MODULE 63: PRICE DISCRIMINATION

Key Economic Concepts For This Module: • Legal forms of price discrimination are the very common practices of selling the same product to different consumers, at different prices. • If a firm has monopoly power to engage in price discrimination, it can increase its profits by doing so. In other words, children do not get discounted theatre tickets out of the kindness of the firm’s heart. • The consumer group that has the greatest price elasticity of demand (the more price sensitive group) will end up paying lower prices. • Perfect price discrimination is the special case where the firm charges each consumer his/her maximum willingness to pay. If successful, consumer surplus is transferred to monopoly profits, and deadweight loss is eliminated.

Topics Covered in this Module I. Price Discrimination Defined II. The Logic of Price Discrimination III. Price Discrimination and Elasticity IV. Perfect Price Discrimination

I. Price Discrimination Defined So far we have looked at a monopolist who charges only one price Pm to all customers buying Qm units. This is called a single-price monopolist. • If you and your grandparents go to Denny’s and order the same Denver omelets, who pays a lower price? • If you buy a plane ticket to Washington DC for a flight that leaves tomorrow, and your buddy bought a ticket on the same flight but bought it a month ago, who is paying a higher price? • Daisy and Donald, twin siblings, turn 16 and go to the insurance company to get car insurance. Who gets the lower rate for the same policy, the girl or the boy? Basically, price discrimination is when the same product is sold to different consumers at different prices. It happens all the time around us and firms do it for a very logical, not illegal, reason: it increases their profits.

II. The Logic of Price Discrimination Or Lenny’s could try to differentiate between the two groups (by asking seniors to show valid ID) and offer two different prices to customers. College students will pay $8 and seniors will pay $4 for a Slam Grand breakfast. Total profit = 100*($8 - $2) + 100*($4 - $2) = $800 We can see the profit in the graph below.

III. Price Discrimination and Elasticity Why would one group of consumers willingly pay a high price for a product, while a second group of consumers is willing to pay a much lower price for the same product? The first group has a lower price elasticity of demand. Senior citizens receive discounts for many goods, like for restaurant meals, because they are more price sensitive. Children are the same way and this is one reason why movie tickets are less expensive for kids under 12 years old. People who are flying to Washington, DC for a business trip are less sensitive to price than a family of four who might fly to Washington for vacation. What makes one group more sensitive? • A smaller budget (children vs. adults at the movie theatre). • More flexibility to alter plans (seniors vs. college students at Lenny’s). • More substitutes (vacation travelers vs. business travelers).

III. Price Discrimination and Elasticity American Airlines Price Discrimination Link (Start at 30:00)

IV. Perfect Price Discrimination All consumer surplus is eliminated. Consumers pay what they are willing to pay. SOME consumers will actually pay a price close to MC. Common Techniques for Price Discrimination: Advance purchase restrictions Volume discounts Two-part tariff (annual fee + discounts) Time discounts Day discounts Seasonal discounts

IV. Perfect Price Discrimination All consumer surplus is eliminated. Consumers pay what they are willing to pay. SOME consumers will actually pay a price close to MC. Some consumer surplus Some consumer surplus No consumer surplus

IV. Perfect Price Discrimination NOTE: D=MR in PERFECT COMPETITION

2011 Free Response 1. A monopolist’s demand, marginal revenue, and cost curves are shown in the diagram below. (a) Assume that the monopolist wants to maximize profit. Using the labeling on the graph, indicate the monopolist’s price. (b) When the output is 8 units, what is the profit per unit? (c) Assume that the monopolist is maximizing profit. Is allocative efficiency achieved? Explain. (d) Between the prices of $16 and $18, is the monopolist in the elastic, inelastic, or unit elastic portion of its demand curve? Explain.

2011 Free Response 1. A monopolist’s demand, marginal revenue, and cost curves are shown in the diagram below. (e) Assume that regulators set an output of 11 units. (i) Is the monopolist earning positive economic profit? Explain. (ii) Is the monopolist earning positive accounting profit? (f) Assume instead that regulators impose a price ceiling of $22. (i) What is the marginal revenue for the eighth unit? (ii) What quantity will be produced? (g) Assume instead that the monopolist practices perfect price discrimination (also called first-degree price discrimination). (i) What quantity will be produced? (ii) What will be the value of the consumer surplus?

2011 Free Response-Rubric (a) 1 point: • One point is earned for identifying the profit-maximizing price as $24. ($22 is also acceptable.) (b) 1 point: • One point is earned for identifying the profit per unit as $6. (c) 1 point: • One point is earned for stating that allocative efficiency is not achieved because price is not equal to MC or MC is not equal to demand.

2011 Free Response-Rubric (d) 1 point: • One point is earned for stating that the demand is inelastic because total revenue increases as price increases from $16 to $18, or because the price elasticity of demand within the price range is less than 1, or because marginal revenue is negative. (e) 2 points: • One point is earned for indicating that the monopolist is not earning positive economic profit, because price equals average total cost. • One point is earned for indicating that the monopolist is earning positive accounting profit.

2011 Free Response-Rubric (f) 2 points: • One point is earned for stating that the marginal revenue of the 8th unit is $22. • One point is earned for stating that 9 units will be produced. (g) 2 points: • One point is earned for stating that 10 units will be produced. • One point is earned for stating that the consumer surplus is zero.

Practice Quiz #1 1. Which of the following characteristics is necessary in order for a firm to price discriminate? a. free entry and exit b. differentiated product c. many sellers d. some control over price e. horizontal demand curve

Practice Quiz #2 2. Price discrimination a. is the opposite of volume discounts. b. is a practice limited to movie theaters and the airline industry. c. can lead to increased efficiency in the market. d. rarely occurs in the real world. e. helps to increase the profits of perfect competitors.

Practice Quiz #3 3. With perfect price discrimination, consumer surplus a. is maximized. b. equals zero. c. is increased. d. cannot be determined. e. is the area below the demand curve above MC.

Practice Quiz #4 4. Which of the following is a technique used by price discriminating monopolists? I. advance purchase restrictions II. two-part tariffs III. volume discounts a. I only b. II only c. III only d. I and II only e. I, II, and III

Practice Quiz #5 5. A price discriminating monopolist will charge a higher price to consumers with a. a more inelastic demand. b. a less inelastic demand. c. higher income. d. lower willingness to pay. e. less experience in the market.

REVIEW

APE U3 L5 A 36-Use interactive graphs online Part A: Pricing w/ Market Power & CS Figure 36.1 Price Qty TR MR $20 1 20 -- 19 2 38 18 18 3 54 16 17 4 68 14 16 5 80 12 15 6 90 10 14 7 98 8 13 8 104 6 12 9 108 4 11 10 110 2 10 11 110 0 9 12 108 -2 8 13 104 -4 7 14 98 -6 6 15 90 -8 5 16 80 -10 4 17 68 -12 3 18 54 -14 2 19 38 -16 1 20 20 -18 2. Recalling Rules: A) A perfectly competitive firm would produce the output at which price is equal to (AC / MC / MR). B) A monopolist firm would produce the output at which MC is equal to (AC / P / MR)

APE U3 L5 A 36 PART B: 1st Degree P Discrimination 3. CS=(20-17)+(19-17)+(18-17) 3 2 1 =$6 4. A. $14 B. 7 C. $21 CS= (20-14)+(19-14)+(18-14)+(17-14)+(16-14)+(15-14)= 6+5+4+3+2+1=$21 5. A. $17 B. 4 C. $6 CS=(20-17)+(19-17)+(18-17)= 3+2+1= $6

APE U3 L5 A 36 6. A. 7 B. $20 $19 $18 $17 $16 $15 $14 C. 0 7. Pat’s profits will be highest in case 6 with the discriminating monopoly, lowest in case 4 with the perfect competitor and the nondiscriminating monopoly in between. PART C: The Effects of Price Discrimination 8. CS decreases. 9. Its profits increase. 10. The quantity supplied is greater. 11. It is the same 12. It improves it because output is increased and price is closer to marginal cost. Part D: Real Examples of P Discrimination 13. Higher tuition for college jr’s & sr’s Different airfare for travelers Car discounts based on negotiation College scholarships based on need Selling hardcover and paperback books Discounts for kids and seniors 14. Factors that make P discrimination easier: An inelastic demand curve The product or service cannot be resold easily Categories of consumers can be separated in the market. 15. (-) Reduces CS & increases profits (+) Increases output over mon. pricing, More consumers will buy product; more efficient level of output.