Chapter 16 – Price Discrimination & Sophisticated Pricing Strategies

Price Discrimination – Core Concepts

• Price discrimination: Selling the same product at different prices.
  • Goal: \text{charge each buyer as close as possible to their reservation price}.
  • Reservation price = buyer’s marginal benefit (MB) = maximum they’ll pay.
• Perfect (first-degree) price discrimination
  • Charge each individual exactly their reservation price.
  • Eliminates consumer surplus; all surplus becomes producer surplus.
• Manager’s two-step recipe under any pricing scheme
  1. Choose quantity where MR = MC.
  2. Set price from the demand (MB) curve.

Perfect vs. Imperfect Price Discrimination – Illustrative Scenario

• Taylor Swift concert tickets example
  • Your reservation price for a near-stage ticket: \$100.
  • Front-row price: \$400 (above your reservation price), so you do not buy it.
  • Organizer sets several prices → effectively price discriminates across fans.
• Graphical comparison (no PD vs. PD)
  • No PD: single price, single quantity; sizable consumer & producer surplus.
  • With PD:
  • High-MB buyers pay more; low-MB buyers may receive discounts.
  • Quantity expands to all units where price (> MC).
  • Surplus transfers from consumers to producers; total surplus rises.

Comparative Welfare Analysis

• STEP 1: Higher prices to high-reservation buyers
  • Raises firm’s profit margin; pure surplus transfer (total ES unchanged).
• STEP 2: Selective discounts to induce new buyers
  • Output rises; both producer & new consumers gain extra surplus.
• Net results
  • Output ↑, total economic surplus ↑, under-production problem solved.
  • Consumer surplus ↓ (unless discounts substantial); equity/fairness debates.

Feasibility Conditions for Price Discrimination

• Firm must possess market power (price-setting ability).
• No resale (arbitrage) between buyers.
• Ability to target the right price to the right customer.

Group Pricing (Third-Degree Price Discrimination)

• Charge different groups different prices when individual reservation prices are unknown.
• Converts one market into multiple segments, each with its own demand curve.
• Common examples
  • Age-based movie tickets, student software pricing, residential vs. business internet, “pink” tax on toiletries, military discounts.

Movie-Theater Example (Adults vs. Students)

• Student demand: lower & flatter (more elastic) than adult demand.
• For each segment:
  • Quantity: where that segment’s MR = MC.
  • Price: read up to demand → e.g. \$12 for adults, \$8 for students.

Insights

1. Charge higher prices to groups with higher MB / less elastic demand.
2. Charge lower prices to groups that are more price-sensitive (elastic).

Segmentation Principles

• Identify groups whose demand differs and relies on:
  1. Verifiable characteristics (ID, age, address).
  2. Hard-to-change traits (student status, military service).
• Use observable proxies correlated with reservation price (e.g., income).

The Hurdle Method (Second-Degree Price Discrimination)

• When observable characteristics are absent → design hurdles so customers self-select into high- and low-reservation segments.
• Hurdle must be:
  • Not too difficult (some buyers should jump).
  • Not too easy (high-value buyers prefer to avoid it).

Typical Hurdle Formats & Illustrations

• Alternative versions & timing
  • Hardcover vs. paperback six months later; high-value fans pay early/high price.
• Fluctuating sale prices / brand switching
  • Weekly cereal promotions; brand-indifferent shoppers chase discounts.
• Haggling
  • Open-air markets; price-tolerant buyers avoid the hassle, pay more.
• Extra hassle / bad service / imperfect goods
  • Outlet malls far away, coupon clipping, economy vs. business class, SD vs. HD streaming.
• Quantity discounts
  • Second item half-off, bulk egg cartons; MB diminishes after first unit, so lower per-unit price encourages extra purchase.
• Bundling (a special quantity discount across goods)
  • Microsoft Word + Excel: Bundle at \$250 vs. \$160 each ⇒ targets English majors (value Word) & Data Science majors (value Excel) simultaneously; cross-subsidizes.

Ethical, Philosophical & Practical Notes

• Efficiency gain: higher total surplus & reduced deadweight loss.
• Equity/fairness concern: consumer surplus shifts to firms; policies like anti-discrimination laws or resale rights can limit PD.
• Real-world relevance: Airlines, ride-sharing surge pricing, stadium tickets, dynamic online pricing algorithms.

Key Takeaways & Study Checklist

• Price discrimination hinges on matching price to reservation price.
• Under PD:
  1. Charge more to high-value buyers.
  2. Offer discounts (group or hurdle) to price-sensitive buyers.
• Relative to uniform-price monopoly: Q{PD} > Q{no\ PD} and ES{PD} > ES{no\ PD}.
• Group pricing succeeds when verifiable, difficult-to-change attributes correlate with MB.
• Hurdle method relies on self-selection via time, effort, or product quality trade-offs.
• Always apply the two-step rule (quantity where MR = MC; price from demand) within each segment or conditional quantity.
• For exams: Be able to draw welfare graphs, compute surplus areas, and explain why PD can raise efficiency yet raise equity concerns.