Nonlinear Pricing and Price Discrimination
Lecture 8

 

Price Discrimination

1. Firms sell consumers products for different prices;

  • Why?

    • A firm captures consumers' surplus, enhancing revenue and profits

    • A firm captures market share

    • A firm undermines competition or force competition out of market

      • Example - Standard Oil reduced its price for petroluem products below competitors in one small town

      • The competitors went out of business

      • Standard Oil bought the competitors' assets for cents on the dollar and raised prices to earn monopoly profits

      • Standard Oil entered into another town

  • Techniques

    • Market Segmentation – consumers can be separated by markets

      • Geographical: BMW is more expensive in Germany than the United States

      • Stores give students and seniors discounts to encourage more sales

        • Example: Discount at stores, restaurants, and software

        • Have to prevent re-sale

        • Students and seniors are sensitive to prices

    • Two-part pricing – company charges two fees

      • Fixed fee: flat fee paid upfront; hookup charge

      • Variable charge: companies charge per usage; rate charge

      • T(q) = A + P q

      • Example: Common for utility companies

        • Gas

        • Telephone

        • Electricity

    • Tying and bundling – producer sells one product that is required for another product

      • Example 1: Printers

        • Ink cartridges are expensive

        • Printers are cheap

      • Example 2: Game console

        • Game consoles like Playstation and Nintendo are cheap

        • Games are expensive

      • Also called “technology ties” because products are complements

    • Quality discrimination – seller sells similar products that differ in quality

      • Example 1: Airfares

        • First class

        • Economy class

      • Example 2: Computers

        • Expensive

        • Cheap

      • Example 3: Intel increase cost to slow down or “dumb down” computer chips and products

        • Intel creates Celeron by taking a good processor and reduces its functions

        • Then it sells Celeron for a discount

      • Example 4: Printers

        • Fast laser printers are expensive

        • Slow laser printers are cheap and could be fast laser printers that are slowed down

2. Conditions for Price Discrimination

  1. Company needs some monopoly power to influence market price

  2. A “mechanism” to separate customers into different groups

  3. Prevent re-sale: Consumer who pays for product for a low price re-sells the product to another consumer who pays a higher price

    • Companies developed strategies to prevent reselling

      • Warranties – companies sell similar products in different countries

        • Example: Cell phones

        • Company will void the warranty if consumer bought product outside the country

      • High transaction costs – firm creates a greater transaction cost (usually time) for low-paying consumers

        • Example 1: High wage earners may not search for coupons to buy at the store

        • Example 2: Publishers sell textbooks

          • International market – textbooks are cheap

          • U.S. market – textbooks are expensive

          • Students who buy international textbooks have to wait longer to get books

      • Contractual remedies – customers sign contracts that they will not re-sell them

      • Vertical integration – a company could integrate a production facility to prevent re-sell

        • Example: Alcoa – supplied aluminum to airline industry for a high price

        • Alcoa expanded into wire production and sold wires cheaply to compete

        • If a firm made aluminum wires, it could sell aluminum to the airline industry, cutting Alcoa out of profits

      • Adulteration – contaminate product that prevents resale

        • Example 1: Alcohol for drinks is expensive, because of taxes

          • Industrial alcohol – add a poison to prevent people from drinking it

          • Industrial alcohol is cheap

        • Example 2: Plastic molding for industry is $0.85 per pound

          • Plastic molding for dentists is $22 per pound

          • Company adds arsenic to plastic molding for industry

      • Legal restrictions – government passes laws that prevent re-sales

        • Example: Ticket scalpers buy tickets for games, concerts, theater, etc.

          • They buy cheap, but re-sale for a higher price

          • Local governments have laws that makes scalping illegal

Types of Price Discrimination

1. First Degree Price Discrimination – monopolist can extract all surplus from customers

  • Demand function – customers can be ranked by their reservation price

  • Reservation price – consumer’s willingness to pay

  • Reservation price (V i)

    • Customer buys P* ≤ V i

    • Customer does not buy, if P* > V i

  • Monopolist needs perfect information about customers

First Degree Price Discrimination

  • Result

    • Monopolist’s profits = consumers' surplus + producers' surplus

    • The last customer pays a reservation price, P i = MC

      • Note: A non-discriminating monopolist reduces output, causing P* > MC

    • Discriminating monopolist ensures customers are satisfied in terms of quality, etc.

  • Monopolist can use Two-part tariff to capture consumers' surplus

    • Example: P(Q) = 100 – Q and MC = 10

Price Discrimination using Two Part Tariffs

  • Monopolist sets P = MC = 10

  • Consumers' surplus = 0.5 (100 – 10)(90 – 0) = 4,050

  • Monopolist charges the price T(Q) = 4,050 + 10 Q

    • The rate charge is 10 Q

    • The fixed charge, 4,050 is divided and charged to the consumers

  • Pacman Pricing – monopolist uses price discrimination over time

    • Works for technological products

Pacman Price Discrimination

  • Company introduces new product and charges price, P 1

  • After some time, the company lowers the price to P 2

  • After more time, the company lowers the price to P 3

  • Monopolist stops lowering the price, when P i = MC(Q)

  • Company will develop a new product to repeat the process

  • Coase stated

    • If consumers are sufficiently patient, then consumers could wait for monopoly to drop prices

    • Have a competitive equilibrium

2. Second Degree Price Discrimination

  • Monopoly cannot separate consumers into groups

  • Information costs

  • Monopolist sets two prices that force consumers to self-select into groups

Second Degree Price Discrimination

  • Monopolist has marginal cost, MC(q 1 + q 2) = c

  • Monopolist charges the sensitive consumer

    • TR(q 1) = A + c q 1*

    • Rate charge is c, where P 1 = c = MC

    • Allocative efficiency

    • The fixed charge is A

    • Profits = A + c q 1* – c q 1* = A

  • Monopolist charges monopoly prices by MR = MC to the “not sensitive consumers”

    • Profits = B

    • The not sensitive consumers pay higher prices, but do not pay the fixed charge, A

    • Note: P 2 > P 1

  • Total profits = A + B

3. Third Degree Price Discrimination

  • Monopolist has information about consumers

  • Monopolist can separate consumers into groups

  • Two demand functions, P 1(q 1) and P 2(q 2)

  • Profit maximization, MR 1(q 1) = MR 2(q 2) = MC(q 1 + q 2)

  • If MC(q 1 + q 2) = c

  • Monopolist charges sensitive consumers P 1 and not sensitive consumers P 2

  • Not allocative efficient, P 2 > P 1 > MC

Third Degree Price Discrimination