Transcript Econ 160 Ch 12



For almost any good or service, some
consumers are willing to pay more than
others.
A firm that sets a single price faces a tradeoff between charging consumers who really
want the good as much as they are willing to
pay and charging a low enough price that the
firm does not lose sales to less enthusiastic
customers.
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As a result, the firm usually sets an
intermediate price.
A price-discriminating firm that varies its
prices across customers avoids this trade-off.
There are two reasons a firm earns a higher
profit from price discrimination than from
uniform pricing.
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First, a price-discriminating firm charges a
higher price to customers who are willing to
pay more than the uniform price, capturing
some or all of their consumer surplus – the
difference between what a good is worth to a
consumer and what the consumer pays –
under uniform pricing.
Second, a price-discriminating firm sells to
some people who are not willing to pay as
much as the uniform price.
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For a firm to price discriminate successfully,
three conditions must be met.
1. A firm must have market power, or else it cannot
charge any consumer more than the competitive
price. A competitive firm cannot price
discriminate.
2. Consumers must differ in their sensitivity to price
(demand elasticities), and a firm must be able to
identify how consumers differ in this sensitivity.
3. A firm must be able to prevent or limit resales to
higher-price-paying customers from customers
whom the firm charges relatively low prices.
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There are three main types of price
discrimination.
1. Perfect price discrimination

Also called first-degree price discrimination

The firm sells each unit at the maximum amount any
customer is willing to pay for it, so prices differ
across customers, and a given customer may pay
more for some units than for others.
2. Quantity discrimination
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Second-degree price discrimination

The firm charges a different price for large quantities
than for small quantities, but all customers who buy
a given quantity pay the same price.
3. Multimarket price discrimination

Third degree price discrimination

The firm charges different groups of customers
different prices but charges a given customer the
same price for every unit of output sold.
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If a firm with market power knows exactly
how much each customer is willing to pay for
each unit of its good and it can prevent
resales, the firm charges each person his or
her reservation price: the maximum amount a
person would be willing to pay for a unit of
output.
Such an all-knowing firm perfectly price
discriminates.
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By selling each unit of its output to the
customer who values it the most at the
maximum price that person is willing to pay,
the perfectly price-discriminating monopoly
captures all possible consumer surplus.
p
6
5
MC
4
3
MR1 = 6
MR2 = 5
Demand Marginal Revenue
Demand,
MR3 = 4
2
1
0
1
2
q
3
4
5
6
cost, MR, p
MC
ps
pc = MCc
MRs
0
Qs
Qc = Qd
Demand, MRd
q
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Many firms are unable to determine which
customers have the highest reservation
prices.
Firms may know, however that most
customers are willing to pay more for the first
unit than for successive units – in other
words, that the typical customer’s demand
curve is downward sloping.
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Such firms can price discriminate by letting
the price that each customer pays vary with
the number of units the customer buys.
Here the price varies only with quantity: All
customers pay the same price for a given
quantity.
Single-Price
Quantity Discrimination
p, cost, MR
p, cost, MR
90
90
70
60
50
MC
30
MC
30
Demand
Demand
MR
0
20
40
60
90 Q
0
30
60
90 Q
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Typically, a firm does not know the
reservation price for each of its customers.
But the firm may know which groups of
customers are likely to have higher
reservation prices than others.
The most common method of multimarket
price discrimination is to divide potential
customers into two or more groups and to set
a different price for each group.
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All units of the good sold to customers within
a group are sold at a single price.
As with perfect price discrimination, to
engage in multimarket price discrimination, a
firm must have market power, be able to
identify groups with different demands, and
prevent resales.
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Suppose that a monopoly can divide its
customers into two groups – for example,
consumers in each of two countries.
It sells Q1 to the first group and earns
revenues of R1(Q1), and it sells Q2 units to the
second group and earns R2(Q2).
Its cost of producing total output
Q = Q1 + Q2 units is C(Q).
The monopoly can maximize its profit
through its choice of price or quantities to
each group.
  R Q   R Q   C Q
max
Q Q
1, 2

1
1
2
2
1
 Q2 
The first-order conditions are obtained by
differentiating with respect to Q1 and Q2 and
setting the partial derivative equal to zero:
dR1 Q1 dC Q  Q



0
Q1
dQ1
dQ Q1
dR2 Q2  dC Q  Q



0
Q2
dQ2
dQ Q2

These imply that
MR1  MC
MR2  MC
United Kingdom
United States
p, cost, MR
35
p, cost, MR
29
CSB
PA = 15
CSA
PB = 18
MRA
πA
1
0
DWLB
DWLA
DA
πB
MC
9.4
19.47
Q
1
0
DB
MC
2.2
4.53
MRB
Q
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In addition to setting its price or quantity, a
monopoly has to make other decisions, one
of the most important of which is how much
to advertise.
Advertising is only one way to promote a
product.
Some promotional tactics are subtle.
For example, grocery stores place sugary
breakfast cereals on lower shelves so that
they are at children’s eye level.
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A successful promotional campaign shifts the
monopoly’s demand curve by changing
consumers’ tastes or informing consumers
about new products.
The monopoly may be able to change the
tastes of some consumers by telling them
that a famous athlete or performer uses the
product.
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If the advertising convinces some consumers
that they can’t live without the product, the
monopoly’s demand curve may shift outward
and become less elastic at the new
equilibrium, at which the firm charges a
higher price for its product.
If the firm inform potential consumers about
a new use for the product, demand at each
price increases.
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Even of advertising succeeds in shifting
demand, it may not pay for the firm to
advertise.
If advertising shifts demand outward or
makes it less elastic, the firm’s gross profit,
which ignores the cost of advertising, must
rise.
The firm undertakes this advertising
campaign, however, only if it expects its net
profit (gross profit minus the cost of
advertising) to increase.
cost, MR, p
19
17
p2 = 12
p1 = 11
B
π1
MC = AC
5
MR1
0
Q1 = 24 Q2 = 28
MR2
D1
68
D2
76
Q