Price Discrimination One of the pricing strategies we will analyze is called price discrimination, which firms can use to attempt to increase their economic profit by setting different prices for the same good or service. Odd Pricing and Cost-Plus Pricing We will also analyze the widely used strategies of odd pricing and cost-plus pricing. Two-Part Tariff Finally, we will analyze situations in which firms are able to charge consumers one price for the right to buy a good and a second price for each unit of the good purchased, which is called a two-part tariff.

Law of One Price Arbitrage Pricing Strategy, the Law of One Price, and Arbitrage Price discrimination is charging higher prices to some customers and lower prices to others. Yield management is a sophisticated form of price discrimination in which firms rapidly adjust the prices of their goods and services based on the preferences of consumers and their responsiveness to changes in prices. Law of One Price According to the law of one price, identical products should sell for the same price everywhere. Arbitrage Buying a product in one market at a low price and reselling it in another market at a high price is referred to as arbitrage. Transactions costs The costs in time and other resources that parties incur in the process of agreeing to and carrying out an exchange of goods or services. The law of one price holds exactly only if transactions costs are zero.

Solved Problem Does eBay serve a useful economic purpose? Is Arbitrage Just a Rip-off? Does eBay serve a useful economic purpose? Economists would say that it does.

Why Don’t All Firms Charge the Same Price? Table 16.1 Which Internet Bookseller Would You Buy From? Product: John Grisham’s The Litigators Company Price Amazon.com $15.23 BarnesandNoble.com 15.23 WaitForeverForYourOrder.com 14.50 JustStartedinBusinessLastWednesday.com 14.25 New Internet booksellers who lack the reputation that Amazon.com and BarnesandNoble.com have built up for fast and reliable service will have to differentiate their products on the basis of price, as the two fictitious firms listed in the table have done. So, the difference in the prices of products offered on Web sites does not violate the law of one price.

Don’t Confuse Price Discrimination with Other Types of Discrimination Price discrimination Charging different prices to different customers for the same product when the price differences are not due to differences in cost. Don’t Let This Happen to You Don’t Confuse Price Discrimination with Other Types of Discrimination Unlike illegally discriminating on the basis of arbitrary characteristics, such as race or gender, price discrimination involves legally charging people different prices for the same product on the basis of their willingness to pay.

The Requirements for Successful Price Discrimination A successful strategy of price discrimination has three requirements: 1. A firm must possess market power. 2. Some consumers must have a greater willingness to pay for the product than other consumers, and the firm must be able to know what prices customers are willing to pay. 3. The firm must be able to divide up—or segment—the market for the product so that consumers who buy the product at a low price are not able to resell it at a high price. In other words, price discrimination will not work if arbitrage is possible. When firms can practice price discrimination, they will charge customers who are less sensitive to price—those whose demand for the product is less elastic—a higher price and charge customers who are more sensitive to price—those whose demand is more elastic—a lower price.

At a price of $7.25, 850 tickets would be sold to evening showings, Figure 16.1 Price Discrimination by a Movie Theater Fewer people want to go to the movies in the afternoon than in the evening. In panel (a), the profit-maximizing price for a ticket to an afternoon showing is $7.25. Charging this same price for evening showings would not be profit maximizing, as panel (b) shows. At a price of $7.25, 850 tickets would be sold to evening showings, which is more than the profit-maximizing number of 625 tickets. To maximize profits, the theater should charge $9.75 for tickets to evening showings.

Airlines: The Kings of Price Discrimination The practice of continually adjusting prices to take into account fluctuations in demand is called yield management. Figure 16.2 33 Customers and 27 Different Prices To fill as many seats on a flight as possible, airlines charge many different ticket prices. The 33 passengers on this United Airlines flight from Chicago to Los Angeles paid 27 different prices for their tickets, including one passenger who used frequent flyer miles to obtain a free ticket. The first number in the figure is the price paid for the ticket; the second number is the number of days in advance that the ticket was purchased.

Making the Connection How Colleges Use Yield Management Traditionally, colleges have based financial aid decisions only on the incomes of prospective students. In recent years, however, many colleges have started using yield management techniques, first developed for the airlines, to determine the amount of financial aid they offer different students. When colleges use yield management techniques, they increase financial aid offers to students who are likely to be more price sensitive, and they reduce financial aid offers to students who are likely to be less price sensitive. Many students (and their parents) are critical of colleges that use yield management techniques in allocating financial aid.

Perfect Price Discrimination If a firm knew every consumer’s willingness to pay—and could keep consumers who bought a product at a low price from reselling it—the firm could charge every consumer a different price. In this case of perfect price discrimination—also known as first-degree price discrimination—each consumer would have to pay a price equal to the consumer’s willingness to pay and, therefore, would receive no consumer surplus. This extreme case helps us to see the two key results of price discrimination: 1. Profits increase. 2. Consumer surplus decreases.

Figure 16.3 Perfect Price Discrimination Panel (a) shows the case of a monopolist who cannot practice price discrimination and, therefore, can charge only a single price for its product. The graph shows that to maximize profits, the monopolist will produce the level of output where marginal revenue equals marginal cost. The resulting profit is shown by the area of the green rectangle. Given the monopoly price, the amount of consumer surplus in this market is shown by the area of the blue triangle. The economically efficient level of output occurs where price equals marginal cost. Because the monopolist stops production at a level of output where price is above marginal cost, there is a deadweight loss equal to the area of the yellow triangle. In panel (b), the monopolist is able to practice perfect price discrimination by charging a different price to each consumer. The result is to convert both the consumer surplus and the deadweight loss from panel (a) into profit.

Figure 16.4 Price Discrimination across Time Publishers issue most novels in hardcover at high prices to satisfy the demand of the novelists’ most devoted fans. Later, publishers issue paperback editions at much lower prices to capture sales from casual readers. I Firms charge a higher price for a product when it is first introduced and a lower price later. Some consumers are early adopters who will pay a high price to be among the first to own certain new products.

Can Price Discrimination Be Illegal? Congress has passed antitrust laws to promote competition. In 1936, Congress passed the Robinson–Patman Act, which outlawed price discrimination that reduced competition, but also contained language that could be interpreted as making illegal all price discrimination not based on differences in cost. Today, claims that price discrimination violates the antitrust laws are extremely rare.

Odd Pricing: Why Is the Price $2.99 Instead of $3.00? Many firms use what is called odd pricing—for example, charging $4.95 instead of $5.00, or $199 instead of $200. If consumers have the illusion that $9.99 is significantly cheaper than $10.00, they will demand a greater quantity of goods at $9.99—and other odd prices—than the estimated demand curve predicts. Why Do Some Firms Use Cost-Plus Pricing? Many firms use cost-plus pricing, which involves adding a percentage markup to average cost. Economists conclude that using cost-plus pricing may be the best way to determine the optimal price in two situations: 1. When marginal cost and average cost are roughly equal 2. When a firm has difficulty estimating its demand curve

Making the Connection Cost-Plus Pricing in the Publishing Industry Many publishers apply a markup to their production costs by multiplying the unit production cost by 7 or 8 to arrive at the retail price they will charge customers in bookstores. Consider the following example for a hypothetical new book, assuming it has 250 pages, the publisher expects to sell 5,000 copies, and plant and manufacturing costs are as given in the following table: Plant Costs Typesetting $3,500 Other plant costs 2,000 Manufacturing Costs Printing $5,750 Paper 6,250 Binding 5,000 Total Production Cost $22,500 Multiplying by 7 the per-unit production cost, which is $22,500/5,000 = $4.50, results in a price of $31.50 for the book, but the publisher receives only $18.90, $14.40 of which equals the cost of editing, marketing, warehousing, paying a royalty to the author of the book, and all other costs.

Why Do Some Firms Use Two-Part Tariffs? Figure 16.5 A Two-Part Tariff at Disney World In panel (a), Disney charges the monopoly price of $26 per ride ticket and sells 20,000 ride tickets. Its profit from ride tickets is shown by the area of the light-green rectangle, B, $480,000. If Disney is in the position of knowing every consumer’s willingness to pay, it can also charge a price for admission tickets that would result in their total amount paid being equal to total consumer surplus from the rides, which equals the area of the dark-green triangle, A, or $240,000. So, when charging the monopoly price, Disney’s total profit equals $480,000 + $240,000 or $720,000. In panel (b), Disney charges the perfectly competitive price of $2, which results in a quantity of 40,000 ride tickets sold. At the lower ride ticket price, Disney can charge a higher price for admission tickets, which will increase its total profits from operating the park to the area of the light-green triangle, or $960,000.

Monopoly Price for Rides Competitive Price for Rides Two-part tariff A situation in which consumers pay one price (or tariff) for the right to buy as much of a related good as they want at a second price. The lower the price Disney charges for ride tickets, the higher the price it can charge for admission tickets. Disney’s profits from the rides will decline to zero because it is now charging a price equal to average cost, but its total profit from Disney World will rise from $720,000 per day to $960,000. Table 16.2 Disney’s Profits per Day from Different Pricing Strategies Monopoly Price for Rides Competitive Price for Rides Profits from admission tickets $240,000 $960,000 Profits from ride tickets 480,000 Total profit 720,000 960,000

It is important to note the following about the outcome of a firm using an optimal two-part tariff: 1. Because price equals marginal cost at the level of output supplied, the outcome is economically efficient. 2. All consumer surplus is transformed into profit. In practice, Disney can’t convert all consumer surplus into profit because The demand curves of customers are not all the same. (2) Disney does not know precisely what these demand curves are.