Price Discrimination - IT Glitz by malj


n   Price discrimination is legal unless it substantially limits
     § Firms will actively price discriminate in an effort to enhance profits
n   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
n   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
     § By separating market into two or more segments
         • Called price discrimination (or Ramsey pricing)
             ¨   Analogous to a multiproduct firm’s supplying products in different markets
n   Our aim in this chapter is to illustrate how firms are always probing
    market for ways to enhance profits
n   For a firm’s 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
n   We first state underlying market conditions required for price
n   We develop categories of first-, second-, and third-degree price
     § Evaluate efficiency and welfare effects of each type
n   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

n   Second-degree price discrimination offers potential social benefits
     § If a firm did not price discriminate it might not be able to produce a desired
n   Third-degree price discrimination segments the market
     § For instance, into a foreign and a domestic market
n   We discuss quality discrimination
     § Generally, same implications associated with price discrimination hold for
       quality discrimination as well
n   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

                Conditions for Price
n   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
n   Two necessary conditions for price discrimination
     § 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                                                                   4
             Conditions for Price
n   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
n   Depending on how a market can be segmented,
    economists have categorized various types of price
    discrimination into
     § First-, second-, and third-degree price discrimination
First-degree Price Discrimination
n   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
n   Table 13.1 lists characteristics and examples of first-, second- and third-
    degree price discrimination
n   First-degree price discrimination involves tapping demand curve
     § Illustrated in Figure 13.1
n   First unit of commodity is sold to a consumer willing to pay highest price,
     § 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

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

Figure 13.1 First-degree price

First-degree Price Discrimination
n   As shown in figure, firm equates MR to SMC and supplies a
    level of output Q1
     § Results in TR being represented by area 0ABQ1
     § STC by area 0FEQ1
     § Pure profit by area FABE
n   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 Q1
             ¨   Which firm captures
                  § Since all of consumer surplus is captured by firm, all consumers are
                     indifferent between buying commodity or not

n   Lowest price offered by firm is p1 = SMC(Q1)
     § Because additional revenue generated by selling an additional unit of
       output is less than additional cost SMC                                             9
First-degree Price Discrimination
n   Last consumer willing to purchase commodity pays this lowest price, p1
n   Consumers who are not willing to pay p1 do not purchase the commodity
n   All other consumers who do purchase commodity pay a price higher
    than p1 equivalent to their maximum WTP
     § Thus, at p1 and Q1, 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(Q1)
         • 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
n   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
              ¨   Person driving a Lincoln with New York plates will probably pay a premium for boiled
                  peanuts at a roadside stand in Georgia

                       Two-Part Tariffs
n   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
n   Firm will price discriminate on entrance fees to extract as
    much of a consumer’s WTP as possible
n   Commodity being sold is priced so it will maximize
     § 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

n   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
n   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

           Quality Discrimination
n   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
       • 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

          Quality Discrimination
n   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 firm’s market power by giving it control
        over new market and market for resales


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