1. Lecture 2(C) Price Discriminaton

2. Price Discrimination: The Easy Questions What is it? What is it? Charging Different Prices for the Same Good Charging Different Prices for the Same Good Why do firms do it? Why do firms do it? To reduce the lost revenue that would result if the price cut was offered to the customers who were willing to pay the higher price. To reduce the lost revenue that would result if the price cut was offered to the customers who were willing to pay the higher price. Who gets discriminated against? Who gets discriminated against? Those customers willing to pay the higher price (i.e., the “low elasticity buyers” Those customers willing to pay the higher price (i.e., the “low elasticity buyers”

3. The Hard Question: Why Do Firms Discriminate in Ways That are Seemingly Counter to Other Interests? Airline Pricing: Lower prices to weekend travelers. Airline Pricing: Lower prices to weekend travelers. “Entrance fees” “Entrance fees” Coupons Coupons Expensive differentiation (Escalades v Suburban sx v dx chips)? Expensive differentiation (Escalades v Suburban sx v dx chips)?

4. To Be a Successful Price Discriminator, The Firm Should Have some degree of market power. Have some degree of market power. Be able to segregate customers according to willingness to pay. Be able to segregate customers according to willingness to pay. Be able to prevent arbitrage. Be able to prevent arbitrage.

5. Perfect Discrimination and Consumer Surplus Consumer Surplus: The difference between what you’re willing to pay and what you have to pay. Consumer Surplus: The difference between what you’re willing to pay and what you have to pay. Price discrimination can be thought of as an attempt to extract more of the consumer surplus Price discrimination can be thought of as an attempt to extract more of the consumer surplus

6. An Example QuantityPrice (What You’d be Willing to Spend for the Next Unit Total Value (What You’d be Willing to Spend for the Total Q 1$5 2$45+4=9 3$39+3=12 4$212+2=14 If P=$3, how many would you buy? Q=3, and so what would you spend? Spending = 3x3=$9, and so what is the surplus? Surplus=12- 9=3

7. Consumer Surplus and Optimal 2- Part Pricing A “2-part” pricing scheme is one where the customer must pay a fixed fee (“entrance fee”) for the right to buy the good at some price. A “2-part” pricing scheme is one where the customer must pay a fixed fee (“entrance fee”) for the right to buy the good at some price. Club charge at Sam’s Club charge at Sam’s Cover charge at a nightclub Cover charge at a nightclub Connect fee for electricity Connect fee for electricity In class we’ll build a model of 2-part pricing and show that the optimal scheme is one where In class we’ll build a model of 2-part pricing and show that the optimal scheme is one where The good is sold at marginal cost The good is sold at marginal cost The entrance fee is set at a level such that the customer pays over the entire consumer surplus. The entrance fee is set at a level such that the customer pays over the entire consumer surplus.

8. If you understand what is meant by consumer surplus, you understand that the ideal scheme of discrimination (ideal from the point of the seller) is to engage extract all possible surplus. If you understand what is meant by consumer surplus, you understand that the ideal scheme of discrimination (ideal from the point of the seller) is to engage extract all possible surplus. This is often what “salesmanship” is all about. This is often what “salesmanship” is all about. It also explains why “take-it-or-leave-it” may be an effective strategy. It also explains why “take-it-or-leave-it” may be an effective strategy. Interestingly, in cases of bilateral monopoly (both sides can only deal with the other) or near bilateral monopoly, the entire negotiation is about surplus and small differences in bargaining power make for big differences in outcomes. Interestingly, in cases of bilateral monopoly (both sides can only deal with the other) or near bilateral monopoly, the entire negotiation is about surplus and small differences in bargaining power make for big differences in outcomes. (Why did the dominant pitcher of the 1960’s,Bob Gibson, never make more than $150 k, while Roger Clements makes almost $20 million?) (Why did the dominant pitcher of the 1960’s,Bob Gibson, never make more than $150 k, while Roger Clements makes almost $20 million?)

9. Bundling and Price Discrimination “Bundling” is the requirement that a customer buy a fixed basket of the goods, rather than buy only what is wanted. “Bundling” is the requirement that a customer buy a fixed basket of the goods, rather than buy only what is wanted. In some cases, this is just to eliminate the cost of negotiating over every detail In some cases, this is just to eliminate the cost of negotiating over every detail But in other cases, this would seem counter productive—after all, in most markets, the firm’s interests are best served by giving the customer what they want. But in other cases, this would seem counter productive—after all, in most markets, the firm’s interests are best served by giving the customer what they want.

10. An Example: Suppose the following represents the maximum amount each movie theater would pay for each movie Movie Biker BingoBarney TheaterHP$6$10 Frat Row$10$6

11. If the producer could discriminate, TR = $32 If the producer could discriminate, TR = $32 But what if the producer doesn’t know the local market But what if the producer doesn’t know the local market Charging $10 per movie yields only $20 Charging $10 per movie yields only $20 Charging $6 per movie yields only $24 Charging $6 per movie yields only $24 Charging $16 for the bundle yields $32 Charging $16 for the bundle yields $32

12. Is Price Discrimination Ethical?