1. Lecture ONE
PRICE DISCRIMINATION

2. Sections Definition and conceptual issues
Importance of Price Discrimination
Conditions necessary for the Existence of Price Discrimination
Profit maximising Price and Output decisions of the discriminating firm
Classification of Price Discrimination by degree

3. Definition and Conceptual Issues
Price discrimination is defined as the sale of technically identical goods at prices disproportional to their marginal cost, taking full account of the cost of manufacture, sale and delivery and also risk and uncertainty.

4. Definition and Conceptual Issues-continued
It is also referred to as the sale (or purchase) of different units of a good/service at price differentials not directly corresponding to differences in supply cost.
In other words, price discrimination is the practice of charging different buyers (or different prices for different sales to the same buyer) for the same good, the difference in price not accounted for by differences in supply cost. (ie at the same supply cost).

5. Definition and Conceptual Issues-continued
The following must be noted
The definition above includes not only the sale of identical (same) products to different persons at different prices, but it also includes
the sale of identical products to the same buyer at different prices. (Example: Utilities charge different prices for units consumed per bill), and
charging the same price on transactions entailing different costs. (Example; paying the same part-time wages to lecturers who lecture different class sizes).

6. Definition and Conceptual Issues-continued
If different prices is a reflection of differences in costs of services it is not price discrimination but rather price differentiation.
How we define a good determines whether there is price discrimination or not. This is so because defining what identical goods may be misleading.
Indeed seemingly identical items often turn out to be different on the basis of geographical location, physical appearance and when they are sold.

7. Importance of Price Discrimination
It allows the price discriminating firm to increase its profits by permitting the firm to;
Secure a higher price for those sales which it is bound to get in any case.
Use a lower price to attract added sales which increase volume, improve utilization of fixed resources and yield extra profits

8. Importance of Price Discrimination - Continued
It implies that by practicing price discrimination the firm makes more profits under conditions in which it otherwise would have been impossible to do so.

9. Conditions Necessary for the Existence of Price Discrimination
For a seller to practice price discrimination profitably several conditions are necessary;
Condition ONE: Control over Price
The seller must have some control over price (i.e. monopoly power). This is so because a perfectly competitive firm can sell all it has at the same price and does not need to reduce price to sell more. i.e. cannot practice discriminate profitably

10. Condition Two: Separable classes of buyers
The two or more identifiable classes of buyers must be separable at a cost that does not exceed the monetary gains from separating them.
In other words the would-be discriminating firm must be able to segregate its customers into groups at a cost not exceeding the benefits to be derived form discriminating.

11. Condition Three: Opportunities for arbitrage should be deterred
Opportunities that will make it possible for resale by low price customers to high price customers (arbitrage) must be constrained.
In other words, the resale by those buyers who pay a low price to those who would be charged a higher price must be deterred.
In fact the possibility of practicing price discrimination are limited by the possibility of resale.

12. For personal services (i. e
For personal services (i.e. Medicare or education) it is virtually impossible to resell and this allows the service industry to lend itself particularly well to price discrimination.
But for goods since it can stored, transported, and resold easily it makes the possibilities of price discrimination are more limited, although by no means negligible.

13. Condition Four: Elasticity of Demand
The price elasticity of demand facing the product of the two or more classes of buyers must be different and must be known by the firm at least in an ordinal sense and this is necessarily true for third degree discrimination.
Some buyers must have a more inelastic demand for the product in the sense that they will be willing and able to pay a higher price for the opportunity to buy the good than others do.

14. Profit Maximising Price and Output Decision
Let us assume that the necessary conditions just discussed are met.
The question is ‘how will the monopolist go about establishing a system of discriminating prices’?
To simplify our analysis, let us consider a monopolist who is able to price discriminate between two classes of buyers – class X and class Y.

15. Profit Maximising Price and Output Decision-Continued
Let us also simplify matters by assuming that marginal costs (MC) are identical for both classes.
For profit maximisation therefore
MRX = MC
MRY = MC
Since MC is identical for both classes, the profit maximising condition for a discriminating monopolist is;
Thus MCx = MCy = MC
Here it is as if the goods sold to the 2 classes of buyers were different goods having exactly the same MC of production.

16. Profit Maximising Price and Output Decision-Continued
To maximize total profits the monopolist has to set MR=MC in all the markets in which he/she is selling.
If MR>MC in either markets, profits will be maximized by increasing sales of output
As a monopolist this will imply a reduction in price, hence MR will fall until MR=MC.

17. Profit Maximising Price and Output Decision-Continued
On the other hand, if MR < MC in either markets, profits will be maximised if sales of output decreased
This would lead to an increase in prices, hence MR increases until
MR = MC.
It is only when MC = MR that profits will be maximised and therefore no need to change output.
Let us show this with the aid of a diagram.

18. Profit Maximising Price and Output Decision-Continued
MKT X MKT Y MKT X and Y

19. Profit Maximising Price and Output Decision-Continued
From the above diagrams, the respective profit maximising rate of output for each class is given by the respective intersection of MRx and MRy with the common constant MC.

20. PRICE DISCR. CONT.
In general case of an upward sloping MC curve, Dx refers to demand curve for class X buyers and MRx for marginal revenue.
In the diagram 3) MRxy is the horizontal summation of MR curves of the 2 classes , ie MRx and MRy.
The summed MR curve intersects the common MC curve at point E
Total output is Qm and this is shared between the 2 classes so that the class X buyers receive Qx and Y, Qy.

21. PRICE DISCR. CONT.
We find out that the prices the monopolist charge for those rates of output is higher for market X than market Y and this obviously depends on the respective slopes of the curves (ie elasticity of demand). Market X has a less elastic demand curve.

22. PRICE DISCR. CONT. For Markets X and Y MRx = Px(1+1/edx) and
MRy = Py(1+1/edy)
If equilibrium MRx = MC = MRy, then
Px(1+1/edx) = Py(1+1/edy)
If class X buyers have a more elastic demand, than class Y buyers, …..
edx>edy
(1+1/edx) < (1+1/edy) … Px >Py so as to ensure that

23. PRICE DISCR. CONT. Px(1+1/edx) = Py(1+1/edy) … Px > Py
Therefore if edx > edy (x is more inelastic) …. Px > Py
At points a and b.

24. PRICE DISCR. CONT.
The output rate for class X demanders is Qx and the price charged is Px.
For class Y demanders, output rate is Qy and a lower price charge Py.
We notice that class Y demanders have a more elastic demand curve than class X demanders who have a higher price to pay.
It can therefore be concluded that ‘the price discriminating monopolist will sell the same product at a higher price to a class of buyers with relatively higher elasticity of demand’.

25. PRICE DISCR. CONT.
There is therefore a crucial relationship between the price elasticity of demand facing a product and the price charged under discrimination.
This crucial relationship can be proved mathematically.
Recall that MR = P (1 + 1/PED)
If MR > MC in either markets, profits will be maximised by increasing sales of output and as a monopolist, this will imply a reduction in price, hence a fall of MR until MR = MC.

26. PRICE DISCR. CONT.
Diagrams