Price Discrimination

Chen Zhao
University of Hong
Kong

1
Social efficiency of monopoly
Under monopoly: MC = MR < P, so output produced by monopoly
is too low for social efficiency.
Price
MC

P* Social efficient point

MC, MR
D
Quantity
Q*
MR 2
Total Economic surplus
• Loss in economic surplus from Monopoly

Price Consumer surplus

MC
12

8 Loss in surplus
=0.5*(9-6)*(8-4)=6
6
4
D
Producer surplus
Quantity
6 9 18
MR 3
Can a Monopolist do better?
Recall that the monopolist would gladly expand output if it could do
so without having to sell the current output at a lower price.
Price
MC

P*

MC, MR
D

Quantity
Q*
MR
4
Price discrimination
• Can the monopolist find ways of lowering prices to some buyers
while keeping price high for others?

• Price discrimination: charging different buyers different prices

for the same good or service.

5
Example: Single price monopoly
• Ram is a monopolist in the market for carved wooden bowls in his
village, a minor tourist stop in Northern India.

6
Example: Single price monopoly
• Each day 8 tourists visit his shop, and each has a different reservation price for
Ram's standard bowl. If these reservation prices are as listed in the table below,
draw the demand curve Ram faces each day.

Visitor Reservation price

A $16
B $14
C $12
D $10
E $8
F $6
G $4
H $2

7
Example: Single price monopoly
Price
16
Visitor Res. price
14
A $16
12
B $14
10
C $12
D $10 8
E $8 6
F $6 4
G $4
2
H $2
Quantity
1 2 3 4 5 6 7 8

8
Example: Single price monopoly
Expand if MR > MC = 3
• Ram has to charge the Price
same price to all 16 MR from 1st bowl = 16;
buyers.
14 MR from 2nd bowl = 12;
• He can produce as 12 MR from 3rd bowl = 8;
many bowls as he
chooses at a cost of $3 10 MR from 4th bowl = 4;
each (and bowls can
be sold only in integer 8 MR from 5th bowl = 0;
amounts). 6

4
• How many bowls
should he sell each day 2
if his goal is to
maximize profit? 2 3 4 5 6 7 8
1
Quantity
9
Example: Single price monopoly
How much profit does Ram make?

Total revenue = 10x4 = $40/day

Total cost = 3x4 = $12/day

Profit = $40 - $12 = $28/day

10
Example: Single price monopoly
Social efficiency
Is 4 bowls per day a socially efficient level of
output?
No, because buyers are willing to pay more
Visitor Reservation for additional bowls than their $3 marginal
price cost.
A $16
B $14 Visitors A-G are willing to pay more for a bowl
C $12 than the cost of producing one, and thus it is
D $10 efficient that they each should have one.
E $8
Visitor H is not willing to pay the cost of
F $6
producing a bowl and so should not have
G $4
one.
H $2

Thus the socially efficient number is 7

bowls/day.
11
Example: Perfect price discrimination
• Now suppose that Ram is a shrewd judge of human nature. After a
moment's conversation with a visitor, he is able to discover the
visitor's reservation price for a bowl. If Ram then charges each
visitor his respective reservation price, how many bowls will he sell
and how much profit will he make?

12
Example: Perfect price discrimination

Visitor Reservation
price
A $16 Ram will sell bowls to
B $14 visitors A-G and each will
C $12 pay his reservation price.
D $10 He will not sell to visitor H.
E $8
F $6
G $4
H $2
Total rev = 16+14+12+10+8+6+4 =
$70/day
Total cost = 7x3 = $21/day
Profit = 70-21 = $49/day 13
Perfect price discrimination
Efficiency
• A monopolist who is able to charge each buyer his or her
reservation price is called a perfectly discriminating
monopolist.
• For a perfectly discriminating monopolist, there is no
efficiency loss.
• All buyers who are willing to pay a price high enough to cover
marginal cost, are served.
o In practice, however, there are virtually no sellers who know
each buyer's reservation price.
o Price discrimination does occur, but it is imperfect price
discrimination.

14
Example: Discrimination using Hurdles
• Ram does not know each buyer's reservation price.
• But he knows that all buyers with a reservation price above $9/bowl
never use discount coupons. Those with reservation prices below
$9 use them whenever they are available.
• If Ram makes coupons available in a tourist magazine, those buyers
who clip and present them get to pay a discount price for bowls.
Others pay the regular list price for bowls.
• To maximize profit, at what levels should Ram set the list price of a
bowl? The discount price?

15
Example: Discrimination using Hurdles
• In each submarket, the monopolist should expand output as long as
MR>MC.

List price submarket Discount price

submarket
Visitor Res. price Visitor Res. price
A $16 E $8
B $14 F $6
C $12 G $4
D $10 H $2

16
Example: Discrimination using Hurdles
• For the list price submarket, MR from sale of fourth bowl is 4 > MC
=3.
• To sell 4 bowls in the list price submarket, Ram will choose a list
price of $10. At that price, all non-coupon clippers buy a bowl.

Visitor Res. price MR

A $16 $16
B $14 $12
C $12 $6
D $10 $4

17
Example: Discrimination using Hurdles
• For the discount price submarket, the MR from the sale of the 2nd
bowl is 4; the MR from the 3rd bowl is 0.
• So Ram should choose a discount price of $6/bowl and sell 2 bowls
in the discount market.

Visitor Res. price MR

E $8 $8
F $6 $4
G $4 $0
H $2 -$4

18
Example: Discrimination using Hurdles
Price
MR(1st bowl) = 16 16

MR(2nd bowl) = 12 14
Hurdle
MR(3rd bowl) = 8 12

MR(4th bowl) = 4 10

8 MR(1st bowl) = 8
6 MR(2nd bowl) = 4
4
MR(3nd bowl) = 0
2

Quantity
1 2 3 4 5 6 7 8
List price buyers Discount price buyers 19
Example: Discrimination using Hurdles
Social Efficiency
• At a list price of $10/bowl and a discount price of $6/bowl in the preceding
example, how many bowls does Ram sell and how much profit does he make? Is
this outcome socially efficient?

Total revenue = 10x4 + 6x2 = $52/day

Total cost = 6x3 = $18/day
Profit = 52-18 = $34/day

• The outcome is not socially efficient because visitor G is excluded even though
he is willing to pay more than marginal cost.
• But it is more efficient than the single-price case.

20
Examples of the hurdles
• Rebate coupons:
hurdle = having to mail the coupon to the manufacturer

21
Examples of the hurdles
• Temporary sales:
hurdle = having to find out when & where the sale
occurs

22
Examples of the hurdles
• Hardback books and paperbacks:
hurdle = having to wait for the paperback

Hardback: $25.00 Paperback: $16.47

23
Examples of the hurdles
• hurdle = Ability to read Spanish

What is
going
on?
¿Qué
Pasa?

24
Price Discrimination
o Price Discrimination = selling the same product at different prices
to different customers.
o Why? To increase profit.
o Profit will be greater with price discrimination.
o Output will be closer to the socially efficient one.

more
$$$ $ student
discount
normal price

25
The Principles of Price Discrimination
o The key is to separate the market into submarkets.
o The separation can be done using hurdles.

1a. If the demand curves of the submarkets are different, it is more

profitable to set different prices in different markets than a single price that
covers all markets. (e.g. the firm wants to set different prices)
1b. To maximize profits the monopolist should set a higher price in markets
with more inelastic demand.

2. Arbitrage makes it difficult for a firm to set different prices in different

markets, thereby reducing the profit from price discrimination. (e.g. the firm
may not be able to set different prices)

26
Why Profits Increase with
Price Discrimination
• Consider two demand curves- AIDs drugs in Africa and Europe
• Setting a single “world price” will necessarily reduce profits.

Price Price
Europe Africa

Note: MC curve
assumed horizontal
PEurope for illustration only.

PWorld PWorld
PAfrica
Profit Profit
MC=AC MC=AC

MR D MR D
Q Q
QEurope QAfrica 27
Who probably gets charged more?
Who probably has more elastic demand for a Hertz rental car: Someone who
reserves a car online weeks before a trip, or someone who walks up to a Hertz
counter after he walks off an airplane after a 4-hour flight? Who probably gets
charged more?

a) The person at the counter has a more elastic demand and will be charged
less.
b) The person at the counter has a more elastic demand and will be charged
more.
c) The person who booked in advance has a more elastic demand and will be
charged more.
d) The person who booked in advance has a more elastic demand and will be
charged less.

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Arbitrage Buy low sell high
o 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.

o Example:
o smuggling cheap AIDs drugs out of Africa for resale in Europe

29
Preventing Arbitrage
o When separating the market into submarkets, choose some
attributes that is difficult to mimic, e.g., age, gender.
o Separate the market into submarkets only for goods that are
difficult to re-sell.

30
Preventing Arbitrage
o Firms develop arbitrage-discouraging techniques
o Red AIDs pills in Africa, White in Europe
o Poisoning ethanol to keep it from being converted to drinkable
alcohol
o Coding DVDs so cheaper Indian DVDs won’t play in US players.

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Which is more acceptable?
A. Suppose the firm has been charging the same price for all
customers. Now, the firm lower the price for elders and raise the
price for the young.
B. Suppose the firm has been charging the same price for all
customers. Now, the firm lower the price for elders and keep the
price for the young.
C. Suppose the firm has been charging the same price for all
customers. Now, the firm keep the price for elders and raise the
price for the young.

32
Other ways of grouping consumers
Tying and Bundling
o Tying = a form of price discrimination in which one good, called
the base good, is tied to a second good called the variable good.
o Firms are not just selling individual goods but rather a package
good.

33
Other ways of grouping consumers
Tying
o Imagine a printer manufacturer is considering to charge different
customers different prices for printing service.
o Known:
o High volume users are less price sensitive and willing to pay
more for the printing service than low volume users.
o Best scenario:
o Charge the high volume users a higher price than the low
volume users.

o Difficult to identify who is high or low volume user based on

observable characteristics.

34
Other ways of grouping consumers
Tying
o Imagine a printer manufacturer is considering to charge different
prices for different customers.

o Firms price discriminate by pricing the base good (the printer) low
and the variable good (ink) high.
o Consumers reveal their willingness to pay for printer through the
variable good.
o Firms basically charge a different price to every consumer based
on their usage of the variable good.
o Printing a lot? You have a higher willingness to pay and will pay
more in ink costs.

35
Other ways of grouping consumers
Bundling
o Bundling = requiring products be purchased together in a bundle or
package.
o Firms use bundling when they have more information on the
demand for the bundle than for the individual parts.

A Bundle of
Chapters?

36
Other ways of grouping consumers
Bundling in Action
Maximum Willingness to Pay for Word and
Excel
Amanda Yvonne
Word $100 $40
Excel $20 $90
o 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.
37
Other ways of grouping consumers
Bundling in Action
Maximum Willingness to Pay for Word and
Excel
Amanda Yvonne
Word $100 $40
Excel $20 $90
Office (Word + Excel) $120 $130

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

38
Is Price Discrimination Bad?
o If price discrimination increases output, then total surplus will
increase.
o This greater output reduces the deadweight loss of monopoly.
o If the firm practices PPD, then the deadweight loss of monopoly is
eliminated.
o Price discrimination makes it easier for firms to cover the fixed
costs -- increasing the incentives to innovate.

39
Examples of Price Discrimination
o Student octopus card
o Student scholarships/Financial aid
o Flight tickets
o Tunnels
o Ladies night
o 11/11, Black Friday

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