2Main Topics Price discrimination: pricing to extract surplus Perfect price discriminationPrice discrimination based on observable customer characteristicsPrice discrimination base on self-selection18-2
3Price Discrimination: Pricing to Extract Surplus Monopolist’s profit would be larger if he could solve two problemsConsumers who buy some of the product receive some consumer surplusMonopolist could increase profit if he could charge them a higher priceConsumers aren’t buying some units that they value less than the monopoly price but more than marginal costMonopolist could increase profit if he could charge these buyers less for those units of the goodMonopolist might be able to do better by price discriminating: charging different prices for different units of the same good18-3
4Price Discrimination: Pricing to Extract Surplus To be able to price discriminate:A firm must have some market powerIf not, a price above marginal cost will result in zero salesThe good or service must be difficult to resellOtherwise few sales will occur at the higher priceFirm must also be able to distinguish sales for which the purchasers have a high willingness to pay from those they have a low willingness to payA monopolist can perfectly price discriminate if he knows perfectly the customer’s willingness to pay for each unit he sells and can charge a different price for each unit18-4
5Price Discrimination: Pricing to Extract Surplus Usually, a firm does not perfectly know a customer’s willingness to payTwo different ways to distinguish purchases for which the customer has a high vs. a low willingness to payPrice discrimination is based on observable customer characteristics when a firm can distinguish consumers with a high vs. low willingness to payPrice discrimination is based on self-selection when the firm offers a menu of alternativesDesigned so that customers will make choices based on their willingness to payIn quantity-dependent pricing, the price a consumer pays for an additional unit depends on how many units she has bought18-5
6Perfect Price Discrimination Under perfect price discrimination, the firm knows perfectly its customers’ willingness to payCan set the price for each individual consumer equal to her willingness to payMarginal revenue curve coincides with the market demand curveProfit-maximizing sales quantity occurs where the market demand curve crosses the marginal cost curveMonopolist produces the same quantity as would occur in a competitive industryEach consumer consumes the same quantity as they would under perfect competitionNo deadweight loss18-6
8Two-Part TariffsTwo-part tariffs are another quantity-dependent pricing plan that allows a perfectly discriminating monopolist to maximize profitWith a two-part tariff, consumers pay a fixed fee plus a separate per-unit price for each unit they buyExamples: amusement parks, rental car companiesCommonly used by monopolists and firms whose market power falls short of monopolyAdvantage is simplicity: name just two pricesTo maximize profit, set per-unit charge equal to marginal cost18-8
9Figure 18.4: Profit with a Two-Part Tariff Per-unit charge equals marginal costFixed fee is the consumer’s surplus at that per-unit priceMaximizes aggregate surplusLeaves the consumer no surplus18-9
10Sample Problem 1 (18.2):If the ice cream company from figure 18.2 (page 669) sells to Juan (whose demand curve is shown on page 524) using a two-part tariff with a per-cone price on $1.50, what is the largest fixed fee it can charge Juan and still persuade Juan to make a purchase? How does its total revenue from Juan under this two-part tariff compare to its total revenue from Juan when it sells Juan four cones, each priced at Juan’s willingness to pay for it? What is its total profit from Juan?
11Price Discrimination Based on Observable Characteristics Most often a firm’s ability to price discriminate is imperfectMay be able to sort consumers into rough groups based on observable characteristicsBut know no more about their willingness to payCannot engage in quantity-dependent pricing because cannot track purchasesExample: small town movie theater with four consumer groups (adults, seniors, students, kids)To maximize profit consider each group’s demand curve separatelySet price to maximize profit earned from that group18-11
12Price Discrimination Based on Observable Characteristics Set different prices whenever the groups have different elasticities of demandCharge a higher price to groups with less elastic demandGenerally the group that will face the higher price is the one with the less elastic demand at the profit-maximizing no-discrimination priceStarting at that price, monopolist will:Raise the price of the less elastic groupLower the price of the more elastic groupCan find optimal prices and quantities for each group using algebra18-12
13Figure 18.5:Profit-Maximizing Price to Two Groups 18-13
14Sample Problem 2 (18.4)Suppose moviegoer’s demand functions are QS = 800 – 100P and QA = 1600 – 100P for students and other adults respectively. Marginal cost is $3 per ticket. What prices will the monopolist set when she can discriminate and when she cannot? How will discrimination affect her profit?
15Welfare Effects of Imperfect Price Discrimination Profit is at least as large with discrimination as withoutCan always charge every group the same price, won’t charge different prices unless it benefits the firmPrice discrimination affects different groups of consumers differentlyWorse off it my price rises as a result of discrimination, better off if it fallsTwo main effects on consumer and aggregate surplus:Different consumers pay different prices, inefficient because a consumer who faces a low price and decides to buy may have a lower willingness to pay than a consumer who faces a high price and decides not to buyMay encourage the monopolist to sell more, increase both consumer and aggregate surplusOpposing effects can combine to either raise or lower consumer and aggregate surplus18-15
16Welfare Effects of Imperfect Price Discrimination In Figure 18.7, total consumer surplus is smaller with discriminationThe gain to college students is smaller than the loss to other adultsAggregate surplus is also smaller with discriminationGain in profit ($800) is smaller than the loss in consumer surplus ($1,200)The number of tickets sold is the sameBut inefficiently distributed with discrimination18-16
17Figure 18.7: Welfare Effects of Price Discrimination 18-17
18Sample Problem 3 (18.8)What is the effect of discrimination on consumer and aggregate surplus in exercise 18.4?
19Price Discrimination and Market Power In a competitive market, firms can’t price discriminatePrice discrimination is a sign of a market that is not perfectly competitiveCan be difficult to determine whether price discrimination exists in a marketDifferent prices may reflect cost differencesMarket does not have to be very far from perfectly competitive to exhibit discriminationOligopolists may price discriminate more than monopolists18-19
20Price Discrimination Based on Self-Selection Often firms cannot distinguish between groups of consumers based on observable characteristicsPrice discrimination may still be possibleOffer a menu of alternativesIf properly designed, customers with different willingness to pay will choose different alternativesA common practiceExamples: supermarket discounts for shoppers who clip coupons, wireless phone companies with multiple calling plans18-20
21Quantity-Dependent Pricing and Self-Selection Recall that a perfectly discriminating monopolist maximizes profit with a two-part tariffThis level of profit is not achievable when consumers’ characteristics are not directly observableIf given the choice between two plans with the same per-minute price, all consumers will opt for the low-demand (low fixed fee) planConsumers will not self-select based on willingness to payThe monopolist can often do better by raising the per-unit charge above its marginal costCan do even better by offering a menu of different two-part tariffs18-21
22Figure 18.9: Two-Part Tariff with Two Types of Consumers 18-22
23Clearvoice Wireless Example Clearvoice is a wireless telephone monopolist in a rural areaTwo types of consumers, high-demand and low-demandDistinct monthly demand curves for wireless minutes for each groupClearvoice’s marginal cost is 10 centsIf could observe consumer characteristics, would offer two-part tariff with 10-cent per-minute priceFixed fee for low-demand customers: $8Fixed fee for high-demand customers: $40.5018-23
24Profit-Maximizing Two-Part Tariff Suppose Clearvoice wants to offer a single two-part tariffPer-minute price of 10 cents and monthly fee of $40.50High-demand customers acceptLow-demand customers rejectPer-minute price of 10 cents and monthly fee of $8All consumer acceptWhich plan is better?If there are a large number of low-demand customers, $8 monthly fee is betterMay be even more profitable to raise per-minute fee above marginal cost18-24
25Profit-Maximizing Two-Part Tariff If the monopolist plans on selling to both types of consumer it is always profitable to raise the per-unit price at least a little above marginal costRegardless of the types’ relative proportionsWould like to extract some of high-demand consumers’ surplus without changing surplus of low-demand consumer (already zero)Raise per-unit price to get more surplus from high-demand consumersAdjust fixed fee so low-demand consumers’ surplus is unchangedThe smaller the faction of low-demand consumer, the more worthwhile it is to raise the per-unit priceDeadweight loss from low-demand consumers increases18-25
26Figure 18.10: Benefits of Raising the Per-Minute Charge 18-26
27Using Menus to Increase Profit Can do even better by offering a menu of two-part tariffs, each designed to attract a specific type of consumerCan eliminate some deadweight loss by introducing a second tariff planExtract more surplus from high-demand consumers by making the low-demand plan less attractive to high-demand customers18-27
28Eliminating Deadweight Loss of High-Demand Consumers Suppose Clearvoice offers a pair of two-part tariffsOne designed for low-demand consumers:Per-minute price of 20 cents, fixed fee of $4.50Second option intended to attract high-demand customers:Per-minute price of 10 cents, equal to Clearvoice’s marginal costFixed fee should be set as high as possible without causing high-demand consumer to choose the other planWith menu of plans:Firm profits are higher from high-demand consumersProfits from low-demand consumers are the sameDeadweight loss from high-demand consumers is eliminated and extracted as surplus18-28
30Making the Low-Demand Plan Less Attractive Can increase profit even more by making the low-demand plan less attractive to high-demand consumersThat plan determines the fixed fee the firm can charge a high-demand consumerIt is the level that makes the high-demand consumer indifferent between the two plansLimit the number of minutes a consumer can purchase in the 20-cent-per-minute planSet the limit equal to the number low-demand consumers wantWill have no effect on value a low-demand consumer derivesMake the plan less attractive to high-demand customersWill increase the fixed fee Clearvoice can charge high-demand consumers for the 10-cent-per-minute plan18-30
32Menu of Two-Part Tariffs A firm can often profit by offering a menu of choicesDesigned for different types of consumersTo maximize its profits, firm should try to make each plan attractive to one group onlyAnd unattractive to other consumer groupsFirm benefits from setting the per-unit price in the plan intended for consumers with the highest willingness to pay equal to the marginal costEliminates deadweight loss for those consumers18-32
33Sample Problem 4 (18.12):Air Shangrila sells to both tourist and business travelers on its single route. Tourists always stay over on Saturday nights, while business travelers never do. The weekly demand function of tourists is QT = 6,000 – 10P, and the weekly demand function of business travelers is QB = 1,000 – P. If the marginal cost of a ticket is $200, what prices should Air Shangrila set for its tourist and business tickets? If the government passes a law that says all tickets must cost the same, what price will Air Shangrila set?