Transcript Price discrimination: the welfare effects

The practice of charging
unequal prices or fees to
different buyers (or
classes of buyers) is
called price
discrimination
Examples of price discrimination
•Physicians charge more for an office visit if the patient
has health insurance.
•Magazines such as Sports Illustrated offer gifts and
discounts to new subscribers.
•Senior citizens may enjoy discounted rates at motels and
restaurants.
•Cinemas charge higher ticket prices for adults than for
kids.
•Japanese steel and Canadian timber producers earn
sharply lower profit margins on products sold in the U.S.
compared to the domestic market.
•“Sizing up their income” pricing by plumbers, auto
mechanics, . . .
A Mercedes driver can
pay more, so why not
charge them more?
When is price discrimination feasible?
Price-discrimination (PD) can be a very lucrative
proposition from the seller’s point of view.
However, PD will not be feasible or possible unless:
1. The seller possesses market power—meaning, the
seller faces a downward sloping demand curve.
2. The seller is capable of segregating buyers into
groups based on differential willingness to pay, or
elasticity of demand (). Hear audio explanation
(wav).
3. The seller can prevent arbitrage or resale of the
product. Her audio explanation (wav)
This is referred to as
“perfect” PD. The seller
charges every buyer their
“reservation price”—that is,
the maximum price they are
willing to pay rather then go
without the marginal unit of
the good or service
Notes
•Perfectly discriminating
monopolist charges PC for the last
unit only.
•Market output is equal to the
competitive output (QC)
•Total Surplus (TS) is equal to
green shaded area APCB
Price
A
B
PC
MC
D
MR
0
QM
Hear audio explanation (wav)
QC
Quantity
3rd degree price discrimination:
the welfare effects
To illustrate these effects we
use the example of Kevlar,
du Pont’s patented, superstrength synthetic fiber.
We assume there are two uses
for Kevlar
1. Undersea cables
2. Tires
Differential elasticities of demand ()
•Steel and fiberglass are good substitutes for Kevlar in
tire production; where there are no good substitutes for
Kevlar in the manufacture of undersea cable.
•Let t denote the elasticity of demand for Kevlar on
the part of tire makers.
•c is the elasticity of demand for Kevlar for use in
production of undersea cables.
Thus:
t > C
[1]
Symbols, assumptions
Let:
•Pc : Price per unit of Kevlar charged to cable
manufactures;
•Pt : Price per unit of Kevlar charged to tire manufacturers;
•qc: Quantity of Kevlar purchased by cable manufacturers;
•qt: Quantity of Kevlar purchased by tire manufacturers.
•We assume that MC = ATC = $20.
•The demand functions are given by:
qC = 100 - Pc
qt = 60 - Pt
Price
Price
discriminating firm
sets MR = MC in
each “sub”market
D cable
N
J
D cable + tires
40 MRC
C
20
MRt
Tires
W
60
50
H
D tires
Audio explanation (wav)
20 10
0
F
MC
A
S
40 50 60
MRC + t
Cable
2 scenarios
Standard monopoly pricing (single price)
•PC = Pt = $50
•Q = qC + qt = 50 + 10 = 60 units
• = TR – TC = [(50)(60)] – [(60)(20)] = $1,800
3rd degree price discrimination
•PC = $60; Pt = $40 audio explanation (wav)
•Q = qC + qt = 40 + 20 = 60 Units
•  = TR – TC = {[(60)(40)] +[(40)(20)]} –
[(60)(20)] = $2,000
So, du Pont can increase
its profits by $200 (from
$1,800 to $2,000) by
practicing price
discrimination
•As a consequence of P.D., cable manufacturers pay $60
per unit instead of $50. This gives rise to a welfare loss
of WFSA or $350.
• If du Pont discriminates, then tire manufacturers pay a
lower price than they otherwise would ($40 instead of
$50). This gives rise to a welfare gain of NHGJ or $250.
Thus,
TS = WFSA + NHGJ = -$250
By enforcing statutes
applicable to price
discrimination
(specifically, section 2 of
the Clayton Act) , the total
surplus could be
potentially increased by
$250.