1 Price discrimination A form of Monopoly Power

2 Our story of monopoly is incomplete. We have seen the case where the monopolist charges all customers the same amount. This is the single price monopoly case. Do not get me wrong, monopolies can change their price. But once they do, the single price monopolies will charge all consumers the same price. But, some monopolies charge different consumers different prices. This type of monopoly is a price discriminating monopoly. Some folks tell us that Microsoft discriminates when it sells Windows to the various computer makers. Some pay less than others. You have probably heard of cases where senior citizens pay less, or maybe college students get to pay less. These are other examples of discrimination.

3 Why discriminate? The answer is that it may be more profitable than charging a single price. Can every firm with monopoly power discriminate? Discrimination can only occur when both of the following hold. 1) The monopolist must have knowledge of how consumers differ in their demand for the good or service. Then the difference can be exploited. 2) Arbitrage must not be possible. Customers in the low price market segment must not be able to sell to the customers in the relatively high price segment. We typically distinguish between three types of discrimination. I show 2 of them here.

4 Let’s note if there are quality differences or cost of service varies by customer, then charging different prices need not be price discrimination. Examples 1) Not discrimination – charging different amounts by seat location because this is a different quality item. 2) Not discrimination – walk-up or game day sales are more costly to serve than advance ticket sales. If walk-up crowd is overestimated seats will go empty. 3) Discrimination – cost of providing sport does not vary by time of day, day of week, or age of fans. 4) Discrimination – same seat on different days has same quality.

5 Example that I will explain on next slides PQTRsMRsTRd1MRd1 1100Can’t do

6 Say we have consumer demand of the form in the first two columns of the table on the last screen. You can see the quantity demanded rises as the price falls. TRs and MRs refer to the total revenue and marginal revenue when we have a single price monopoly. For example, when the price is 9, 2 units are demanded and the total revenue is 18. At a price of 10 the TRs was 10, so the additional revenue of the second unit – what we call the marginal revenue – is 8. Remember that when we have a single price monopoly and the demand has the general form P = a – bA, then the MRs = a – 2bA. TRd1 and MRd1 refer to the total revenue and marginal revenue when we have a price discriminating monopoly using the first degree method.

7 1 st degree discrimination In 1 st degree price discrimination the monopoly knows what the individual is willing to pay for each unit and is able to extract that amount. In the example we know the individual will pay 10 for the first unit. Since two units are demanded at a price of 9, we know the individual is willing to pay 9 for the second unit. So on the two units the monopoly can charge 10 for the first one and 9 for the second one. Think about a quantity discount idea. Pay 10 for one or get 2 for 19. The TRd1 for two units is thus 19 and the MRd1 for the second unit is 9. We follow the same idea the rest of the way down the columns

8 Note that the MRd1 and the P are the same. This is an example that shows that the price and marginal revenue are equal for a 1 st degree price discriminator. Now if demand is P = a – bA, then MR = a – bA. The MRd1 curve is the demand curve for the 1 st degree discriminator.

9 $ Q MRs Demand of consumer and MRd1

10 If the market was single price monopoly we would use the MRs line and the A at 4 would have MR = 4 and the price on the demand curve is 7. Now, if the monopoly can discriminate in the first degree in this example, then it will charge 10 for the first unit, 9 for the second unit, on down to 7 for the 4th unit. NOTE 1st degree discriminator 1) charges a different price on each unit 2) takes all the consumer surplus away from the consumer. Remember consumer surplus is what consumers are willing to pay minus what they have to pay and the 1st degree discriminator has the ability to get them to pay their willing amount on each unit.

11 Special way to look at 1st degree discriminator - two part tariff or pricing. A two part tariff is a special way to get the consumer to pay all they are willing to pay for units they buy. If you think back to the graph, the discriminator extracts all the surplus from consumers. It can do the same thing in two steps. 1) charge a single price for all the units it wants to sell, 2) charge a fee to be able to buy any units at all and make the fee the consumer surplus that results from the single price. As an example from the graph from before, if the single price is 7, 4 units are demanded and the fee is the consumer surplus triangle above the 7 price line and below the demand curve. An example of this is the Personal Seat License that many teams use. The consumer surplus is the cost of the PSL.

12 3 rd Price Discrimination

13 Third degree discrimination The third degree price discriminator see consumers as being in distinct groups with distinct elasticities. The key to this method working is that buyers in one group can not have the ability to sell to buyers in the other group. Here we have two groups and in each group we have to charge each the same amount in their group – kind of like a single price monopoly in each group. From a graphical point of view the group may have distinctly different demands. The basic idea is to sell the next unit to the group that has the higher marginal revenue. A whole company MR can be constructed from the separate parts.

14 3 rd degree MKT 1MKT2firm level analysis MR1 D1 D2 MR2 MR

15 3 rd degree In this situation the firm is in two markets (has 2 types of customers) and would like to maximize profit. It has to decide what to charge in each market and how much to sell in each market. As the firm continues to sell units in each market it has to be cognizant of costs as well. But, if it sells another seat to a game it would want the marginal revenue to be the most and then on the last unit sold the marginal revenue in each group should be the same.

16 Recall we said in a market MR = P(1 – [1/E]), where I know use E to be the price elasticity of demand. If the MR’s between the two groups are equalized we would have MR1 = P1(1 – [1/E1]) = P2(1 – [1/E2]) = MR2 Rearranging we would have P1/P2 = (1 – [1/E2])/ (1 – [1/E1]). It would be the case that P1 = P2 when E1 = E2.

17 3 rd degree It would be the case that P1 > P2 when 1 – 1/E2 > 1 – 1/E1 or – 1/E2 > – 1/E1 or 1/E2 < 1/E1 or E1 < E2 This means that the group with the lower elasticity would get charged the higher price.