1 Price Discrimination Per Baltzer Overgaard February, 2003 Adapted from the notes of H. Peter Møllgaard (by courtesy) Based on Carlton and Perloff chap. 9/10

2 Outline: Non-uniform pricing Common types of Price Discrimination Necessary conditions for PD 1st-degree PD 3rd-degree PD 2nd-degree PD Tying as a PD vehicle

3 Common types of PD Student discounts on computers, software, books, … -> 3rd degree PD –Customers segmented into separate sub-markets Quantity discounts -> 2nd degree PD –Customers self-select their discount by the size of their order Individualized prices -> 1st degree PD –Special price for you, my friend.

4 Outline: Non-uniform pricing Common types of PD Necessary conditions for PD 1st-degree PD 3rd-degree PD 2nd-degree PD Tying as a PD vehicle

5 Necessary conditions for PD (1) Existence of market power –i.e. ability to raise price above MC. Identification of different consumers’ willingness to pay. –identification method differs in 1st, 2nd, and 3rd degree PD Firm must be able to prevent or limit resales –arbitrage eliminates price differences

6 Necessary conditions for PD (2) Ways to prevent or limit resales services can often not be resold –Want to buy my haircut? resale can make warranty void transportation costs may limit resales contractual clauses may forbid resale vertical integration may prevent resales....

7 Outline: Non-uniform pricing Common types of PD Necessary conditions for PD 1st-degree PD 3rd-degree PD 2nd-degree PD Tying as a PD vehicle

8 1st-degree or perfect PD (1) Each consumer needs one unit. Their willingness to pay for a unit differs. Firm can identify a consumer’s w.t.pay so offers each consumer the unit at a price = w.t.pay (-  ) no consumer surplus is left -- firm gets it all but the market outcome is efficient:

9 1st-degree or perfect PD (2) # of units willingness to pay price MC MC Firm sells as many units as it would under perfect competition so the market is allocatively efficient … but consumers might dislike the distributive effects

10 1st-degree or perfect PD (3) Each consumer needs several units. Individual demand curves differ. Firm can identify a consumer’s demand offers each an individualized two- part tariff w.t.p.MC q JS MC John Smith’s demand curve Offer a two-part pricing scheme: Pay = F JS +p JS q JS

11 1st-degree or perfect PD (4) What should p JS and F JS optimally be set at? Profit maximum is where –p JS = MC –F JS = “CS” w.t.p.MC q JS MC John Smith’s demand curve Offer a two-part pricing scheme: Pay = F JS +p JS q JS

12 Outline: Non-uniform pricing Common types of PD Necessary conditions for PD 1st-degree PD 3rd-degree PD 2nd-degree PD Tying as a PD vehicle

13 3rd-degree PD (1) Markets may be separated –geographically –according to e.g. demographic characteristics: age (youth, elderly) employment status (employed, unemployed, student) income level...

14 3rd-degree PD (2) Profits may be split into two separate parts if monopolist has constant MC=m π = (p 1 (Q 1 )-m) Q 1 + (p 2 (Q 2 )-m) Q 2 F.O.C.: p i - m + p i ’ Q i = 0, i = 1,2 => p i - m = - p i ’ Q i => (p i - m)/p i = - p i ’ Q i / p i = - 1/ε i OR p 1 /p 2 = (1+ 1/ε 2 )/(1+ 1/ε 1 )

15 3rd degree PD (3) So the firm acts as a monopolist on each market segment Exploits differences in demand elasticities by charging higher prices on less elastic market segments If all markets are served, with a linear demand welfare is reduced if firm is allowed to do PD.

16 3rd degree PD (4) But sometimes the firm would decide not to serve small markets, if it is forced to do uniform pricing -> blackboard drawing. In that case, PD may increase welfare. Demands in two market segments are given by P 1 = Q 1 and P 2 = 25 - Q 2. MC = 0. –Find the profit maximizing prices (3rd degree) –Find the uniform monopoly price.

17 Outline: Non-uniform pricing Common types of PD Necessary conditions for PD 1st-degree PD 3rd-degree PD 2nd-degree PD Tying as a PD vehicle

18 2nd-degree PD (1) What if the firm cannot sort or separate consumers? Consumers willingness to pay or demand curve is often not observable. The firm must make them self-select their payments Consumers with high willingness to pay could mimic low consumers

19 2nd-degree PD (2) A single two-part tariff: Payment = T + pq Two types of consumers, but firm cannot see who’s who At any price p, Type 2 would be willing to pay a higher fixed fee T 2 than would type 1: IF the firm wants to sell to both types of consumers, the maximal T it can set is T 1 :

20 2nd-degree PD (3) Type 1 Type 2 q1q1q1q1 q2q2q2q2 P MC T1T1T1T1 T2T2T2T2

21 2nd-degree PD (4) Firm has to leave CS for Type 2!!! Might try to use two different two-part tariffs but then the customers might have incentive to imitate another type. Trade-off between getting more profits and ensuring that pricing scheme is incentive compatible to all consumers.

22 Outline: Non-uniform pricing Common types of PD Necessary conditions for PD 1st-degree PD 3rd-degree PD 2nd-degree PD Tying as a PD vehicle

23 Tying as a PD vehicle To screen customers, you may tie two products together in service contract E.g. Xerox machines and Xerox paper/toner Heavy users will have higher willingness to pay. Sell the machine at cost and reap the profits through the paper/toner.

24 What’s next? Shapiro & Varian Versioning and bundling, etc.