10.4 Price Discrimination

Market Power and Pricing

  • Firms with market power set higher prices than in perfect competition but cannot charge any price due to a downward-sloping demand curve.
    • Higher prices lead to lower sales volumes (output effect vs. discount effect).

Price Discrimination

  • Definition: Selling the same good at different prices to different customers.
    • The term is loaded but does not inherently imply prejudice; it is a common business practice.

Demand Curve and Marginal Revenue

  • Example Demand Curve:
    • Q_d = 1000 - 100P
    • Rewritten: P = 10 - \frac{Q}{100}
  • Revenue Calculation: Revenue = Price × Quantity.
  • Marginal Revenue: Calculated using calculus but understanding the concept is emphasized over calculations.

Constant Marginal Cost

  • Assume Marginal Cost (MC) = 3.
  • For a firm with market power:
    • Set quantity where Marginal Revenue (MR) = MC.
    • From curves, at quantity 400, the price is $6.

Perfect Competition Comparison

  • In a perfectly competitive market:
    • Price = MR = MC, where MC = 3 leads to quantity 700.
  • The difference in quantities leads to consumer surplus for original buyers and deadweight loss for missing transactions.
    • The deadweight loss triangle represents unfulfilled transactions that could bring gains from trade.

Market Power and Deadweight Loss

  • Firms (monopoly, monopolistic competition, oligopoly) limit quantity to maintain market power:
    • Results in lower quantities than the socially optimal level.
  • Firms could capture consumer surplus by charging different prices based on willingness to pay.
  • Under perfect price discrimination, each consumer pays their maximum willingness to pay (reservation price).

Perfect Price Discrimination

  • Achieves maximum profit by selling at each consumer's reservation price.
  • Eliminates deadweight loss by maximizing total sales. Total surplus increases, but all goes to the producer.
    • No discount effect as each buyer pays exactly what they are willing to.

Conditions for Price Discrimination

  1. Market Power: The firm must hold pricing power (not a price taker).
  2. No Resale: Prevents lower-priced customers from reselling to higher-priced ones.
  3. Market Segmentation: The ability to identify and target different consumer groups based on willingness to pay.

Examples of Price Discrimination

  • Discounts for new customers, senior citizens, or students are forms of price discrimination.
  • Sales tactics like offering discounts when a customer hesitates represent this concept.
  • Different financial aid offers and pricing variations in movie tickets show price discrimination in practice.

Conclusion

  • Price discrimination is a strategic approach businesses use to maximize profits and manage their market power.