Chapter 10 Price Discrimination

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					           Resale and Price Discrimination
              Types of Price Discrimination
     Price Discrimination and Public Policy




      Chapter 10: Price Discrimination

                                     Kerry Tan



                                   July 9, 2009




Economics 570: Government and Business        Price Discrimination
                   Resale and Price Discrimination
                      Types of Price Discrimination
             Price Discrimination and Public Policy


Price Discrimination



  price discrimination
  The practice of setting different prices for the same product.

  Prices depend on:
      the quantity purchased
      the buyer’s characteristics
      various sales clauses




        Economics 570: Government and Business        Price Discrimination
                 Resale and Price Discrimination
                    Types of Price Discrimination
           Price Discrimination and Public Policy


Motivation




     In all the previous chapters, we assumed that the firm sets
     a single price for each product.
     This chapter examines the case when a firm is able to
     discriminate between consumers and set different prices
     directed at different market segments.




      Economics 570: Government and Business        Price Discrimination
                   Resale and Price Discrimination
                                                      Law of One Price
                      Types of Price Discrimination
                                                      Cost Differences and Price Discrimination
             Price Discrimination and Public Policy


Law of One Price


  Law of One Price
  In a perfectly competitive market, there cannot be two different
  prices for the same product

      If there were two different prices, there is an opportunity for
      arbitrage.
            An agent could earn a profit by buying at the low price and
            selling at the high price.
      In the real world, it is common to observe more than one
      price set for the same (or essentially the same) good, while
      little or no arbitrage occurs.



        Economics 570: Government and Business        Price Discrimination
                    Resale and Price Discrimination
                                                       Law of One Price
                       Types of Price Discrimination
                                                       Cost Differences and Price Discrimination
              Price Discrimination and Public Policy


Resale




  Two reasons for more than one price to prevail in equilibrium:
      Agents are imperfectly informed about the different prices.
      The transaction costs of buying and selling are so high that
      resale is not profitable.




         Economics 570: Government and Business        Price Discrimination
                  Resale and Price Discrimination
                                                     Law of One Price
                     Types of Price Discrimination
                                                     Cost Differences and Price Discrimination
            Price Discrimination and Public Policy


Resale and Arbitrage: Hypothetical Situation

     Suppose that a supermarket sells three tubes of
     toothpaste for the price of two.
     This is an example of price discrimination.
           A consumer who buys one tube pays a different price (per
           tube) than a consumer who buys three tubes.
     Suppose that a certain consumer is interested in buying
     only one tube.
     The consumer could buy three tubes (for the price of two)
     and sell two of those to other customers at the regular
     price.
     The consumer could make a profit from this strategy, but
     the costs could be high (wasted time and finding its own
     customers) that this strategy is unprofitable.

       Economics 570: Government and Business        Price Discrimination
                    Resale and Price Discrimination
                                                       Law of One Price
                       Types of Price Discrimination
                                                       Cost Differences and Price Discrimination
              Price Discrimination and Public Policy


Resale




     In some cases, resale is illegal.
             It is illegal to resell electricity bought from a public utility.
     Sometimes resale is impossible.
             How do you resell a a haircut?
     Price discrimination requires the absence of resale.




         Economics 570: Government and Business        Price Discrimination
                 Resale and Price Discrimination
                                                    Law of One Price
                    Types of Price Discrimination
                                                    Cost Differences and Price Discrimination
           Price Discrimination and Public Policy


Cost Differences

     One way to test for price discrimination is to examine the
     ratio of prices across markets and the ratio of marginal
     costs.
     Example: textbooks
          Suppose a hardcover book sells for $15 and the
          corresponding paperback costs $5.
          Are they the same product?
                  Yes, in the sense that they contain the same content.
                  No, in the sense that they are made of a different material.
          They are sufficiently similar that the ratio test should be
          considered a sufficient indicator of price discrimination.
                  The price differences could be attributed to the different
                  marginal costs of producing a hardcover/paperback book.



      Economics 570: Government and Business        Price Discrimination
                Resale and Price Discrimination
                                                   Law of One Price
                   Types of Price Discrimination
                                                   Cost Differences and Price Discrimination
          Price Discrimination and Public Policy


Example: BMW


    Is a BMW in the US the same product as a BMW in
    Germany?
    It costs more to sell a German car in the US than it does to
    sell it in Germany due to transportation costs and import
    tariffs.
    It makes sense that the price of a BMW is higher in the US
    than in Germany.
    This is not the case of price discrimination because you
    could think of the BMW in the US and in Germany as
    different goods.



     Economics 570: Government and Business        Price Discrimination
                   Resale and Price Discrimination    First-Degree Price Discrimination
                      Types of Price Discrimination   Second-Degree Price Discrimination
             Price Discrimination and Public Policy   Third-Degree Price Discrimination


3 Types of Price Discrimination




   1   First-degree price discrimination
   2   Second-degree price discrimination
   3   Third-degree price discrimination




        Economics 570: Government and Business        Price Discrimination
                   Resale and Price Discrimination    First-Degree Price Discrimination
                      Types of Price Discrimination   Second-Degree Price Discrimination
             Price Discrimination and Public Policy   Third-Degree Price Discrimination


First-Degree Price Discrimination



  first-degree price discrimination
  The situation in which the seller sets different prices for each
  buyer and for each unit purchased by each buyer.

      The firm sets price equal to each consumer’s willingness to
      pay.
      The firm extracts all consumer surplus.
      This is also referred to as perfect discrimination.




        Economics 570: Government and Business        Price Discrimination
                 Resale and Price Discrimination    First-Degree Price Discrimination
                    Types of Price Discrimination   Second-Degree Price Discrimination
           Price Discrimination and Public Policy   Third-Degree Price Discrimination


Example: Medical Doctor




     Suppose that there’s a doctor in a small-town.
     Suppose the doctor has good knowledge of the town’s
     inhabitants, including information on their financial status.
     The doctor can evaluate the patient’s willingness to pay
     before each visit and sets the fee accordingly.




      Economics 570: Government and Business        Price Discrimination
                   Resale and Price Discrimination    First-Degree Price Discrimination
                      Types of Price Discrimination   Second-Degree Price Discrimination
             Price Discrimination and Public Policy   Third-Degree Price Discrimination


Second-Degree Price Discrimination

  second-degree price discrimination
  The situation in which firms discriminate between different
  buyers by means of offering a menu of selling contracts that
  include various clauses in addition to price.

      Firms sell different versions, bundles, or quantities at
      different prices
      Consumers get to select preferred price/version
      Firm has some information about the heterogeneity of the
      buyers’ preferences but cannot observe the characteristics
      of each buyer in particular.
      This is also referred to as self-selection.

        Economics 570: Government and Business        Price Discrimination
                 Resale and Price Discrimination    First-Degree Price Discrimination
                    Types of Price Discrimination   Second-Degree Price Discrimination
           Price Discrimination and Public Policy   Third-Degree Price Discrimination


Example: Business Cards


     UniPrint makes business cards for Ohio State staff and
     faculty.
     UniPrint offers a quantity discount for certain bundles (the
     more you buy, the cheaper it is per unit).

                     quantity            price        price per card
                       250              $26.00            $0.104
                       500              $30.00             $0.06
                      1000              $55.00            $0.055




      Economics 570: Government and Business        Price Discrimination
                  Resale and Price Discrimination    First-Degree Price Discrimination
                     Types of Price Discrimination   Second-Degree Price Discrimination
            Price Discrimination and Public Policy   Third-Degree Price Discrimination


Welfare Implications

     Suppose I have a monopoly on cookies.
           Demand Curve: P = 1 - 0.05Q
           MC = AC = 0.40
     What would I do if I couldn’t price discriminate?




       Economics 570: Government and Business        Price Discrimination
                  Resale and Price Discrimination    First-Degree Price Discrimination
                     Types of Price Discrimination   Second-Degree Price Discrimination
            Price Discrimination and Public Policy   Third-Degree Price Discrimination


Welfare Implications

     Suppose I have a monopoly on cookies.
           Demand Curve: P = 1 - 0.05Q
           MC = AC = 0.40
     What would I do if I couldn’t price discriminate?
           monopoly price: P = $0.70
           monopoly quantity: Q = 6
     Suppose I could set up quantity discounts.




       Economics 570: Government and Business        Price Discrimination
                  Resale and Price Discrimination    First-Degree Price Discrimination
                     Types of Price Discrimination   Second-Degree Price Discrimination
            Price Discrimination and Public Policy   Third-Degree Price Discrimination


Welfare Implications

     Suppose I have a monopoly on cookies.
           Demand Curve: P = 1 - 0.05Q
           MC = AC = 0.40
     What would I do if I couldn’t price discriminate?
           monopoly price: P = $0.70
           monopoly quantity: Q = 6
     Suppose I could set up quantity discounts.
           Set price = $0.70 for the first 6 cookies.
           Set price = $0.50 for each additional cookie (up to 10
           cookies total).
           What happens to total welfare?




       Economics 570: Government and Business        Price Discrimination
                  Resale and Price Discrimination    First-Degree Price Discrimination
                     Types of Price Discrimination   Second-Degree Price Discrimination
            Price Discrimination and Public Policy   Third-Degree Price Discrimination


Welfare Implications

     Suppose I have a monopoly on cookies.
           Demand Curve: P = 1 - 0.05Q
           MC = AC = 0.40
     What would I do if I couldn’t price discriminate?
           monopoly price: P = $0.70
           monopoly quantity: Q = 6
     Suppose I could set up quantity discounts.
           Set price = $0.70 for the first 6 cookies.
           Set price = $0.50 for each additional cookie (up to 10
           cookies total).
           What happens to total welfare? Increases.
                   Consumer surplus increases.
                   Producer surplus increases.
                   Deadweight loss decreases.


       Economics 570: Government and Business        Price Discrimination
                  Resale and Price Discrimination    First-Degree Price Discrimination
                     Types of Price Discrimination   Second-Degree Price Discrimination
            Price Discrimination and Public Policy   Third-Degree Price Discrimination


Welfare Implications



     Can be used to charge different prices for different units
     purchased by a single consumer.
           Consumer willing to pay more for first unit than for
           additional units.
           Firm can capture more consumer surplus than if it had to
           sell to this consumer at a single price.
                   Also leads to less deadweight loss, meaning higher total
                   welfare.




       Economics 570: Government and Business        Price Discrimination
                  Resale and Price Discrimination    First-Degree Price Discrimination
                     Types of Price Discrimination   Second-Degree Price Discrimination
            Price Discrimination and Public Policy   Third-Degree Price Discrimination


Nonlinear Pricing



     An alternative definition to second-degree price
     discrimination is that unit price depends on quantity
     purchased.
     Nonlinear pricing means that as you purchase more of a
     good, the average cost per unit changes (usually,
     decreases).
     An example of nonlinear pricing is a two-part tariff.




       Economics 570: Government and Business        Price Discrimination
                  Resale and Price Discrimination    First-Degree Price Discrimination
                     Types of Price Discrimination   Second-Degree Price Discrimination
            Price Discrimination and Public Policy   Third-Degree Price Discrimination


Two-Part Tariff


      Two-part tariffs have two pricing components:
           fixed price (f ): each consumer must pay regardless of the
           quantity purchased
           variable price (p): each consumer pays p for each quantity
           purchased.
      Optimal two-part tariff:




       Economics 570: Government and Business        Price Discrimination
                  Resale and Price Discrimination    First-Degree Price Discrimination
                     Types of Price Discrimination   Second-Degree Price Discrimination
            Price Discrimination and Public Policy   Third-Degree Price Discrimination


Two-Part Tariff


      Two-part tariffs have two pricing components:
           fixed price (f ): each consumer must pay regardless of the
           quantity purchased
           variable price (p): each consumer pays p for each quantity
           purchased.
      Optimal two-part tariff:
           fixed price = consumer surplus
           variable price = marginal cost
           Firms are able to extract as much profit as possible while
           maximizing total welfare.




       Economics 570: Government and Business        Price Discrimination
                  Resale and Price Discrimination    First-Degree Price Discrimination
                     Types of Price Discrimination   Second-Degree Price Discrimination
            Price Discrimination and Public Policy   Third-Degree Price Discrimination


Buffet Pricing




      For a fixed entry fee, consumers can consume an unlimited
      quantity during a specified period of time.
      Special case of two-part tariff.
           fixed price = "buffet price"
           variable price = 0




       Economics 570: Government and Business        Price Discrimination
                 Resale and Price Discrimination    First-Degree Price Discrimination
                    Types of Price Discrimination   Second-Degree Price Discrimination
           Price Discrimination and Public Policy   Third-Degree Price Discrimination


Versioning and Damaged Goods




     Versioning: Selling different “packages" of price and quality
     level
          Damaged goods: When firms reduce the quality of some of
          their existing products in order to price discriminate.
          Damaged goods is an example of how firms practice
          versioning.




      Economics 570: Government and Business        Price Discrimination
                 Resale and Price Discrimination    First-Degree Price Discrimination
                    Types of Price Discrimination   Second-Degree Price Discrimination
           Price Discrimination and Public Policy   Third-Degree Price Discrimination


Versioning and Damaged Goods

     The introduction of a damaged good to a firm’s product line
     could be good for everyone.
     The firm can make higher profits from being able to sell to
     an extra market segment.
     Low-valuation customers are better off because without
     damaged goods, they wouldn’t buy at all.
          It is better to buy a damaged good at its low price than to
          not buy at all.
     High-valuation customers are better off because the firm
     may have to reduce the price for the high-quality version.
          A large price gap may induce high-valuation consumers to
          switch to the low-quality version.


      Economics 570: Government and Business        Price Discrimination
                 Resale and Price Discrimination    First-Degree Price Discrimination
                    Types of Price Discrimination   Second-Degree Price Discrimination
           Price Discrimination and Public Policy   Third-Degree Price Discrimination


Example: IBM LaserPrinter

     IBM used to sell only one laser printer model
     (LaserPrinter).
          Its capability to print 10 pages per minute was considered
          high quality at the time.
     HP introduced a lower-quality substitute (LaserJet IIP) to
     IBM’s LaserPrinter.
     IBM decided to expand its product line by introducing the
     LaserPrinter E.
          It was identical to the original LaserPrinter except for the
          fact that its software limited its printing to five pages per
          minute.
          This allowed IBM to compete with HP for low-end users.
          fighting brand: expanding the product line, often to include
          a lower-quality good.

      Economics 570: Government and Business        Price Discrimination
                  Resale and Price Discrimination    First-Degree Price Discrimination
                     Types of Price Discrimination   Second-Degree Price Discrimination
            Price Discrimination and Public Policy   Third-Degree Price Discrimination


Tie-in Sales



     Customer can buy one product only if they agree to buy
     another as well.
     Two types of tie-in sales:
           Requirement tie-in: customer buying one product must buy
           all units of another product from that firm
           Bundling (package tie-in): two goods are combined so
           customer can’t buy either good separately
     Many tie-in sales increase efficiency by lowering
     transaction costs.




       Economics 570: Government and Business        Price Discrimination
                 Resale and Price Discrimination    First-Degree Price Discrimination
                    Types of Price Discrimination   Second-Degree Price Discrimination
           Price Discrimination and Public Policy   Third-Degree Price Discrimination


Requirement Tie-In



     Often firms cannot identify which customers will be heavy
     users.
          Firms want to figure out who has the highest willingness to
          pay.
     Requirement tie-in can be used to charge higher prices to
     heavy users.
          Printers are sold at a low price.
          Ink/Toner for printers are sold at a very high price.




      Economics 570: Government and Business        Price Discrimination
                 Resale and Price Discrimination    First-Degree Price Discrimination
                    Types of Price Discrimination   Second-Degree Price Discrimination
           Price Discrimination and Public Policy   Third-Degree Price Discrimination


Example: Kodak Copiers




     Kodak sells copiers, Kodak parts, and service
     Kodak refused to sell some parts to independent service
     firms, forcing customers to use Kodak service.
     Kodak charged with illegally typing copier sales with parts
     and service.
          Accused of preventing competition in service market.




      Economics 570: Government and Business        Price Discrimination
                 Resale and Price Discrimination    First-Degree Price Discrimination
                    Types of Price Discrimination   Second-Degree Price Discrimination
           Price Discrimination and Public Policy   Third-Degree Price Discrimination


Example: Kodak Copiers



     Kodak argued that copier market was competitive and
     customers would not buy Kodak if they knew the service
     would be more expensive.
     Court ruled that consumers might be uninformed.
          Tying enabled Kodak to use its monopoly in Kodak parts to
          also monopolize the market for servicing Kodak copiers.
     Kodak prohibited from tying.




      Economics 570: Government and Business        Price Discrimination
                 Resale and Price Discrimination    First-Degree Price Discrimination
                    Types of Price Discrimination   Second-Degree Price Discrimination
           Price Discrimination and Public Policy   Third-Degree Price Discrimination


Bundling




     Bundling: The strategy of a firm to package at least two
     separate products together.
           pure bundling: buyers must purchase the bundle or nothing
           mixed bundling: buyers are offered the choice between
           purchasing the bundle or one of the separate parts
           individually.




      Economics 570: Government and Business        Price Discrimination
                 Resale and Price Discrimination    First-Degree Price Discrimination
                    Types of Price Discrimination   Second-Degree Price Discrimination
           Price Discrimination and Public Policy   Third-Degree Price Discrimination


Example: Microsoft Office


     Microsoft Office is a software “suite" that comprises a
     series of different applications:
          Excel: spreadsheet application
          Word: word processor
          Powerpoint: presentation application
          Access: database application
          Mail: e-mail (now called Outlook)
     In 1993, the price for each individual application was $80
     for Microsoft Mail and $495 for each of the remaining
     applications (total price: $2060).
     The price for the entire package was $750.



      Economics 570: Government and Business        Price Discrimination
                 Resale and Price Discrimination    First-Degree Price Discrimination
                    Types of Price Discrimination   Second-Degree Price Discrimination
           Price Discrimination and Public Policy   Third-Degree Price Discrimination


Example: Cable Channels


     Suppose there are only two cable channels: Starz and
     ESPN Classic.
     Suppose there are two types of consumers: movie fans
     and sports fans.
          Movie fans are willing to pay $5 for Starz and $2 for ESPN
          Classic.
          Sports fans are willing to pay $2 for Starz and $5 for ESPN
          Classic.
     Marginal cost of supplying a channel to an additional
     customer is zero.



      Economics 570: Government and Business        Price Discrimination
                 Resale and Price Discrimination    First-Degree Price Discrimination
                    Types of Price Discrimination   Second-Degree Price Discrimination
           Price Discrimination and Public Policy   Third-Degree Price Discrimination


Example: Cable Channels


     Price each at $5:




      Economics 570: Government and Business        Price Discrimination
                 Resale and Price Discrimination    First-Degree Price Discrimination
                    Types of Price Discrimination   Second-Degree Price Discrimination
           Price Discrimination and Public Policy   Third-Degree Price Discrimination


Example: Cable Channels


     Price each at $5:
          Producer Surplus = $10
          Consumer Surplus = $0
     Price each at $2:




      Economics 570: Government and Business        Price Discrimination
                 Resale and Price Discrimination    First-Degree Price Discrimination
                    Types of Price Discrimination   Second-Degree Price Discrimination
           Price Discrimination and Public Policy   Third-Degree Price Discrimination


Example: Cable Channels


     Price each at $5:
          Producer Surplus = $10
          Consumer Surplus = $0
     Price each at $2:
          Producer Surplus = $8
          Consumer Surplus = $6
     Sell bundle for $7:




      Economics 570: Government and Business        Price Discrimination
                 Resale and Price Discrimination    First-Degree Price Discrimination
                    Types of Price Discrimination   Second-Degree Price Discrimination
           Price Discrimination and Public Policy   Third-Degree Price Discrimination


Example: Cable Channels


     Price each at $5:
          Producer Surplus = $10
          Consumer Surplus = $0
     Price each at $2:
          Producer Surplus = $8
          Consumer Surplus = $6
     Sell bundle for $7:
          Producer Surplus = $14
          Consumer Surplus = $0
     Bundling will increase both producer surplus and welfare
     over the single price monopolist outcome.



      Economics 570: Government and Business        Price Discrimination
                 Resale and Price Discrimination    First-Degree Price Discrimination
                    Types of Price Discrimination   Second-Degree Price Discrimination
           Price Discrimination and Public Policy   Third-Degree Price Discrimination


Bundling



     Allows firms to charge customers different prices
     Profitability depends on consumers’ tastes and ability to
     prevent resale
     Bundling is profitable when consumers’ demands are
     negatively correlated.
     Can increase overall welfare relative to a single price
     monopolist.




      Economics 570: Government and Business        Price Discrimination
                   Resale and Price Discrimination    First-Degree Price Discrimination
                      Types of Price Discrimination   Second-Degree Price Discrimination
             Price Discrimination and Public Policy   Third-Degree Price Discrimination


Third-Degree Price Discrimination


  third-degree price discrimination
  The situation in which firms set different prices based on
  customers’ characteristics.

      Firms divide buyers into groups, setting a different price for
      each group.
            This practice is called market segmentation.
      Firms must be able to form groups based on an observable
      characteristic.
      This is also referred to as selection by indicators.



        Economics 570: Government and Business        Price Discrimination
                  Resale and Price Discrimination    First-Degree Price Discrimination
                     Types of Price Discrimination   Second-Degree Price Discrimination
            Price Discrimination and Public Policy   Third-Degree Price Discrimination


Example: Movie Tickets

      Movie theaters charge different prices depending on age of
      customer.
           child: 2-12 years old
           adult: 13-60 years old
           senior: 60+ years old
      Student discounts are also common.
  Prices for AMC Promenade (Woodland Hills, CA):

                                   age group            price
                                      child             $7.50
                                      adult            $10.50
                                     senior             $9.50


       Economics 570: Government and Business        Price Discrimination
                  Resale and Price Discrimination    First-Degree Price Discrimination
                     Types of Price Discrimination   Second-Degree Price Discrimination
            Price Discrimination and Public Policy   Third-Degree Price Discrimination


Elasticity Rule


  Suppose that a monopolist sells a good to two separate
  markets.
      Elasticity Rule: p1 (1 − 1 ) = p2 (1 − 1 ) = MC
                               1             2
           pi : price in market i.
            i : demand elasticity in market i.

      Under third-degree price discrimination, a seller should
      charge a lower price in those market segments with
      greater price elasticity.
      This helps explains why museum tickets would be cheaper
      for students than for adults.



       Economics 570: Government and Business        Price Discrimination
                  Resale and Price Discrimination
                     Types of Price Discrimination   Robinson-Patman Act
            Price Discrimination and Public Policy


Price Discrimination in the United States


      In the United States, the main concern has been to prevent
      price discrimination from injuring competition.
      Robinson-Patman Act (1936) is the law that prohibits
      anticompetitive price discrimination in the United States.
           “It shall be unlawful for any person engaged in
           commerce...to discriminate in price between different
           purchasers of commodities of like grade and quality...where
           the effect of such discrimination may be substantially to
           lessen competition or to tend to create a monopoly in any
           line of commerce."




       Economics 570: Government and Business        Price Discrimination
                 Resale and Price Discrimination
                    Types of Price Discrimination   Robinson-Patman Act
           Price Discrimination and Public Policy


Should We Care if Firms Price Discriminate?




     Maybe not if it increases welfare.
          Both consumer surplus and producer surplus increased in
          the cookie example.
     Generally price discrimination would only be a concern if it
     allowed a firm to exclude competitors from the market and
     reduce competition.




      Economics 570: Government and Business        Price Discrimination
                 Resale and Price Discrimination
                    Types of Price Discrimination   Robinson-Patman Act
           Price Discrimination and Public Policy


Example: Anheuser-Busch

     In the 1950s, Anheuser-Busch lowered the price of its
     Budweiser beer in the St. Louis market with respect to the
     price that it charged everywhere in the United States.
     The Supreme Court determined that such practice violated
     the Robinson-Patman Act by injuring local competitors.
          Local competitors could not compete with Budweiser’s low
          prices.
     Budweiser’s market share rose form 12.5% to the 39.3%
     as a result of the price cut.
     The Appeals Court decided to dismiss the case since no
     injury to competition was made and that the primary
     beneficiaries of the price cut were the St. Louis customers.


      Economics 570: Government and Business        Price Discrimination