L16 price discrimination

Microeconomics: Price Discrimination

Aims of the Lecture

• Understanding Price Discrimination: This lecture aims to delve deeper into the concept of price discrimination, exploring how it deviates from the traditional assumption that all buyers are charged the same price. Price discrimination is a practical strategy employed by firms to maximize profits by charging different prices to different consumers according to their willingness to pay.

Examples of Price Discrimination:

• Students vs. Non-Students: Many transportation services, including train companies, offer discounts to students, illustrating how firms can leverage demographic differences for pricing.

• Pubs and Entertainment Services: Some pubs may charge higher prices for services like Sky Sports, especially during major sports events, to capitalize on consumer demand differences.

• Variable Electricity Pricing: Utility companies might implement pricing based on tariff structures that vary by time of day or consumption levels, allowing them to optimize revenue based on user behavior.

Today’s Focus: Effects of Price Discrimination in Monopolist Markets

• The lecture will focus explicitly on the impact of price discrimination in monopolistic markets, as these settings represent an ideal framework for analyzing pricing strategies.

Lecture Outline

• Profitability of Price Discrimination: Analyzing how and when price discrimination can lead to increased profitability for firms.

• Necessary Conditions for Price Discrimination: Identifying the prerequisites that must be met for effective price discrimination.

• First-Degree Price Discrimination (Perfect Price Discrimination): Understanding an extreme case where sellers charge each buyer the maximum they are willing to pay.

• Third-Degree Price Discrimination (Group Price Discrimination): Examining how firms charge different prices based on identifiable characteristics of groups.

• Second-Degree Price Discrimination (Nonlinear Price Discrimination): Exploring strategies that allow sellers to charge different prices based on quantities consumed.

Reading Material:

• Core: Lipsey & Chrystal, Chapter 7

• Extra: Perloff, Chapter 12

Profitability of Price Discrimination

Scenario Overview:

• Consider a seller with a constant cost per unit of £10 aimed at two buyers, Miss Rich and Mr. Poor, whose willingness to pay is £40 and £20 respectively.

• Pricing Strategies:

  • Charging only Miss Rich £40 results in no sales to Mr. Poor.

  • Charging a flat rate of £20 makes sales to both buyers, albeit at a lower total profit.

  • The optimal strategy involves charging Miss Rich £40 and Mr. Poor £20, maximizing sales revenue from both.

Question: Under what conditions can a seller effectively implement price discrimination?

Conditions for Profitable Price Discrimination

• C(1): Sellers Must Be Price Makers: Firms must have significant market power to set prices rather than being price takers dictated by the market.

• C(2): Differentiated Buyers: Sellers must be capable of distinguishing between buyer segments based on differing elasticity of demand.

  • Example: Differentiations may arise due to age (students vs. seniors) or geographical location (urban vs. rural consumers).

• C(3): No Arbitrage: It must be impossible for buyers who receive lower prices to resell to those who are charged higher prices, which ensures that price differentials remain intact.

Quick Exercise

Scenarios: Assess whether each supports profitable price discrimination.

• (a) Sports Event: Variability in ticket pricing based on seating and timing of purchase.

• (b) Supermarket: Customer loyalty programs that offer discounts based on purchase history.

• (c) Coca-Cola Vending Machine: Pricing variations based on location and time (e.g., higher prices at events).

Assumptions

• Retain assumption A(1) from the perfect competition lecture.

• A(2): Buyers operate as price takers with full information regarding market prices.

• A(3): Focus on a pure monopolist as a simplified model, acknowledging potential variations in multi-seller markets.

• A(4): Entry barriers preventing new firms from entering the market stabilize existing firms' pricing strategies.

Consumer Surplus and Producer Surplus Visualization

• This section provides an overview of monopolist behavior, illustrating total welfare through producer surplus and the associated deadweight loss that arises in non-competitive market scenarios.

First-Degree Price Discrimination

• Definition: In this model, sellers charge each buyer the maximum amount they are willing and able to pay.

  • Example: A seller could charge £40 to Miss Rich for the first unit of a product and £20 for any subsequent units, effectively capturing more consumer surplus than in a traditional pricing model.

• Importance: This theory represents an extreme case essential for further analysis in the scope of economics.

Marginal Output Rule

• To maximize profits, the monopolist must balance marginal revenue (MR) against marginal cost (MC).

• In a single-price model, MR is affected by adjustments across all units sold. However, for a price-discriminating monopolist, MR aligns with the average revenue (AR) as prices generally remain uniform for units sold concurrently.

Welfare Effects of First-Degree Price Discrimination

• Outcome: Consumers engaged in first-degree price discrimination do not receive any surplus, contrasting sharply with competitive market outcomes.

  • This scenario maintains a similar production level without deadweight loss but results in zero consumer surplus captured by consumers.

Third-Degree Price Discrimination

• Definition: This form involves varying prices based on distinguishable groups among buyers, capitalizing on different demand elasticity.

  • Example: Charging different prices for students versus non-students or geographical distinctions like developed versus developing countries.

• Analysis: Observations and insights derived from this model often parallel non-discriminating monopolist behavior while accommodating variable demand elasticities.

Implications of Third-Degree Price Discrimination

• The overall output level remains unchanged in comparison to scenarios utilizing single pricing.

• Pricing reflects varied demand elasticities, leading to the emergence of consumer surplus and creating deadweight loss in the market landscape.

Second-Degree Price Discrimination

• Definition: This approach involves employing non-linear tariffs that allow sellers to take advantage of different consumer preferences and consumption levels.

  • Linear Tariff Example: A simplistic charging strategy such as £0.25 per minute of service.

  • Non-linear Example: Conversely, a pricing schema combining a flat fee of £10 per month plus £0.05 per minute would attract varied consumer profiles: low usage customers favoring linear pricing and high usage customers opting for more complex offerings.

Summary of Price Discrimination

Key Conditions:

• Sellers must maintain control of pricing.

• The ability to distinguish between different buyer types is crucial.

• The absence of arbitrage opportunities strengthens the distinct pricing structure.

Types:

• First-degree aims for maximized surplus but results in no consumer surplus.

• Second-degree pricing methods tailor to consumer preferences, allowing for variable pricing structures.

• Third-degree focuses on grouping buyers to leverage differing elasticities and consumer surplus benefits.

Post-Lecture Objectives

• By the end of this session, students should be able to:

  • Specify the necessary conditions for profitable price discrimination.

  • Define the unique characteristics of first, second, and third-degree price discrimination clearly.

  • Diagrammatically represent equilibrium scenarios for both first- and third-degree price discrimination.

  • Compare welfare effects across different discrimination types and market structures, providing insight into their respective efficiencies and consumer outcomes.