Price Discrimination and Economic Principles
Chapter 11: Pricing Discrimination in Theaters and Other Businesses
TPS Question: How do local theaters charge high prices for snacks when cheaper options exist elsewhere?
Concept: Demand among theater snack bar users is relatively inelastic.
Example of Price Discrimination with Pizza:
Menu at Little Nero’s:
Cheese Pizza: $8
Supreme Pizza: $11
Analysis:
Is this price discrimination? No, because the supreme pizza has more toppings, reflecting higher costs.
Example of Airline Pricing:
Tom and Anne both buy economy tickets, Tom pays $400 and Anne $483 (Tom paid $83 less).
Is this price discrimination? Yes, because airlines deduce that booking closer to departure implies less sensitivity to price.
First Class vs Economy Pricing:
Tom’s ticket: $400 (economy), Anne’s ticket: $800 (first class).
Is this price discrimination? No, they are different products with different service levels.
Oil Change Pricing:
Mary’s oil change: $49 at Cars N’ Stuff, Allison’s: $39 at Oils R Us.
Is this price discrimination? No, simply having different prices does not define price discrimination.
Student Discount at the Ballet:
Amir pays $5 less than Sheila for the same performance.
Is this price discrimination? Yes, student pricing is a form of price discrimination.
Gas Prices in Different Locations:
Marfa, TX: $4.49; Austin, TX: $3.96.
Is this price discrimination? No, higher prices in Marfa reflect higher logistical costs.
Grocery Store Cereal Pricing:
Mark and Liam each buy a box, Liam uses a coupon for a $1 discount.
Is this price discrimination? Yes, users of coupons represent varying willingness to pay, thus establishing price discrimination.
Bud Light Pitcher Pricing Example:
Price by time:
12pm-3pm: $3.00
3pm-4pm: $4.00
4pm-5pm: $5.00
Analysis:
Pricing varies by time suggests differing customer willingness to pay, indicating third-degree price discrimination.
Pricing Helicopter Rides: Analyzing Capacity and Willingness
Helicopter Capacity:
Capacity for 7 passengers; Marginal cost for an additional passenger: $10.
Willingness to Pay of Customers:
Amelia (age 66): $80
Orville (age 34): $70
Wilber (age 17): $40
Neil (age 16): $50
Charles (age 9): $60
Chuck (age 49): $100
Buzz (age 9): $20
Optimal Single Price:
Price should be set at $50.
Customer Segmentation for Price Discrimination:
Possible segmentation by age (children and adults).
Two Potential Prices:
Adults: $50
Children: $40
Perfect Price Discrimination:
Results in a higher volume of sold units compared to a single-price scenario, capturing consumer surplus from all price points.
If firms can determine exact willingness to pay, it represents first-degree price discrimination.
Profit Equation in Perfect Price Discrimination:
Profit = $18,000, capturing the area under the demand curve above average total cost.
Impact on Quantity Sold:
Perfect price discrimination increases quantity sold by 300 units.
Economic Efficiency:
Does price discrimination reduce economic efficiency? False.
It actually increases efficiency by selling units otherwise unsold if a single price was charged.
Chapter 12: Product Differentiation
Definition of Product Differentiation:
Occurs when a business creates a product that stands out from competitors.
Price Effects of Differentiation:
Greater differentiation leads to larger price disparities.
The more a firm can enhance consumer perception of necessity or uniqueness, the more inelastic the demand curve and thus higher pricing.
Advertising and Demand Curve Shifts:
Increased awareness through advertising can lead to a more inelastic demand curve as consumers associate value with the product.
Little brand loyalty and minimal differentiation correlate with smaller price markups.
Advertising and Long-Run Average Total Cost (LRATC):
Statement: False. Advertising tends to elevate the LRATC due to associated costs.
Monopolistic Competition Characteristics:
Features:
Easy entry and exit in the long run
Each firm produces a differentiated product
Firms partake in advertising
Long-Run Market Dynamics:
Zero economic profits, due mainly to free entry and exit.
If a firm like H2O Goo operates profitably, new entrants will dilute market demand, leading to profit declines.
Monopolistic Competition Pricing Basics:
Typically results in higher prices than perfect competition due to demand being downward sloping.
The long-run equilibrium conditions:
Price (P) equals average total cost (ATC)
Price (P) greater than marginal cost (MC)
Price (P) exceeds minimum average total cost (min(ATC))
Chapter 13: The Prisoner's Dilemma
Assumptions in the Prisoner's Dilemma:
Participants are viewed as rational actors aiming to optimize their individual payoffs.
Provides insight into why rational individuals might choose not to collaborate.
Table Outcomes:
Pareto-Efficient vs Nash Equilibrium: The optimal outcome isn’t always reached due to one-off, non-cooperative decisions.
The Nash equilibrium occurs at the top left of the table, identifying strategies with no incentive for unilateral change.
Negative-Sum Game Example:
Climate change exemplifies this as a scenario where overall outcomes are detrimental for all.
Nash Equilibrium Description:
An outcome where neither player changes strategies, especially when adhering to their dominant strategies.
Predatory Pricing Definition:
Occurs when prices set below average variable costs (AVC).
Sequential Games Example:
If wolf 1 hunts deer, wolf 2 will similarly choose deer for higher payoff (10) over rabbit (8).
Best Strategy in Long-Run Cooperative Games:
Apply tit-for-tat: initially cooperate, then match the opponent’s previous action.
Chapter 16: Utility Maximization and Consumption
Utility from Different Goods/Prices:
Example with Frank:
Utility from pork: 12 utility units at $9
Utility from eggs: 18 utility units
Calculation: Solve for egg price using equation:
\frac{12}{9} = \frac{18}{x}
Find x: Price of eggs = $13.50.
Optimum Consumption:
With a budget of $8, the optimum bundle would consist of 1 sandwich and 2 ICEEs.
Decision-Making on Utility:
Utility per dollar dictates that higher utility is derived from hamburgers compared to fries. Hence, consume more hamburgers when utility per dollar favors them.
Subject to Diminishing Marginal Utility:
All leisure activities like ice cream, gaming, etc. experience diminishing returns over time.
Total Utility Dynamics:
Increasing at a decreasing rate indicates declining marginal utility.
Marginal Rate of Substitution (MRS) Example:
Between points C and D, MRS = -¼.
Price Reduction Effects:
A 10% price reduction on the Kia Soul prompts both substitution and real-income effects, affecting consumer purchasing decisions significantly.
A similar price reduction on peanut butter cups relates only to the substitution effect due to its lesser price change.
Indifference Curves and Goods Relationship:
Managing different curves implies goods are either complements (fixed proportions) or substitutes (interchangeable).
Chapter 17: The Allais Paradox
Gamble Outcomes:
1st Gamble: A: $1M win with 100% certainty.
2nd Gamble: C: $5M with 10% chance, nothing 90% of the time; D: $1M with 11% chance, nothing 89% of the time.
Expected Value of Outcomes:
For gamble A = $1M, and for gamble B: calculated as:
0.89 imes 1,000,000 + 0.10 imes 5,000,000.
Cognitive Bias - Gambler's Fallacy:
Bob expects the next coin flip to be tails after five heads, demonstrating this misconception.
Risk Neutral Decision Making:
A risk-neutral individual prefers Gamble A due to its superior expected value.
Consumer Behavior:
Positive time preferences illustrate an inclination towards current over future consumption.
Strategies like nudges, demonstrated via banking commercials emphasizing urgency, reflect behavioral economics principles.
The Ultimatum Game Insights:
Highlights fairness concerns in payoffs, while loss aversion leads to overly cautious behavior regarding potential risks.