Price Discrimination

Prof. Dr. Murat Yulek

Market structures

There are different market structures with varying effects on the consumer and total welfare of the society such as • Competitive markets• Oligopolistic markets• Monopoly markets• Monopolistically competitive markets.

Firm strategy / behavior

We should distinguish those types of market structures with firms’ strategies aiming at maximizing profits under those conditions.• E.g. We have seen that, natural monopoly, if

acts rationally from its point of view (profit maximization), would reduce the output from the competitively market clearing level, so that the market price would go beyond the competitive price.

Firm strategy behavior

• There are other, more complex, strategies and conduct that firms may adopt. One very prominent way of firm behaviour may be price discrimination.

• In the standard model we looked at so far, there is one price (competitive, monopolistic or else) that applies to every customer.

• Firms, however, realize that if they could charge different prices to different customers or customer groups, they may reap further profits.

Types of price discrimination

The literature have identified three categories of price discrimination (PD): • First degree (perfect ) PD: each customer is

charged a different price.• Second degree PD: prices charged for a

customer is tied to quantity of purchase. • Third degree PD: Each customer category is

charged a different price.

How can a firm price-discriminate ?

PD means setting price above the firm’s MC. Competitive firms can not price-discriminate. Because they do not have the power to raise their price beyond MC. For PD, the firms need some market power. • Ability to identify the level of willingness of

customers to pay higher prices than the MC.• No resale.

First degree (perfect) PD

• If the firm can charge each customer the (max) price that he/she is wiling to pay, then the firm’s profits could go beyond even the monopolistic profit level. In fact, the firm can pocket the entire Consumer Surplus.

First degree (perfect) PD

Perfect price discriminator can pocket the entire CS:A+B+C = CS under perfect competition = perfect price discrimating firm’s profitB = the profit of an ordinary monopoly

p

q

A

CB

pmonopoly

Qmonopoly Qcompetiitve

MR D

S; MC

Third Degree Price Discrimination

• If the firm can not identify the price willingness of each customer what can it do?

Third Degree price discrimination: Price discriminating firm can then charge different prices to each different customer category it faces. If it can identify categories of customers and their willingness to pay.

The profit maximizing rule is: charge each group according to its price elasticity of demand. Thus, charge the inelastic customers higher.

Third Degree Price Discrimination

• Assume two groups. Profit maximization would lead to

That means: if then 2 > . Low elacticity (more inelastic) group will be charged higher.

Third Degree Price Discrimination

The chart depicts the case where and thus 2 < .

Second Degree PD

Non-linear pricing• Bundles (Tie-in sales): Buy good A only if you

buy good B also.• Quantity discounts: Buy one- get the second at

50% reduction• Two part-tariffs: e.g. club entry fees. Pay

initially for the right to buy.

Welfare Effects of price discrimination

• Discuss• Perfect PD: Welfare is lower than in competitive. Quantity

consumed is equal to the case of the competitive market. But consumers are charged higher than the competitive price. So their CS is pocketed by the price discriminating firm. And actually the loss of the consumer equals the entire CS; that is much more than the ordinary monopoly profits.

• Third Degree PD: welfare effects compared to ordinary (non-discriminating) monopoly is ambiguous. Third degree PD may or may not end up better efficiency outcomes compared to ordinary Monopoly.