Simon Cowan

Department of Economics and Worcester

College

Thursday 27
th
May, 2010
MFE Course on Industrial Organization
Price Discrimination

outline
What is price discrimination, when is it feasible,
why do firms do it?

What types of price discrimination are there?

What are the welfare effects?

Price discrimination and oligopoly


2
What is price discrimination?
Simple definition: discrimination means selling the
same good at different prices
Microsoft sets different prices for the Office suite
Airlines charge different amounts for similar tickets
More generally price discrimination is present
when two or more similar goods are sold at prices
that are in different ratios to marginal costs
(Varian, 1989, p 598)
So a uniform delivered price, e.g. for letters, is
discriminatory if costs differ
If price differences reflect cost differences then
there is no discrimination

3
When is discrimination feasible?
No arbitrage (i.e. no resale)
Especially for services

Firm has market power
Can raise price above marginal cost
Market power need not be complete

Ability to sort or classify customers



4
Why do firms discriminate?

The firm aims to convert consumer surplus into profit
full conversion requires
1. complete knowledge of customers
2. sufficient pricing instruments
3. no competition

Often the firm is better off with the ability to
discriminate

But discrimination does not always raise profits:
1. Oligopolistic discrimination
2. Durable-goods monopoly
5
Types of discrimination
Pigous 1920 three-fold classification, applied here to
monopoly

First-degree: complete information, take-it-or-leave-it offers
by the firm, no competition

Second-degree: customer self-selection
Partial information, full set of pricing instruments, no
competition
Menus of tariffs; Nonlinear tariffs
Airline customers can choose when to travel and whether
to stay a Saturday night or not, phone customers can
choose their tariffs

Third-degree: exogenous signal that the firm uses to
classify customers
Partial information, linear pricing, no competition
Educational discounts for software
Consultants paying more for conferences than
academics
6
Simple monopoly pricing
Price
Quantity
Marginal
Cost

Monopoly
price
Monopoly volume
Demand
MR
7
Monopoly pricing and the price
elasticity




The monopoly mark-up, at the profit-maximizing
price, is





Percentage change in quantity demanded
Price Elasticity of Demand =
Percentage change in price

Price Marginal Cost 1

Price Price Elasticity

=
8
Can the firm do better?
Customers with valuations above the monopoly
price obtain a surplus
If they could be identified then they could be
charged more (as long as there is no resale)
Customers who value the good below the price
set by the monopolist dont buy at all
Can they be persuaded to buy, without at the same
time cutting the price(s) that existing customers
pay?



9
The lost surpluses
Price
Quantity
Marginal
Cost

Monopoly volume
Surplus of consumers who buy at the monopoly price
Surplus lost because these customers dont
buy at all this is the loss to society from
monopoly: the deadweight loss
Monopoly
profit
Monopoly
price
10
First-degree price discrimination
The firm knows the maximum amount that each
customer is willing to pay, and charges each customer
this amount
Marginal revenue now becomes the (inverse) demand
function (no need to drop the price on other units)
De Beers sales of rough diamonds:
Diamonds sorted into 12,000 categories based on size,
shape, quality, colour. Offered on a take-it-or-never buy
from us again basis.
With linear demand profits double: the firm grabs both
the triangles as well as the rectangle
Social welfare is maximized, but it all goes to the firm
Requires too much information to be feasible in most
cases
11
Third-degree price discrimination
The firm sorts customers into separate markets using an
exogenous signal
E.g. students, seniors, families, income bracket, business v.
domestic
Instruments: linear pricing in each separate market
So standard monopoly pricing in each market
Price is higher in less elastic markets (remember the elasticity in
general is endogenous)
Microsoft Office
UK price of Office Standard was 329 in 2008
USA price was $399.95 (=200.98 at the exchange rate of $1.99: 1)
The American Economic Association charges according to
income for membership
Annual income < $50,000: $64
$50,000 s Annual Income s $66,000: $77
$66,000 < Annual income: $90
Student member (written verification required): $32



12 Is third-degree price
discrimination good for social
welfare?
In general the effect is ambiguous
The firm gains from extra flexibility
Customers offered higher prices lose
Customers offered lower prices gain

Discrimination may open a new market
anti-retroviral drugs are now available in Africa at
prices much lower than in North America and
Europe
this gives a weak Pareto improvement if (but not
only if) only one market was served without
discrimination, and marginal cost is not increasing
in output


13
Price discrimination opens a new
market
Price
Quantity
Marginal
Cost

Price in
Market 1
Monopoly volume
Market 2
If required to sell at the same price
in both markets, the firm will just set
the best price for Market 1 and not
bother to sell in Market 2
Demand in 1
Aggregate
demand
14
What about when new markets
are not opened?

Schmalensee (AER, 1981): a necessary condition for
discrimination to raise welfare is that total output rises

Misallocation effect: Inefficient distribution of the given
output across markets with discrimination

Output effect: An output increase is good for welfare
when prices exceed marginal cost

15 With linear demand functions
output is constant, so welfare
falls
Suppose q
1
= 1 p
1
and q
2
= 2 p
2
; c = 0
Discriminatory prices and quantities:
Profit in 1, p
1
(1 p
1
), is maximized with p
1
= 0.5, q
1
= 0.5
Profit in 2, p
2
(2 p
2
), is maximized with p
2
= 1, q
2
= 1
With non-discriminatory pricing, the profit function is
p(1 p + 2 p) = p(3 2p) for p 1 and
p(2 p) for p > 1
Best non-discriminatory price is p = 0.75 and
q
1
+ q
2
= 3 20.75 = 1.5
Total output is the same with and without
discrimination when demand functions are linear
16
A generalization
Define the curvature (or convexity) of demand as o
pq(p)/q'(p)
The non-discriminatory price is p
N

Call the low-price market L and the high-price market H
For a very large set of demand functions a sufficient
condition for social welfare to fall with discrimination is
o
H
(p
N
) > o
L
(p
N
)

The linear example is a special case
So a necessary condition for discrimination to raise welfare
is that
o
L
(p
N
) > o
H
(p
N
)

Aguirre, Cowan and Vickers (AER, forthcoming) give
additional conditions


17
Second-degree: two-part tariffs
Conventional pricing is known as linear pricing
Price per unit = p, total payment for q units = pq
The total payment is proportional to the quantity

Tariffs need not be linear
A two-part tariff is the simplest form of nonlinear
pricing
Total payment = fixed fee + price quantity; T(q) =
A + pq
E.g. utility tariffs, gym membership, warehouse
clubs, railcards to obtain discounts, mobile phone
tariffs
Such tariffs are used to extract additional
consumer surplus
18
Individual two-part tariffs
Suppose (i) the firm knows each customers
demand function (and therefore their consumer
surplus) and (ii) it can use individual two-part
tariffs {A
i
, p
i
}
The profit-maximizing strategy is to set the same
marginal price, equal to marginal cost, for all i: p
i

= c
The lump-sum fees are individual, A
i
, and are set
to extract each consumers surplus
Equivalently the firm sets total payment-quantity
bundles: {T
i
, q
i
}={A
i
+ cq
i
(c), q
i
(c)}
This is first-degree discrimination again

19 An individual two-part tariff, and
its total payment-quantity
package
Price
Quantity
p
i
=c



A
i

20
q
i
(c)
cq
i
(c)
second-degree: nonlinear pricing
Now assume the firm cannot identify each
customers type
Large customers are willing to pay more than
small customers, and want to buy more
First-degree discrimination is not incentive-
compatible
The firm offers alternative packages that specify
the quantity and total payment. Customers can
choose.
The key is to extract as much profit as possible
from the large customers, while still selling to the
small customers
This is done by making the package for the small
customers sufficiently unattractive for large
customers

21
First-degree discrimination is not
incentive-compatible
Price
Quantity
22
c
B
D
E
With first-degree discrimination the large
customer pays B + D + E for q
H
while the small
customer pays B for q
L
.
When given a choice the large customer
will pay B for q
L
, giving a surplus of D.
Profit = 2B.
More profitable: offer a choice between:
{B, q
L
} and {B + E, q
H
}
Profit = 2B + E


q
L
q
H

Dupuit and incentive compatibility

On railway tariffs and classes (1849)
It is not because of the few thousand francs which
would have to be spent to put a roof over the third-
class carriages or to upholster the third-class seats
that some company or other has open carriages with
wooden benches...What the company is trying to do is
prevent the passengers who pay the second-class
fare from travelling third-class; it hits the poor, not
because it wants to hurt them, but to frighten the
rich...And it is again for the same reason that the
companies, having proved almost cruel to third-class
passengers and mean to second-class ones,
becomes lavish in dealing with first-class passengers.
Having refused the poor what is necessary, they give
the rich what is superfluous.
Source: Tirole, p 150
23
Nonlinear pricing: distorting the
quantity to capture more surplus
Price
Quantity
24
c
B
D
E
q
L
q
H
q*
Now the firm offers q* at B x, and
q
H
at B + E + y .
Profits rise by y x.
Optimal q* balances marginal y against
marginal x.
The large customer consumes the efficient
quantity, but the quantity for the small
customer is distorted below q
L
.


y
x
Optional two-part tariffs: a simple
form of nonlinear pricing
total payment
volume of calls
tariff designed for households
tariff designed for business
customers
Household chooses here
Business customer chooses here
25
Damaging goods
Another way to encourage customers to self-
select is to damage ones good, in order artificially
to provide a range of qualities
The Intel 486 chip came in two versions
The main version had the math-coprocessor
working
The secondary version had the math-coprocessor
switched off
IBM sold a printer which came in two versions
The main version worked at 12 pages per minute
The other version included an instruction to slow
down the rate of printing, so that it printed 8 pages
per minute
Otherwise the printers were identical

26
Oligopoly: no discrimination
Hotelling model, consumers uniformly distributed
along [0, 1]
Firm A located at 0, price p
A
; firm B at 1, p
B

Consumer at x pays p
A
+ tx when buying from A, p
B
+
t(1 x) from B. t = unit transport cost
When p
A
+ tx = p
B
+ t(1 x) the consumer at x is
indifferent:
q
A
= x = + (p
B
p
A
)/2t
q
B
= 1 x = + (p
A
p
B
)/2t
H
A
= (p
A
c)[ + (p
B
p
A
)/2t]
H
B
= (p
B
c)[ + (p
A
p
B
)/2t]
Bertrand-Nash equilibrium in prices: p
A
= p
B
= c + t
Profit per firm is t/2


27
Oligopoly Discrimination I
Now both firms know the location of each consumer,
i.e. x, and can offer individual prices
Consider a consumer located near A with x <
Given the price that B offers, p
B
(x), A could offer a
price that gives just as good a deal defined by
p
A
(x) + tx = p
B
(x) + t(1 x)
So p
A
(x) = p
B
(x) + t(1 2x) > p
B
(x)
The firms compete for this customer until the less-
favoured firm, B, just makes zero profit, i.e. p
B
(x) = c
At this point A can win by pricing a penny lower than
the price implied by the equally good deal equation: to
find this set p
B
(x) = c in the equation, giving p
A
(x) = c
+ t(1 2x)


28
Oligopoly Discrimination II
The discriminatory price schedules are:
p
A
(x) = c + t(1 2x) for x 0.5
p
A
(x) = c for x > 0.5
p
B
(x) = c for x < 0.5
p
B
(x) = c + t(2x 1) for x > 0.5

Apart from the consumers at 0 and 1, every
consumer pays less when there is price
discrimination
Profits per firm drop from t/2 to t/4 with
discrimination

29
Prices and profits
0 1
c + t c + t
0.5
c
30
Oligopoly discrimination III
The model has assumed best-response
asymmetry, so the firms do not share the same
view about which market will have the higher
price once discrimination is allowed
I want to price high in my back-yard, while you
want to price low in my back-yard
Alternatively there may be best-response
symmetry: e.g. when the demand functions for
each firm in a large market are both higher than
those in a small market
In this case price rises in the large market and
falls in the small market
31
Summary
Price discrimination is very common, and takes
many forms
The main aim of the discrimination analyzed here
is to extract more surplus from consumers
This usually has ambiguous welfare effects
Discrimination is of antitrust concern, particularly
in intermediate goods markets, when it is a sign
of something else:
excessive market power
predatory pricing
market foreclosure and exclusion

32
Reading, with annotations
J. Tirole, Theory of Industrial Organization, 1988, Ch 3 excellent textbook
survey

H. Varian, Ch 10 in Handbook of Industrial Organization, Vol 1, edited by R.
Schmalensee and R. Willig, 1989 the main survey of monopolistic
discrimination

M. Motta, Competition Policy, CUP, 2004, Ch 7.4 (discrimination) emphasis on
competition policy implications

L. Stole, Ch 34 in Handbook of Industrial Organization, Vol 3, edited by M.
Armstrong and R. Porter, 2007, especially Section 3.4, available at
http://econpapers.repec.org/bookchap/eeeindchp/3-34.htm very
comprehensive on discrimination and competition.

Iaki Aguirre, Simon Cowan and John Vickers, "Monopoly Price Discrimination
and Demand Curvature", American Economic Review, forthcoming, available at
the AER website and at
http://www.economics.ox.ac.uk/members/simon.cowan/PapersandFiles/WelfareE
ffects10Sep.pdf new results on the welfare effects of third-degree
discrimination

33