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DYNAMIC POWERPOINT™ SLIDES BY SOLINA LINDAHL

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Price DiscriminationPrice Discrimination

CHAPTER OUTLINE

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Price Discrimination

Price Discrimination Is Common

Is Price Discrimination Bad?

Tying and BundlingFor applications, click here

To Try it! To Try it! questionsquestions

To To VideoVideo

Some good blogs and other sites to get the juices flowing:

Food for Food for Thought….Thought….

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¿Qué Pasa?

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Price Discrimination

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Is it right for consumers to face different prices based on their age?a)Yesb)No

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A New York politician has suggested making gasoline “Zone Pricing” (price discrimination) illegal. (1 minute)

http://www.dailymotion.com/video/xi6rlu_gas-price-discrimination_news

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Price Discrimination Price Discrimination = selling the same product at different prices to different customers.

Why? To increase profit. Profit will be greater with price discrimination than without.

Price Discrimination

$$$ normal price

$ student discount

more

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Try it!Try it!Who probably has more elastic demand for a Hertz rental car: Someone who reserves a car online weeks before a trip, or someone who walks up to a Hertz counter after he walks off an airplane after a 4-hour flight? Who probably gets charged more?a)The person at the counter has a more elastic demand and will be charged less.b)The person at the counter has a more elastic demand and will be charged more.c)The person who booked in advance has a more elastic demand and will be charged more.d)The person who booked in advance has a more elastic demand and will be charged less.

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Price Discrimination and Profit Maximization

Recall the profit-maximizing rule for firms with Monopoly power:

produce the Quantity where MR = MCbased on that Quantity, charge as much as the market will bear (found by the position of the demand curve)

But what if you sell to more than one market, each with its own demand curve?

E.g. senior citizens and young people, business travelers and leisure travelers.

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Can you spot who is willing to pay the most for an airplane ticket?

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Do you expect prices to be higher or lower near the pirate dens in Somalia?

Pirates pay $5 for a shoeshine, everyone else $.50. Full article here

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Why Profits Increase with Price Discrimination

Consider two demand curves- AIDs drugs in Africa and EuropeSetting a single “world price” (assume the average of the two markets) will necessarily reduce profits.

QEurope QAfrica

PEurope

PAfrica

Profit Profit

MR

MC=AC

D D

MC=AC

MR

Europe Africa

Price Price

Q Q

PWorld PWorld

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The Principles of Price Discrimination

1a. If the demand curves are different, it is more profitable to set different prices in different markets than a single price that covers all markets. (e.g. the firm wants to set different prices)

1b. To maximize profits the monopolist should set a higher price in markets with more inelastic demand.

2. Arbitrage makes it difficult for a firm to set different prices in different markets, thereby reducing the profit from price discrimination. (e.g. the firm may not be able to set different prices)

Try it!Try it!What price should the monopolist charge in Market A?a)$5b)$10c)$7d)Any price higher than $10

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Try it!Try it!A dry cleaner has a sign in its window: “Free internet coupons.” The dry cleaner lists its website, and indeed there are good discounts available with the coupons. Most customers don't use the coupons. What is probably the main difference between customers who use the coupons and those who don’t?a)Coupon users have elastic demand and non-users have inelastic demand.b)Coupon users have inelastic demand and non-users have elastic demand.c)Coupon users have perfectly inelastic demand and non-users have perfectly elastic demand.d)Coupon users have a higher value of their own time than the non-users use the coupons.

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Arbitrage Arbitrage is taking advantage of price differences for the same good in different markets by buying low in one market and selling high in another market.

E.g. smuggling cheap AIDs drugs out of Africa for resale in Europe

Arbitrage

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Arbitrage makes it easier for a firm to set different prices in different markets.

a)Trueb)False

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Think of a good someone should invent.

How would you price discriminate?

How would you prevent arbitrage?

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Firms develop arbitrage-discouraging techniques

Red AIDs pills in Africa, White in Europe

Injecting arsenic into cheap industrial plastics to prevent it from being pirated into the denture industry (proposed but not practiced!)

Poisoning ethanol to keep it from being converted to drinkable alcohol

Coding DVDs so cheaper Indian DVDs won’t play in US players.

Preventing Arbitrage

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Perfect Price Discrimination

PPD PPD = each customer is charged his or her maximum willingness to pay.Since each consumer pays his or her maximum willingness to pay under PPD, consumers end up with no consumer surplus.

All of the gains from trade flow to the monopolist.

With this pricing strategy, the monopolist produces until P = MC.

This level of output equals that of competition.

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PPD and Consumer Surplus

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A Perfect Price Discriminator Marches Down the Demand Curve Charging Each Customer Their Maximum Willingness to Pay

Price

Quantity

Alex’s willingness to pay

Qx

Tyler’s willingness to pay

Robin’s willingness to pay

Bryan’s willingness to pay

MC

D

Marginal Revenue with PPD

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Perfect price discrimination causes the marginal revenue curve to equal the demand curve.

a)Trueb)False

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PPD in Practice

In practice PPD is difficult to implement: it requires very detailed information on consumers’ maximum willingness to pay.

Still, producers go to great lengths to gather information on their consumers

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Is Price Discrimination Bad?

If price discrimination increases output, then total surplus will increase.

This greater output reduces the deadweight loss of monopoly.

If the firm practices PPD, then the deadweight loss of monopoly is eliminated.

Price discrimination makes it easier for firms to cover the fixed costs- increasing the incentives to innovate.

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Tying and Bundling

TyingTying = a form of price discrimination in which one good, called the base good, is tied to a second good called the variable good.

Firms are not just selling individual goods but rather a package good.

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Tying

Tying allows firms to price discriminate.Firms price discriminate by pricing the base good below cost and the variable good above cost.Consumers reveal their willingness to pay through the variable good.Firms basically charge a different price to every consumer based on their usage of the variable good.Printing a lot? You have a higher willingness to pay-- and will pay more in ink costs.

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Bundling

BundlingBundling = requiring products be purchased together in a bundle or package.

Firms use bundling when they have more information on the demand for the bundle than for the individual parts.Bundling may help prevent arbitrage.

A Bundle of Chapters?

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Bundling in Action

If Microsoft sets prices individually, it can earn greater profits by pricing Word at $100 and Excel at $90 (assuming marginal cost of zero).

–At a price of $40, both Amanda and Yvonne will purchase Word and profits will be $80.–At a price of $100, only Amanda will purchase Word and profits will be $100.–At a price of $20, both Amanda and Yvonne will purchase Excel and profits will be $40.–At a price of $90, only Yvonne will purchase Excel and profits will be $90.

Maximum Willingness to Pay for Word and Excel

Amanda Yvonne

Word $100 $40

Excel $20 $90

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Bundling in Action

If Microsoft bundles Word and Excel, the profit maximizing price is $120 (assuming marginal cost of zero).

At a price of $130, only Amanda will purchase Office and profits will be $130.At a price of $120, both Amanda and Yvonne will purchase Office and profits will be $240.

By bundling Word and Excel into Office, Microsoft increases profits.

Maximum Willingness to Pay for Word and Excel

Amanda Yvonne

Word $100 $40

Excel $20 $90

Office $120 $130