Chapter 12 Price Discrimination

Price Discrimination Price Discrimination is selling the same product at different prices to different customers. A firm with market power can use price discrimination to increase profit. This level of profit will be greater than that of a single price strategy. Instructor Notes:

Price Discrimination A monopolist produces a level of output where MR = MC and sets a price equal to the point on the demand curve corresponding to that level of output. What if the firm sells the same product in two different markets like Africa and Europe? A single price strategy would involve setting price somewhere in between the profit-maximizing prices if each country were the only market. As such, profit will decline in both markets. Instructor Notes:

Price Discrimination Price Discrimination Increases Profits Europe Africa Price Q MR MC=AC D PEurope PWorld PWorld PAfrica Instructor Notes: Figure 12.1: A Price Discrimination Can Increase Profits If Europe were the only market, the monopolist would maximize profit by producing QEurope and charge a price of PEurope . If Africa were the only market the monopolist would maximize profit at an output level of QAfrica and a price of PAfrica. With both markets the monopolist would have to set a single world price Pworld (in between PEurope and PAfrica). Under this pricing strategy, profits are lower in Europe and in Africa. If possible, the monopolist could increase profits by segmenting the markets and charging a different price in each country. Profit Profit QEurope QAfrica

Price Discrimination A price discrimination strategy will involve the following principles: If the demand curves are different, it is more profitable to set different prices in different markets than a single price that covers all markets; To maximize profits the monopolist should set a higher price in markets with more inelastic demand; Arbitrage makes it difficult for a firm to set different prices in different markets, thereby reducing the profit from price discrimination. Arbitrage is taking advantage of price differences for the same good in different markets by buying low in one market and selling high in another market. Instructor Notes:

Price Discrimination To increase profits through price discrimination, the firm must be able to prevent arbitrage activity. For some goods this will be easy while for some goods it will be difficult to prevent arbitrage. Services, in general, are difficult to arbitrage. If the firm cannot prevent arbitrage at a low cost, it will not benefit from price discrimination. Instructor Notes:

Why does a monopolist want to segment a market? Would a price discriminating firm set higher or lower prices for a market segment with more inelastic demand? What is arbitrage? How does arbitrage affect the ability of a monopolist to price discriminate? Instructor Notes:

Price discrimination is a common practice with airlines. Business travelers often need to take a trip on short notice and are less sensitive to price (i.e., inelastic demand). Vacationers, on the other hand, tend to plan their trips in advance and are more sensitive to price (i.e., elastic demand). As such, airlines charge higher prices to business travelers and lower prices to vacationers. Instructor Notes: It should be noted that airlines do not simply ask fliers the purpose of their travels but set different prices according to characteristics that are correlated with willingness to pay.

Price Discrimination Airlines Can Increase Profits by Charging Business People More Than Vacationers Business People (Inelastic Demand) Vacationers (Elastic Demand) Price Q MR MC=AC D PBusiness D PVacation Instructor Notes: Figure 12.2: Airlines Can Increase Profits by Charging Business People More Than Vacationers A monopolist maximizes profit by choosing the quantity where MR = MC in Europe and pricing at PEurope and where MR = MC in Africa and pricing at PAfrica. If the monopolist instead sets a single world price, PWorld, it profits are lower in Europe and in Africa. Thus, if possible, a monopolist always wants to segment markets. Profit Profit QBusiness QVacation

Price Discrimination Instructor Notes: Figure 12.3 Different Prices for the Same Flight Airlines are able to separate fliers based on willingness to pay by offering different prices based on the number of days in advance airline tickets are purchased.

Price Discrimination Under Perfect Price Discrimination (PPD), each customer is charged his or her maximum willingness to pay. Since each consumer pays his or her maximum willingness to pay under PPD, consumers end up with no consumer surplus. All of the gains from trade flow to the monopolist. With this pricing strategy, the monopolist produces until P = MC. This level of output equals that of competition. Instructor Notes:

Price Discrimination A Perfect Price Discriminator Marches Down the Demand Curve Charging Each Customer Their Maximum Willingness to Pay Price Quantity Alex’s willingness to pay Qx Tyler’s willingness to pay Robin’s willingness to pay Bryan’s willingness to pay MC D Instructor Notes: Figure 12.4: A Perfect Price Discriminator Marches Down the Demand Curve Charging Each Customer Their Maximum Willingness to Pay The monopolist under PPD charges each consumer a price based on the consumer’s maximum willingness to pay. Alex has the highest value and, thus, pays the highest price. Tyler values the good a little bit less and pays a lower price. Robin’s value is lower than Tyler’s, so she pays a lower price. The monopolist will continue charging a lower price to those who value the good less but always charges a price equal to the maximum willingness to pay. Under PPD MR = P, so the monopolist will not lower price below MC. At prices below MC, profits will fall. Thus, Bryan will be last consumer to purchase the good. Total production, Qx, will occur where P = MC. This is the same level of output in a competitive market. Hence PPD will eliminate the deadweight loss of a monopoly.

Price Discrimination In practice PPD may be difficult to implement since it requires very detailed information on consumers’ maximum willingness to pay. Nevertheless, producers go to great lengths to gather information on their consumers to achieve the goals of PPD. Instructor Notes:

Price Discrimination Universities often practice PPD through their financial aid packages which require an extraordinary amount of information. Table 12.1 Price Discrimination at Williams College, 2001-2002 Income Quintile Family Income Range Net Price after Financial Aid Low $0-$23,593 $1,683 Lower Middle $23,594-$40,931 $5,186 Middle $40,932-$61,397 $7,199 Upper Middle $61,398-$91,043 $13,764 High $91,044- $22,013 Note: Students who did not apply for financial aid paid $32,470 Instructor Notes: Table 12.1 Price Discrimination at Williams College, 2001-2002 Source: Hill, Catharine B., and Gordon C. Winston, 2001. Access: Net Prices, Affordability, and Equity at Highly Selective College. Williams College, DP-62.

Is the early bird special (eating dinner at a restaurant before 6:00PM or 6:30PM) a form of price discrimination? If so, what are the market segments? Can you think of another explanation (Hint: one based on opportunity cost) for this type of pricing? Why is it much more expensive to see a movie in a theater than to wait a few months and see it at home on DVD? Can you give an explanation based on price discrimination? Instructor Notes:

Though price discrimination sounds unfair, is it bad? If price discrimination increases output, then total surplus will increase. This greater output reduces the deadweight loss of monopoly. If the firm practices PPD, then the deadweight loss of monopoly is eliminated. Price discrimination makes it easier for firms to cover the fixed costs increasing incentives to innovate. Instructor Notes:

When is price discrimination likely to increase total surplus? How does price discrimination help industries with high fixed costs? Use universities as an example. Instructor Notes:

Tying and Bundling Tying is a form of price discrimination in which one good, called the base good, is tied to a second good called the variable good. Firms pursuing this strategy are not just selling individual goods but rather a package good. This approach allows firms to charge a high price to consumers with a high willingness to pay while charging a low price to consumers with a low willingness to pay. Instructor Notes: Examples: Hewlett-Packard printers and ink cartridges Microsoft Xbox and Xbox games Gillette Sensor razors and Sensor razor blades

Tying and Bundling With tying firms price discriminate by pricing the base good below cost and the variable good above cost. It is through the variable good that consumers reveal their willingness to pay and firms can earn higher profits. Firms basically charge a different price to every consumer based on their usage of the variable good. Instructor Notes:

Tying and Bundling Tying generates the same benefits as traditional price discrimination. Tying may increase output by lowering the price to consumers with limited use of the variable good. Tying allows firms to spread fixed costs of research and development over more consumers thus encouraging innovation. Firms may, however, incur additional costs ensuring that lower priced substitutes to its variable good do not emerge. Instructor Notes: Firms often spend resources to construct a strict compatibility relationship between the base and variable goods.

Tying and Bundling Bundling is a strategy that requires products be purchased together in a bundle or package. Firms use bundling when they have more information on the demand for the bundle than for the individual parts. Bundling may also be preferred to traditional price discrimination when preventing arbitrage is too difficult or expensive to enforce. Instructor Notes:

Maximum Willingness to Pay for Word and Excel Tying and Bundling Consider two consumers, Amanda and Yvonne, whose maximum willingness to pay for Word and Excel is given below. Maximum Willingness to Pay for Word and Excel Amanda Yvonne Word $100 $40 Excel $20 $90 Instructor Notes: Table 12.2: Maximum Willingness to Pay for Word and Excel

Tying and Bundling If Microsoft sets prices individually, it can earn greater profits by pricing Word at $100 and Excel at $90 (assuming marginal cost of zero). At a price of $40, both Amanda and Yvonne will purchase Word and profits will be $80. At a price of $100, only Amanda will purchase Word and profits will be $100. At a price of $20, both Amanda and Yvonne will purchase Excel and profits will be $40. At a price of $90, only Yvonne will purchase Excel and profits will be $90. Instructor Notes:

Maximum Willingness to Pay for Word and Excel Tying and Bundling If Microsoft bundles Word and Excel and sells them as Office, the maximum willingness to pay is given below. Maximum Willingness to Pay for Word and Excel Amanda Yvonne Word $100 $40 Excel $20 $90 Office $120 $130 Instructor Notes: Table 12.3: Maximum Willingness to Pay for Office The maximum willingness to pay for Office is simply the sum of the maximum willingness to pay for Word and the maximum willingness to pay for Excel

Tying and Bundling If Microsoft bundles Word and Excel, the profit maximizing price is $120 (assuming marginal cost of zero). At a price of $130, only Yvonne will purchase Office and profits will be $130. At a price of $120, both Amanda and Yvonne will purchase Office and profits will be $240. By bundling Word and Excel into Office, Microsoft increases profits. Instructor Notes:

Tying and Bundling Bundling generates the same benefits as traditional price discrimination. Bundling may increase output and increase total surplus. Bundling allows firms to spread fixed costs of research and development over more consumers thus encouraging innovation. Instructor Notes:

When is bundling likely to increase total surplus? If cell phone companies were not allowed to bundle cell phones with service plans, what would you predict would happen to the price of cell phones, and what would you predict would happen to the price of cell phone calls? When is bundling likely to increase total surplus? Instructor Notes:

PPD generates a level of output equal to that of competition. Price discrimination is selling the same product at different prices to different customers. Firms with market power practice price discrimination to earn greater profits. Under perfect price discrimination (PPD), each customer is charged his or her maximum willingness to pay. PPD generates a level of output equal to that of competition. Instructor Notes:

Other results of price discrimination: If price discrimination increases output, then total surplus will increase; This greater output reduces the deadweight loss of monopoly; If the firm practices PPD, then the deadweight loss of monopoly is eliminated; Price discrimination makes it easier for firms to cover the fixed costs increasing incentives to innovate. Instructor Notes:

Tying generates the same benefits as traditional price discrimination. Tying is a form of price discrimination in which one good, called the base good, is tied to a second good called the variable good. With tying firms price discriminate by pricing the base good below cost and the variable good above cost. Tying generates the same benefits as traditional price discrimination. Instructor Notes:

Bundling is a strategy that requires products be purchased together in a bundle or package. Firms use bundling when they have more information on the demand for the bundle than for the individual parts. Bundling generates the same benefits as traditional price discrimination. Instructor Notes: