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Price Discrimination
• How does someone price discriminate?
 Age
 Sex
 Quantity
 Patience (lines, express delivery)
 Flexibility (plane tickets)
 Ability or willingness to bargain
 Information
 Membership
 Coupons
1st Degree Price Discrimination
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AKA Perfect Price Discrimination
Charge each person his/her WTP
Allocatively efficient, no DWL
Extracts all of the consumer surplus
Difficult to implement
Can use a 2-part tariff
Using a Two-Part Tariff to Price Discriminate
$
V
Fixed Fee =
(V-PM)/2
Supply = MC
PM
Demand = WTP
QM
Quantity
Even Better - From the Monopolist’s Point of View
$
V
Fixed Fee =
(V-PC)/2
Supply = MC
PC
Demand = WTP
QM
Quantity
2nd Degree Price
Discrimination
• All consumers face same price “menu”
• Actual price paid depends on consumer’s
preferences or type
• Usually used when consumers cannot be
distinguished ex ante
• Ex: Quantity discount
3rd Degree Price
Discrimination
• AKA Market Segmentation
• Consumers separated into submarkets based
on some external characteristic
• Different prices in each submarket
• No arbitrage between submarkets
• Ex: Airlines
Market Segmentation
$
V
Demand of
Group 1
Demand of
Group 2
PM
PS
MC
Demand = WTP
QM
MR
Quantity
Implementing 3rd Degree Price
Discrimination
• Must be able to identify different demand and to
prevent resale/arbitrage
• Screening: Offering different features to appeal to
customers with different WTP
– 2 model years of the same car on the same lot
– Different passes at CW and Busch Gardens
• Crimping: Limiting the usefulness of the product
to "screen” customers
– Prevents resale from low price to high price market
– Shareware versions that aren't fully functional
Consequences of Price Discrimination
• 1st Degree:
– Quantity at competitive level
– Extracts all of the potential surplus
• 2nd Degree
– Expands output, but not to competitive level
• 3rd Degree = Market Segmentation
– Doesn’t necessarily expand output, may
redistribute
– May lead to loss in total surplus
Antitrust and Price Discrimination
• 1887: Interstate Commerce Act
– Prohibited undue discrimination in railroad rates.
• 1914: Clayton Act
– Price discrimination illegal if it lessens competition or
tends to create a monopoly.
– OK to discriminate based on grade, quality, or quantity.
• 1936: Robinson-Patman Act
– Closed the quantity loophole - no difference in price
allowed when effect is to lessen competition.
Illegal Price Discrimination
• Primary Line
– The firm practicing PD injures its own rivals.
• Secondary Line
– The injury to competition occurs in the buyers’
market.
Anheuser-Bush Case: Primary
Line Discrimination
• AB dropped price of premium brand
(Budweiser) in St. Louis only
• Claim was it would hurt AB’s competitors
because it would divert consumers from
other brands
Morton Salt Case: Secondary
Line Discrimination
• Salt sold at a quantity discount
• Only 5 customers bought at the lowest price
-- all large chain stores
Commodity Bundling and Tie-In Sales
• Techniques used by multi-product firms to
extract additional consumer surplus
• Bundling: Selling two or more products in a
single package
– Ratio of the products is fixed
– Example: Happy Meal
• Tie-In Sales: Purchase of one good
conditional on purchase of another
– Ratio of the products not fixed
– Example: Polaroid cameras
How Bundling Works
Two Types of TV Viewers: Series Lovers and Event Watchers
WTP for Network TV WTP for Sports/Special Interest
Series Lover
$15
$10
Event Watcher
$8
$12
Selling products separately, maximize revenue by charging
$8 for Network TV and $10 for Sports/Special Interest.
Total Revenue = $36, Total Consumer Surplus = $9
Selling bundled products, maximize revenue by charging
$20 for combined package.
Total
Revenue = $40, Total Consumer Surplus = $5
General Model of Commodity Bundling
Each consumer will buy at most one unit of each of two good.
Consumers have different values (V) for the two goods.
V1
Consumer A
A’s value for
good 1
V2
A’s value for good 2
Firm produces goods at different constant marginal costs, c1 & c2.
Without bundling, prices are set at the monopoly level.
With “pure” bundling (can only buy the bundle) sales increase.
V1
c2
P2
PB
P1
c1
V2
PB
With “mixed” bundling, consumers can buy products either
separately, or together.
V1
c2
P2
PB
P1
c1
V2
PB
In both cases, PB > c1 + c2 , but PB < P1 + P2.
Therefore, although sales increase, profit may not. For profit to increase,
there must be significant variation in valuations.
How Tie-In Sales Work
1. Amount of each good that must be bought is not specified.
2. Usually complementary goods.
Allows firm to price discriminate. Acts like a 2-part tariff.
Everyone pays same amount for camera, but heavy users
buy more film than light users, so the two groups will pay
different average prices.
Tie-in sales can also be used to get rid of externalities that
may exist if the goods are related.
Assume goods 1 and 2 are complements, but are produced
by separate firms.
QD (Pair) = A - (P1 + P2 )
There’s an externality, because
QD (good 1) = A - (P1 + P2 ) and
QD (good 2) = A - (P1 + P2 )
Start by focusing on good 1. Assume the mkt is a monopoly.
QD (good 1) = A - (P1 + P2 )
Inverse Demand  P1 = A - P2 - Q1 TR = (A - P2 - Q1)Q1
MR1 = A - P2 - 2Q1
If MC = 0, Q1 = (A - P2 )/2 and likewise, Q2 = (A - P1 )/2
So P1 = A - P2 - (A - P2 )/2 = (A - P2 )/2
and likewise, P2 = (A - P1 )/2
Let’s graph this.
P1
To solve, set the two curves equal:
P1 = (A - P2 )/2
A
P2 = (A - P1 )/2  P1 = A - 2 P2
(A - P2 )/2 = A - 2 P2  3/2 P2 = 1/2 A
A/2
P2 = A/3 (and by symmetry P1 = A/3 )
A/3
P2
A/3
A/2
A
Now assume that 1 firm makes both goods.
QD (pair) = A - (P for the pair )
Inverse Demand  P = A - Q TR = (A - Q)Q
MR = A - 2Q
If MC = 0, Q = A/2 and thus P = A/2
So  = (A/2)A/2 = A2 /4
Compare to profit if goods priced independently.
P = 2A/3, Q = A - A/3 - A/3 = A/3,  = 2A2 /9
A2 /4 > 2A2 /9