 45 Quality Discrimination There is a difference in consumers willingness-to-pay for a given quality rather than quantity of a commodity For example, manufacturer of DVD players is practicing quality discrimination By offering a range of different physical components and different warranties for its DVDs Fundamentally, price discrimination and quality discrimination are identical models Same implications associated with various degrees of price discrimination hold for quality discrimination Actual commodity may be the same with a difference only in service Or commodity itself may be altered

46 46 Quality Discrimination Product quality can also take form of determining level of its durability A highly durable product, such as a new consumer appliance designed to last a lifetime, may result in market saturation Once most consumers have purchased product there remains only limited product demand A firm may also face competition from resale of durable goods it produced previously For example, if product (such as aluminum) can be recycled at a competitive price Monopoly power of firm could be eroded away

47 47 Quality Discrimination Number of strategies firms can use to counter product durability problem Build in planned obsolescence of product by Marketing an improved version of product Changing its physical appearance For example, automobile manufactures generally change their vehicle models appearance and market models improvements on an annual basis Lease their products instead of selling them Maintains a firms market power by giving it control over new market and market for resales

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