Price Discrimination How does someone price discriminate?  Age  Sex  Quantity  Patience (lines, express delivery)  Flexibility (plane tickets)  Ability or willingness to bargain  Information  Membership  Coupons

1st Degree Price Discrimination AKA Perfect Price Discrimination Charge each person his/her WTP Allocatively efficient, no DWL Extracts all of the consumer surplus Difficult to implement Can use a 2-part tariff

Using a Two-Part Tariff to Price Discriminate Demand = WTP Supply = MC Quantity $ QMQM PMPM Fixed Fee = (V-P M )/2 V

Even Better - From the Monopolist’s Point of View Demand = WTP Supply = MC Quantity $ QMQM PCPC Fixed Fee = (V-P C )/2 V

2nd Degree Price Discrimination All consumers face same price “menu” Actual price paid depends on consumer’s preferences or type Usually used when consumers cannot be distinguished ex ante Ex: Quantity discount

3rd Degree Price Discrimination AKA Market Segmentation Consumers separated into submarkets based on some external characteristic Different prices in each submarket No arbitrage between submarkets Ex: Airlines

Market Segmentation Demand = WTP MC Quantity $ V QMQM PMPM MR PS Demand of Group 1 Demand of Group 2

Implementing 3rd Degree Price Discrimination Must be able to identify different demand and to prevent resale/arbitrage Screening: Offering different features to appeal to customers with different WTP –2 model years of the same car on the same lot –Different passes at CW and Busch Gardens Crimping: Limiting the usefulness of the product to "screen” customers –Prevents resale from low price to high price market –Shareware versions that aren't fully functional

Consequences of Price Discrimination 1st Degree: –Quantity at competitive level –Extracts all of the potential surplus 2nd Degree –Expands output, but not to competitive level 3rd Degree = Market Segmentation –Doesn’t necessarily expand output, may redistribute –May lead to loss in total surplus

Antitrust and Price Discrimination 1887: Interstate Commerce Act –Prohibited undue discrimination in railroad rates. 1914: Clayton Act –Price discrimination illegal if it lessens competition or tends to create a monopoly. –OK to discriminate based on grade, quality, or quantity. 1936: Robinson-Patman Act –Closed the quantity loophole - no difference in price allowed when effect is to lessen competition.

Illegal Price Discrimination Primary Line –The firm practicing PD injures its own rivals. Secondary Line –The injury to competition occurs in the buyers’ market.

Anheuser-Bush Case: Primary Line Discrimination AB dropped price of premium brand (Budweiser) in St. Louis only Claim was it would hurt AB’s competitors because it would divert consumers from other brands

Morton Salt Case: Secondary Line Discrimination Salt sold at a quantity discount Only 5 customers bought at the lowest price -- all large chain stores

Commodity Bundling and Tie-In Sales Techniques used by multi-product firms to extract additional consumer surplus Bundling: Selling two or more products in a single package –Ratio of the products is fixed –Example: Happy Meal Tie-In Sales: Purchase of one good conditional on purchase of another –Ratio of the products not fixed –Example: Polaroid cameras

How Bundling Works Two Types of TV Viewers: Series Lovers and Event Watchers Selling products separately, maximize revenue by charging $8 for Network TV and $10 for Sports/Special Interest. Total Revenue = $36, Total Consumer Surplus = $9 Selling bundled products, maximize revenue by charging $20 for combined package. Total Revenue = $40, Total Consumer Surplus = $5

General Model of Commodity Bundling Each consumer will buy at most one unit of each of two good. Consumers have different values (V) for the two goods. V1V1 V2V2 A’s value for good 1 Consumer A A’s value for good 2

Firm produces goods at different constant marginal costs, c 1 & c 2. Without bundling, prices are set at the monopoly level. With “pure” bundling (can only buy the bundle) sales increase. PBPB PBPB PBPB P1P1 P2P2 c1c1 c2c2 V1V1 V2V2

With “mixed” bundling, consumers can buy products either separately, or together. PBPB PBPB c1c1 c2c2 V1V1 V2V2 P1P1 P2P2 PBPB In both cases, P B > c 1 + c 2, but P B < P 1 + P 2. Therefore, although sales increase, profit may not. For profit to increase, there must be significant variation in valuations.

How Tie-In Sales Work 1. Amount of each good that must be bought is not specified. 2. Usually complementary goods. Allows firm to price discriminate. Acts like a 2-part tariff. Everyone pays same amount for camera, but heavy users buy more film than light users, so the two groups will pay different average prices.

Tie-in sales can also be used to get rid of externalities that may exist if the goods are related. Assume goods 1 and 2 are complements, but are produced by separate firms. Q D (Pair) = A - (P 1 + P 2 ) There’s an externality, because Q D (good 1) = A - (P 1 + P 2 ) and Q D (good 2) = A - (P 1 + P 2 )

Start by focusing on good 1. Assume the mkt is a monopoly. Q D (good 1) = A - (P 1 + P 2 ) Inverse Demand  P 1 = A - P 2 - Q 1  TR = (A - P 2 - Q 1 )Q 1 MR 1 = A - P 2 - 2Q 1 If MC = 0, Q 1 = (A - P 2 )/2 and likewise, Q 2 = (A - P 1 )/2 So P 1 = A - P 2 - (A - P 2 )/2 = (A - P 2 )/2 and likewise, P 2 = (A - P 1 )/2 Let’s graph this.

P1P1 P2P2 A A/2 A/2 A A/3 To solve, set the two curves equal: P 1 = (A - P 2 )/2 P 2 = (A - P 1 )/2  P 1 = A - 2 P 2 (A - P 2 )/2 = A - 2 P 2  3/2 P 2 = 1/2 A P 2 = A/3 (and by symmetry P 1 = A/3 )

Now assume that 1 firm makes both goods. Q D (pair) = A - (P for the pair ) Inverse Demand  P = A - Q  TR = (A - Q)Q MR = A - 2Q If MC = 0, Q = A/2 and thus P = A/2 So  = (A/2)A/2 = A 2 /4 Compare to profit if goods priced independently. P = 2A/3, Q = A - A/3 - A/3 = A/3,  = 2A 2 /9 A 2 /4 > 2A 2 /9