ECON-115 Lecture 041. Determine aggregate demand in the two markets. 2. Determine marginal revenue...

ECON 115

Industrial Organization


1. Linear (3rd Degree) Price

Discrimination


First Hour

• QUIZ

Second Hour

• Introduction to Price Discrimination

• Third-degree price discrimination

• Two Rules

• Examples of price discrimination

• One Problem


• Last week we completed the background

portion of the course: the origins of the

“industrial organization” in antitrust policy

(Week 1), basic micro theory (Week 2) and

finally the time value of money, measuring

market structure and cost (Week 3).

• This week we begin the “meat” of the course,

using economic theory to understand how

firms and industries are organized.

`


• Over the next 12 weeks we will investigate:

– Monopolies; capturing the consumer surplus

– Oligopolies; how they interact

– Monopolies; methods of limiting competition

• This week we begin with monopolies

capturing some of the consumer surplus

through price discrimination.

`


• Price discrimination is common in the real economy.

• These are examples of price discrimination:

– Prescription drugs are cheaper in Canada than the

United States.

– Textbooks are generally cheaper in Britain than the

United States.

• Effects of price discrimination

– presumably profitable

– may affect efficiency: not necessarily adversely

`


• Price discrimination means charging different

prices to different consumers for the same good.

• Recall that a monopolist facing a downward

sloping demand curve and employing non-

discriminatory pricing must reduce its price to all

consumers in order to sell more product.


• If price discrimination allows a monopolist to

sell more product, it may be seen as increasing

total surplus, thus improving efficiency.

• We will look at how that might happen at the end

of the next lecture.


• Two issues confront a firm wishing to price discriminate:

1. Identification: can the firm identify demands of

different types of consumer or in separate markets

• easier in some markets than others: e.g tax

consultants, doctors

2. Arbitrage: can the firm prevent consumers charged a

low price from reselling to consumers charged a high

price

• prevent re-importation of prescription drugs to the

United States


• The firm then must choose the type of price

discrimination

– first-degree or personalized pricing

– second-degree or menu pricing

– third-degree or group pricing


• There are three types of price discrimination:

Type Name Example

First Degree Personalized

Pricing

Maximum price charged to each

consumer

Second Degree Menu Pricing Quantity discounts

Third Degree Group Pricing Group discounts (“early bird special”

“senior discount” )


• Third-degree price discrimination: Group pricing.

• Consumers differ by some observable

characteristic(s). A uniform price is charged to

everyone in the group. This is “linear pricing.”

• Different uniform prices are charged to different

groups:

– “children under 12 are free”

– “senior discounts”

– high variety of airline ticket prices

– early-bird specials 13


• The pricing rule is very simple:

– consumers with low elasticity of demand

should be charged a high price.

– consumers with high elasticity of demand

should be charged a low price.

14


• An example of 3rd Degree Price Discrimination:

• Assume the sellers of the last Harry Potter book

face the following demand curves in the United

States and Europe respectively.

• Demand:

– United States: PU = 36 – 4QU

– Europe: PE = 24 – 4QE

• Marginal cost constant in each market

– MC = $4 15

Industrial Organization• We begin with NO PRICE DISCRIMINATION, i.e., the

same price is charged in both markets.

• Use the following procedure to determine price:

1. Determine aggregate demand in the two markets.

2. Determine marginal revenue for that aggregate.

demand

3. Equate marginal revenue with marginal cost to

identify the profit maximizing quantity.

4. Identify the market clearing price from the aggregate

demand.

5. Calculate demands in each market from the individual

market demand curves and the equilibrium price. 16


17

United States: PU = 36 – 4QU Invert this:

QU = 9 – P/4 for P < $36

Europe: PU = 24 – 4QE Invert this

QE = 6 – P/4 for P < $24

1. Determine aggregate demand:

Q = QU + QE = 9 – P/4 for $36 < P < $24

At these

prices only

the US

market is

active

Q = QU + QE = 15 – P/2 for P < $24

Now both

markets

are active


18

RE-Invert the direct demands

P = 36 – 4Q for Q < 3

P = 30 – 2Q for Q > 3

$/unit

Quantity15

36

302. Determine marginal

revenue:

MR = 36 – 8Q for Q < 3

MR = 30 – 4Q for Q > 3DemandMR

3. Set MR = MC:MC

Q = 6.5

P = $17

6.5

17

4. The Market Clearing Price

from the demand curve:


19

5. Calculate demands in each market from the individual

market demand curves and the equilibrium price :

QU = 9 – P/4 = 9 – 17/4 = 4.75 million

QE = 6 – P/4 = 6 – 17/4 = 1.75 million

Aggregate profit = (17 – 4)x6.5 = $84.5 million

These are the results WITHOUT PRICE

DISCRIMINATION.


• The firm can improve on this outcome by

using 3rd degree price discrimination.

• Note that MR is not equal to MC in both

markets:

– MR > MC in Europe

– MR < MC in the US

– Therefore, the firms should transfer some

books from the US to Europe.

20


• This requires that different prices be

charged in the two markets.

• Procedure:

1. Evaluate each market separately.

2. Identify equilibrium quantity in each

market by equating MR and MC.

3. Identify the price in each market from

market demand.

21


22

1. Evaluate each market separately.

Start with US demand function:

PU = 36 – 4QU

$/unit

Quantity

Demand2. Identify the equilibrium

quantity by equating MR = MC:

MR = 36 – 8QU

36

9

MR

MC = 4

MC4

At MR = MC, QU = 4

3. Identify the price in each

market from market demand:

PU = $20

4

20


23

1. Now use Demand in the Europe

. . . PE = 24 – 4QU

$/unit

Quantity

Demand

to calculate marginal revenue:

MR = 24 – 8QU

24

6

MR

MC42. Equate MR and MC = 4 to

determine quantity:

QE = 2.5

PE = $14

2.5

14

3. Again, identify the price in each

market from market demand:


• In this case, the firm enjoys a significant

advantage from price discrimination.

• Aggregate sales are 6.5 million books, which

is the same with no price discrimination.

• However, Aggregate profit is (20 – 4)x4 +

(14 – 4)x2.5 = $89 million.

– $4.5 million greater than without price

discrimination

24


• With price discrimination the procedure is:

1. Identify marginal revenue in each market.

2. Identify equilibrium MR from the aggregate

MR curve.

3. Equate this MR with MC in each market

to give individual market quantities.

4. Identify equilibrium prices from individual

market demands.

25

Industrial Organization• RULE: If demands are linear –

– price discrimination results in the same

aggregate output as no price discrimination.

– price discrimination increases profit because

allocated more profitably across two markets.

• For any demand specifications two rules apply:

– marginal revenue must be equalized in each

market.

– marginal revenue must equal aggregate

marginal cost.26


• Suppose that there are two markets with the same MC.

• MR in market i is given by MRi = Pi(1 – 1/hi)

– where hi is (absolute value of) elasticity of demand

• From rule 1 (above)

– MR1 = MR2

– so P1(1 – 1/h1) = P2(1 – 1/h2)

– Therefore:

–𝑷𝟏

𝑷𝟐

= (𝟏−

𝟏

𝒉𝟐

)

(𝟏−𝟏

𝒉𝟏

)= 𝒉𝟏𝒉𝟐−𝒉

𝟏

𝒉𝟏𝒉𝟐−𝒉𝟐

27

Price is lower in

the market with

the higher

demand elasticity

Industrial Organization• Third Degree Price Discrimination often arises when firms sell

differentiated products:

– hard-back versus paperback books

– first-class versus economy airfare

• Price discrimination exists in these cases when:

– “two varieties of a commodity are sold by the same seller to

two buyers at different net prices, the net price being the

price paid by the buyer corrected for the cost associated with

the product differentiation.” (Phlips, 1983)

• The seller needs an easily observable characteristic that signals

willingness to pay and must be able to prevent arbitrage.

28


• NEXT WEEK:

• Exploring 3rd Degree Price Discrimination Further: disaggregating the demand function.

• Nonlinear Price Discrimination (1st

and 2nd Degree Price Discrimination)

• Bonus Lecture on Standard Oil

29


• Please make sure you have read Chapters 5 and 6 in the text.

• Start reading Chapter 7 (Sections 7.1 and 7.2)

ECON-115 Lecture 041. Determine aggregate demand in the two markets. 2. Determine marginal revenue...

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