1 Price Discrimination (when there is no strategic interaction)

2 Profit Maximization when setting a Single Price Profits are maximized at Q=4 and P=6. Profits=TR-TC= 6*4-4.5*4= 24-18=6 Or Profits=P*Q-ATC*Q =(P-ATC)*Q =(6-4.5)*4=6 Consumer Surplus - the value consumers get from a good but do not have to pay for. Q MR PROFITS CONSUMER SURPLUS

3 Definition of Price Discrimination The practice of charging different prices to consumers for the same good or service (and the price differences do not reflect cost differences)

4 Three Conditions Required for Price Discrimination to Occur 1. Seller must exercise some “price control” (i.e. face a downward sloping demand) 2. Seller must be able to distinguish among customers who are willing to pay different prices. 3. It must be impossible or too costly for one buyer to resell the good to other buyers (i.e., buyers cannot arbitrage).

5 Strategic Behavior By Firms What actions do firms take to prevent resale or make resale more “costly”? 1. Warranty becomes invalid if item is resold. 2. Software firms do not provide support services if software is resold. Any others you can think of?

6 Types of Price Discrimination 1. First-Degree (Perfect) Price Discrimination - Occurs when the seller charges the highest price each consumer would be willing to pay for the product (consumer's reservation values) rather than go without it. Universities, Car Dealers, Contractors, Flea Market (at least they all try) 2. Third-Degree Price Discrimination - Occurs when the seller charges different prices in different markets, or charges a different price to different segments of the buying population. Movies, Soda, Computers, prescription drugs, textbooks, safety gates, airlines, dry cleaning, haircuts, …

7 Types of Price Discrimination 3. Second-Degree Price Discrimination - Occurs when the seller charges a uniform price per unit for one specific quantity, a lower price for an additional quantity, and so on. QUANTITY DISCOUNTS (2-part Pricing is a type of quantity discount) Electric Utilities, Country Clubs, Michigan Athletic Club, Disneyland (in old days), Grocery Stores, Espresso Royale, … 4. Peak Load Pricing – the practice of charging higher prices during “peak hours” (i.e. high demand times) than during off-peak hours. Hotels, Ski Resorts, Airlines, Stadiums, Restaurants, Toll roads, Bridges, …

8 Types of Price Discrimination 5. Screening- the practice of requiring consumers to “jump over a hurdle” to obtain a lower price. Coupons, Warranties, Rebates, Outlet malls, Saturday Night Stayovers for airlines,….

9 No Price Discrimination Profits are maximized at Q=20 and P=30. Profits=TR-TC =P*Q-ATC*Q =30*20-14*20=320 MR

10 First-Degree (Perfect) Price Discrimination Definition: Occurs when the seller charges the highest price each consumer would be willing to pay for the product (consumer's reservation values) rather than go without it. Universities, Car Dealers, Contractors, Flea Market (at least they all try)

11 1 st -Degree Price Discrimination Charge Every Consumer the maximum he/she is willing to pay. The demand curve is based on what consumers are willing to pay.

12 Market Demand is Obtained from Adding Individual Demand Curves

13 Suppose Market Demand is Obtained from Individual Demands Below

14 1 st -Degree Price Discrimination What output would the firm produce to maximize profits if it could 1 st - degree price discriminate? Q=30 What would be the firm’s total revenue? TR=.5*(50-20)*30+20*30 =1050 What would be the firm’s TC at an output of 30? TC=ATC*Q=15*30=450 Profits= =600 TR TC Marginal Revenue is the Demand Curve

15 Certain Degrees Now Cost More at Universities The New York Times,

16 Expensive Lesson: Colleges Manipulate Financial Aid Offers The Wall Street Journal

17 Expensive Lesson: Colleges Manipulate Financial Aid Offers The Wall Street Journal

18 Expensive Lesson: Colleges Manipulate Financial Aid Offers The Wall Street Journal

19 Reckonings; What Price Fairness? The New York Times

20 Third-Degree Price Discrimination Definition: Occurs when the seller charges different prices in different markets, or charges a different price to different segments of the buying population. Movies, Soda, Computers, prescription drugs, textbooks, safety gates, airlines, …

Movie Theater with 300 seats that price discriminates based on age by offering different prices to senior citizens and non-senior citizens. Assume (Daily) Fixed Costs of $1,000 and constant Marginal Cost of $2. 21 Senior CitizenNon-Senior Citizen DsDs D ns MR s MC MR ns MC Set a price of $6 for Senior Citizens and have 160 buy tickets. Set a price of $11 for Non-Senior Citizens and have 90 buy tickets. Daily Profits would then be 6*160+11*90-2*160-2* = 450.

22 Lower Rates for Women Are Ruled Unfair New York Times, August 13, 2008

23 Insurance ‘eggheads” Make Women Pay Los Angeles Times, June 22, 2008

24 Second-Degree Price Discrimination Definition: Second-Degree Price Discrimination - Occurs when the seller charges a uniform price per unit for one specific quantity, a lower price for an additional quantity, and so on. QUANTITY DISCOUNTS (2-part Pricing is a type of quantity discount). Electric Utilities, Country Clubs, Michigan Athletic Club, Disneyland (in old days), Espresso Royale, …

25 2-Part Pricing Suppose the graph to the right depicts the demand and cost curves for a country club where quantity (Q) represents the number of rounds of golf. Q

26

27 Suppose the country club sets the price per round of golf at $20. What membership fee (fixed fee) should the country club set? If the price per round is $20 and the membership fee isn’t too high, how many rounds of golf will Individual A play? 3 What is the maximum membership fee Individual A will pay given the price per round is $20?.5*(50-20)*3=45 Individual A Maximum membership fee Individual A is willing to pay.

28 Suppose the country club sets the price per round of golf at $20. What membership fee (fixed fee) should the country club set? If the price per round is $20 and the membership fee isn’t too high, how many rounds of golf will Individual B play? 6 What is the maximum membership fee Individual B will pay given the price per round is $20?.5*(50-20)*6=90 Maximum membership fee Individual B is willing to pay. Individual B

29 Suppose the country club sets the price per round of golf at $20. What membership fee (fixed fee) should the country club set? Given the cost of each round is $20, the country club should charge a membership fee of either $45 or $90. Profits if membership fee is $45 Both types of individuals join with Type A golfing 3 rounds each and Type B golfing 6 rounds. 45*9+20*(8*3+1*6)-15*30= 555 Profits if membership fee is $90 Only Type B joins and Type B golfs 6 rounds. 90*1+20*(1*6)-35*6= 0 SET MEMBERSHIP FEE AT $45

30 2-Part Pricing If membership fee is $45, total number of rounds golfed is 8*3+1*6=30. At Q=30, ATC=15 so TC=ATC*Q=15*30=450. If membership fee is $90, total number of rounds golfed is 1*6=60. At Q=6, ATC=35 so TC=ATC*Q=35*6=210. Q

31 Peak Load Pricing Definition The practice of charging higher prices during “peak hours” (i.e. high demand times) than during off-peak hours. Hotels, Ski Resorts, Airlines, Stadiums, Restaurants, …

32 Demands at a Restaurant for Lunch and Dinner

33 Suppose Restaurant’s Capacity is 45 seats, Fixed Costs are $1800 per day and Marginal Cost of a meal is constant at $20 What prices will the Restaurant charge for lunch and dinner? P L =$35 and P D =$60 What are the Restaurant’s daily profits? TR-TC=TR-TVC-TFC= 35*15+60*40- 20*(15+40)-1800= 25 MC=AVC PL=PL= PD=PD=

34 Suppose Restaurant’s Capacity is 30 seats, Fixed Costs are $1200 per day and Marginal Cost of a meal is constant at $20 What prices will the Restaurant charge for lunch and dinner? P L =$35 and P D =$70 What are the Restaurant’s daily profits? TR-TC=TR-TVC-TFC= 35*15+70*30- 20*(15+30)-1200= 525 MC=AVC PL=PL= PD=PD=

35 Screening The practice of requiring consumers to “jump over a hurdle” to obtain a lower price. Coupons, Warranties, Rebates, Outlet malls, Saturday Night Stayovers for airlines,… , &li=lmd&z=14&t=m

36 Coupon for Box of Cereal – Assume MC of a box is constant at $.50 and TFC=15

37 Suppose Don’t Issue a Coupon Set Price at $2 or $3 to maximize profits. If Set Price=$2 Profits = 30*2-30*.5-15= 30 If Set Price=$3 Profits = 10*3-10*.5-15= 10

38 Suppose the opportunity cost of cutting a coupon is $0 for Type A individuals and $1.50 for Type B individuals. What Price and Coupon Value Maximizes Profits? Price=$3 and Coupon Value=$1 Type A cuts coupon and Type B does not. TR=3*10+(3-1)*20 = 70 TC=.5*30+15=30 Profits= 70-30=40

39 Suppose the opportunity cost of cutting a coupon is $0.25 for Type A individuals and $1.50 for Type B individuals. What Price and Coupon Value Maximizes Profits? Price=$3 and Coupon Value=$1.25 Type A cuts coupon and Type B does not. TR=3*10+(3-1.25)*20 = 65 TC=.5*30+15=30 Profits= 65-30=35

40 Suppose the opportunity cost of cutting a coupon is $0.75 for Type A individuals and $1.50 for Type B individuals. What Price and Coupon Value Maximizes Profits? Price=$2.75 and Coupon Value=$1.50 Type A cuts coupon and Type B does not. TR=2.75*10+( )*20 = TC=.5*30+15=30 Profits= =22.50 Better off just charging a price of $2 and not using coupon.

41 Suppose the opportunity cost of cutting a coupon is $0.75 for Type A individuals and $1.50 for Type B individuals. What Price and Coupon Value Maximizes Profits? Price=$2.75 and Coupon Value=$1.50 TR=2.75*10+( )*20 = TC=.5*30+15=30 Profits= =22.50 You could make Price=$2.74 and Coupon Value=$1.49 if you want to make Type B strictly prefer to not cut the coupon.

Intuition There are two types of consumers. One with a high willingness to pay and one with a low willingness to pay. The cost of “jumping over the hurdle” is greater for the high willingness to pay type. You want the low willingness to pay type to jump over the hurdle and then pay the maximum he/she is willing to pay. You then want to charge the high willingness to pay the maximum possible without providing him/her the incentive to “jump over the hurdle” or to not buy. 42

43 iPhone Buyer Sues The Times (London)

44 Reckonings; What Price Fairness? The New York Times