Transcript Chapter Twenty-Four

Chapter 8
Price Discrimination
Outlines..
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Pricing new products
Pricing objectives
Definition of P.D
Types of P.D
Two conditions P.D
P.D and consumer surplus
– Mechanism for capturing consumer surplus
• Profit maximization with P.D
– Graphical explanation
– Numerical examples
Pricing New Products
• For new products, there is a significant amount of uncertainty
about demand conditions. Two strategies have been suggested
(Dean 1950)
• SKIMMING - set an initially high price. IF that produces a high
level of profits, leave the price high until conditions change and
demand becomes more elastic. Do this when:
– there is a significant group of buyers prepared to pay high prices
– when demand is inelastic
• PENETRATION - set a low price from the beginning in order to
build a large market share quickly. Do this when:
– demand is elastic
– low volume is very high cost
– entry is a major danger
Pricing Objectives
 The central objective of pricing is PROFIT MAXIMIZATION
 Companies may either express this in a different way, or
have intermediate level objectives for pricing.
 target rate of return
 target market share
 stabilize output
 match the competition
Price Discrimination
• Price discrimination refers to charging of
different prices for different quantities of a
product, at different times, to different
customer groups or in different markets, when
these price differences are not justified by cost
differences.
• Not all price differences are price
discrimination.
Conditions for Price Discrimination
• Three conditions must be me for a firm to be able to
practice discrimination.
1. Firm must be an imperfect competitor (a price maker). The
firm must have some control over the prices of the
product. PD is not possible in the case of perfectly
competitive firm
2. Price elasticity must differ for different quantities, at
different times for different customer groups, or in
different markets. Price elasticity should not be unitary.
3. Firm must be able to segment the market and prevent
resale of units across market segments ( e.g. gas or electric
meter for business and home, hair cuts, doctors’ visits)
First-Degree
Price Discrimination
A form of price discrimination in which a
seller charges the highest price that buyers
are willing and able to pay for each quantity
of output sold.
• Firm extracts all of the consumers’ surplus
• Firm maximizes total revenue and profit
from any quantity sold
Second-Degree
Price Discrimination
• Charging a uniform price per unit for a
specific quantity, a lower price per unit for
an additional quantity, and so on
• Firm extracts part, but not all, of the
consumers’ surplus
First- and Second-Degree
Price Discrimination
In the absence of price discrimination, a
firm that charges $2 and sells 40 units will
have total revenue equal to $80.
First- and Second-Degree
Price Discrimination
In the absence of price discrimination, a
firm that charges $2 and sells 40 units will
have total revenue equal to $80.
Consumers will have consumers’ surplus
equal to $80.
First- and Second-Degree
Price Discrimination
If a firm that practices first-degree price
discrimination charges $4 and sells 40
units, then total revenue will be equal to
$160 and consumers’ surplus will be zero.
First- and Second-Degree
Price Discrimination
If a firm that practices second-degree
price discrimination charges $4 per unit
for the first 20 units and $2 per unit for the
next 20 units, then total revenue will be
equal to $120 and consumers’ surplus will
be $40.
Third-Degree
Price Discrimination
• A form of price discrimination in which a seller
charges different prices to groups that are
differentiated by an easily identifiable
characteristic, such as location, age, gender, or
ethnic group. This is the most common type of
price discrimination
• Firm maximizes profits by selling a quantity on
each market such that the marginal revenue
on each market is equal to the marginal cost of
production
Third-Degree
Price Discrimination
Q1 = 120 - 10 P1
or
P1 = 12 - 0.1 Q1 and
MR1 = 12 - 0.2 Q1
Q2 = 120 - 20 P2
or
P2 = 6 - 0.05 Q2 and
MR2 = 6 - 0.1 Q2
MR1 = MC = 2
MR2 = MC = 2
MR1 = 12 - 0.2 Q1 = 2
MR2 = 6 - 0.1 Q2 = 2
Q1 = 50
Q2 = 40
P1 = 12 - 0.1 (50) = $7
P2 = 6 - 0.05 (40) = $4
Third-Degree
Price Discrimination
Price Discrimination and Consumer Surplus
• The key idea behind price discrimination is to convert
consumer surplus into economic profit.
• When all the units consumed are sold for a single price,
consumers get benefit. The benefit is the value the
consumers get from each unit of the good minus the
price actually paid for it. This benefit is Consumer
Surplus.
• So Price discrimination is an attempt by a monopolist
to capture as much of the consumer surplus as possible
for itself.
Mechanism for Capturing Surplus
The purpose of P.D is to capture more surplus than
obtainable with uniform pricing. Following
mechanisms are employed by firms for this purpose.
 Market segmentation
 Two-Part Pricing
 Tying
How Should a Monopoly Price?
• So far a monopoly has been thought of as a
firm which has to sell its product at the same
price to every customer. This is uniform pricing.
• Can price-discrimination earn a monopoly
higher profits?
Profiting by Price Discriminating
$/output unit
Sell the y th unit for $p( y ).
p ( y )
MC(y)
MR
y
y
Profiting by Price Discriminating
$/output unit
p ( y )
Sell the y th unit for $p( y ). Later on
sell the y th unit for $ p( y ).
p( y )
MC(y)
MR
y
y
y
Profiting by Price Discriminating
$/output unit
p ( y )
p( y )
Sell the y th unit for $p( y ). Later on
sell the y th unit for $ p( y ). Finally
sell the y th unit for marginal
cost, $ p( y ).
MC(y)
p( y )
MR
y
y
y
y
Profiting by Price Discriminating
$/output unit
So the sum of the gains to
the monopolist on all
trades is the maximum
possible total gains-to-trade.
PS
MC(y)
MR
y
y
Third-degree Price Discrimination
• A monopolist manipulates market price by
altering the quantity of product supplied to
that market.
• So the question “What discriminatory prices
will the monopolist set, one for each
group?” is really the question “How many
units of product will the monopolist supply
to each group?”
Let:
Numerical Example of P.D
•Pc : Price per unit of Kevlar charged to cable manufactures;
•Pt : Price per unit of Kevlar charged to tire manufacturers;
•qc: Quantity purchased by cable manufacturers;
•qt: Quantity purchased by tire manufacturers.
•We assume that MC = ATC = $20.
•The demand functions are given by:
qC = 100 – Pc
qt = 60 – Pt
2 scenarios
Single Pricing by Monopoly
PC = Pt = $50
Q = qC + qt = 50 + 10 = 60 units
 = TR – TC = [(50)(60)] – [(60)(20)] = $1,800
After Price discrimination
PC = $60; Pt = $40
Q = qC + qt = 40 + 20 = 60 Units
 = TR – TC = {[(60)(40)] +[(40)(20)]} – [(60)(20)] = $2,000
So, Producer can
increase its profits by
$200 (from $1,800 to
$2,000) by practicing
price discrimination
Thanks
Third-degree Price Discrimination
( y1 , y2 )  p1 ( y1 )y1  p 2 ( y2 )y2  c( y1  y2 ).
if MR1(y1) > MR2(y2) then an output unit should
be moved from market 2 to market 1 to increase
total revenue.
The marginal revenue common to both markets
equals the marginal production cost if profit is to
be maximized.
Third-degree Price Discrimination
Market 1
Market 2
p1(y1)
p1(y1*)
p2(y2)
p2(y2*)
MC
y1
y1*
MR1(y1)
MC
y2*
y2
MR2(y2)
MR1(y1*) = MR2(y2*) = MC and p1(y1*)  p2(y2*).
Profiting by Price Discriminating; a real
world example
A case study of global Air Line, which increased
its profit on certain route by using the
technique of Price Discrimination.