Lecture 6: More on price discrimination and nonlinear pricing Intro to product differentiation Tom Holden io.tholden.

org

Marks
Left from last week:
Third degree price discrimination. Tying and bundling. Durable goods.
Price discrimination in time.

Product differentiation

The Dixit-Stiglitz (1977) model of exogenous differentiation. The Hotelling (1929) linear-city model model of endogenous differentiation.

Mark (out of 32) Mark (percentage) Number Percentage

19 59% 1 2%

20 63% 1 2%

21 66% 0 0%

22 69% 0 0%

23 72% 1 2%

24 75% 3 7%

25 78% 5 12%

26 81% 7 17%

27 84% 8 19%

28 88% 3 7%

29 91% 0 0%

30 94% 6 14%

31 97% 7 17%

Third degree price discrimination:

OAP discounts for museums. Student discounts on software. Academic discounts for conferences. Magazine price varying by country.

Firms base price on consumers observable characteristics. E.g.:

AEA membership price varying by income.

The New Statesman is 5.80 throughout the EU, except in Greece, where it is 5.40.

Most common form of price discrimination. The firm sets the monopoly price in each market (i.e. MR=MC).

Market is equally split between type 1 and type 2 consumers:

Firm has costs to produce = 1 + 2 . Profits: 1 1 1 + 2 2 2 1 + 2 FOC 1 : 0 = 1 1 1 + 1 1 1 + 2 I.e.: 1 = . Likewise: 2 = . Exercise: Show that this condition is still valid when there are type 1 consumers and type 2s.
Type 1 consumers have demand: 1 1 Type 2 consumers have demand: 2 2

Recall the FOC for 1 says: 1 1 1 + 1 1 = 1 + 2 .

So:

1 1 1 1 1

+1=

1 +2 1 1

Note:

demand. Remember:

1 1 1 1 1

1 1 1 1

= 1 1 =
1 1

where is the price elasticity of

will almost always be negative. large means elastic demand. In general is a function of the price/quantity.
1 +2 1+
1

So: 1 1 =

.
1

Elastic demand means is small, so 1 1 1 + 2 . I.e. the market with the more elastic demand will have the lower price. Students are more put-off by high prices, so you should charge them less.

Ambiguous:

The firm gains.

Consumers offered the high price lose out. Consumers offered the low price gain.

It can always get the same as before by setting the same price in both markets. Before they might not have been buying the good even.

A necessary condition for a welfare improvement is that output increases.

Varian (1985) or Varian (1989)
No need to understand the proof.

Maths on slides from last week gave a linear example of this. Icing.

Printers and cartridges are complements, but not in fixed proportions. Given resale is possible, only one price can be charged for printers. If this price is low, high demand consumers get a large surplus. Tying enables firms to extract some of this.
E.g. If you buy a printer from me, you have to buy cartridges from me too. Enables > for cartridges. A kind of two part tariff.

OZ 14.1 gives a slightly strange definition of tying.

More usual one is that the purchase of one good requires the future purchase of another. See https://en.wikipedia.org/wiki/Tying_%28commerce%29

As in the cases above, depends on whether by tying the firm can open up a new market.
E.g. suppose that without tying printers would be priced so high that only businesses could buy them. In this situation tying (if performed) will generally increase welfare. But if all consumers would buy even without tying, welfare will generally fall.

=Selling two goods in fixed proportions. Imagine you are Rupert Murdoch. What channels do you want to bundle into Sky?
Valuations Jock Geek Sky Sports 15 8 Discovery 10 12 Total 25 20

If you sell both channels separately (and there are as many Geeks as Jocks) the optimal prices are 8 and 10 for Sky Sports and Discovery respectively, giving a total profit of 2 8 + 2 10 = 36.
Exercise: How would this change if Jocks valued Sky Sports at 17.

If you sell a bundle, then the optimum price is 20, giving a profit of 40. Key requirement for profitability of bundling: valuations must be negatively correlated across types.

=Selling both a fixed proportion bundle, and the components separately. Strategy one: Word and Excel are both 30. Strategy two: Word and Excel are both 50.
Revenue: 120 30 = 3600. Revenue: 80 50 = 4000.

Strategy three: Word and Excel are sold in a bundle at price 50.
Strategy four: Word and Excel are sold in a bundle at price 60. Strategy five: Word and Excel are sold individually at price 50, or in a bundle at price 60.
Revenue: 80 50 + 20 60 = 5200. Revenue: 20 60 = 1200. Revenue: 100 50 = 5000.

User Type Writer Accountant Generalist

Number 40 40 20

Valuation of Word 50 0 30

Valuation of Excel 0 50 30

Total Valuation 50 50 60

E.g. cars/washing machines etc.

If a firm charges a high price for a durable good today and so sells to all of the high value customers, then tomorrow, it will be tempted to cut its price to sell to the low value ones. Knowing this, the high value consumers will delay purchasing.
This hurts profits!

The firm would prefer not to be able to discriminate (i.e. not to be able to set different prices in different periods).

Maths on slides from last week gave a linear example in which, given the choice, firms would prefer to commit to set the same price in both periods.
Maths is icing.

Such commitment is generally difficult.

A few examples of this in practice:
Chrysler offered a lowest price guarantee on their cars. If the price is lower in future, people who buy now will be reimbursed the difference. Xerox only leased their copiers in the 60s and 70s.
If you lease you have to pay every period, so theres no point delaying.

Price discrimination (generally) enables firms to extract additional profit. If consumer characteristics are observable, firms perform 1st or (more likely) 3rd degree price discrimination. If they are unobservable, firms perform 2nd degree price discrimination, subject to the incentive compatibility constraints. Versioning, tying, bundling and time (i.e. durables) provide other avenues for discrimination. Welfare is usually improved by discrimination when it opens new markets, but is not otherwise.

OZ Ex. 5.7
Question 3, 4, 5, 6 (tricky)

OZ Ex. 13.5
Question 1

OZ Extra exercises:
http://ozshy.50webs.com/io-exercises.pdf Set #5, 20

How do firms choose which products to produce? How does product differentiation affect price competition? Are there too many products, or too few?

A model of consumers preference for variety within a market.

E.g. breakfast cereals.

Rather than assuming different consumers want different products, assumes the existence of a representative consumer who wants a little of everything.

The representative consumers utility is given by:

= 0 +
=1

1 1+

1+

= 0 +

1 1+ 1

1 1+ 2

+ +

1 1+ 1+

Good zero represents e.g. money (a good that is useful for other things). Good > 0 is produced by the th firm. Adding another good (increasing ) makes consumers better off.
Consumers value variety.

With this utility function, all products are equally close substitutes for all other products.

When = 0, this is linear utility, so goods are perfect substitutes. When is large, goods are poor substitutes. OZ 7.2.1 covers the = 1 case.

The representative consumer maximises utility subject to the budget constraint 0 + = , where is their =1 income. Using the BC we can substitute 0 out of utility giving: 1+
1 1+ 1 1+ 1 1+

= 1 1 + 2 2 + + + 1

+ 2

+ +

FOC 1 gives:
0 = 1 + 1 + 1
1 1 1+ 1 1+

+ 2

1 1+

+ +
1 1+

1 1+

i.e.: 1 = 1 where = 1 + 2 + + Key simplification: when is large the effect of 1 on is negligible.

1 1+

1 1+

1 1 1+ 1 1+

So from1the last slide, we know firm faces the demand curve

1+ =

Each firm then sets their quantity as a monopolist would, when facing this (iso-elastic!) inverse demand curve. We call this monopolistic competition.

for their good.

Firm profits (assuming constant MC of ): 1 1

1+ =

1+ =

FOC: 0 =

1 1 1+ 1+

= 1+ .

So = 1 + . I.e. each firm charges the same mark-up over its marginal cost.
When = 0 we get = i.e. perfect competition.

Suppose firms have to pay a fixed cost to enter, and suppose all firms have the same MC, . Then the zero-profit condition says: = =
So, in equilibrium, each firm produces units. Thus, firms are larger when:
the entry cost is high, and when goods are close substitutes.

Dixit-Stiglitz (1977) show that the market equilibrium with free entry is a constrained optimum.
No lump sum transfers/subsidies. Firms do not make negative profits.

It is the value for , , a social planner would using if they were maximising utility subject to:

Recall with Bertrand competition there was too little entry, and with Cournot there was too much.

Under Dixit-Stiglitz (1977) competition we have the Goldilocks levelthe optimal balance between variety and scale.

No. The Goldilocks property is a consequence of special properties of this particular utility function. More general utility functions lead to variable P.E.D. and there are two opposing effects.
1. Non-appropriability of social surplus.
A new firm entering benefits consumers because of their preference for variety. Firms cannot capture this surplus, and so there will tend to be too little entry. Just as we saw with Cournot, when a new firm enters all other firms lose out, since the new firm will sell to some of their old customers. This negative externality of entry means there will tend to be too much entry.

2. Business stealing.

In the Dixit-Stiglitz (1977) model, firms do not really choose which product to produce.

They enter, and then they are magically producing a differentiated product. All products are equally close substitutes.

In models of endogenous product differentiation, firms will choose how different to make their product from those of their rivals.
How close a substitute a product is becomes a choice variable.

One way firms can differentiate themselves is by location choice.

Two competing ice cream sellers want to serve the sunbathers. Where should they locate?

E.g. imagine a long beach, with sunbathers spread along it.

The Hotelling model has exactly this structure. This week we will analyse the problem with fixed location. (Well look at location choice next week.)

Location is also a metaphor for any difference in preference:

E.g. spicy versus non-spicy food. Alcoholic versus non-alcoholic drinks.

Consumers are uniformly distributed along 0,1 (the beach). There are two firms and , both with constant MC of 0.
Firm locates at point 0 and charges a price for ice cream. Firm locates at point 1 and charges a price for ice cream. They are prepared to buy it at any price. The cost to a consumer located at to buy from firm is: + The cost to a consumer located at to buy from firm is: + 1 measures just how lazy consumers are.

Consumers really want ice cream. Consumers are lazy:

Two stages: firms choose price, then consumers choose which firm to buy from.

There must be a point such that the consumer at is just indifferent between buying from firm (and walking left) or firm (and walking right). At we must have: + = + 1 So: = +
1 2 2

So if is expensive, the indifferent consumer is further along, meaning more buy from .

Consumers located left of will buy from and consumers located right of will buy from . 1 Firm s profits are thus = + and 2 2 1 = firm s are 1 + .
2 2

FOC for firm : +

Similarly from firm s FOC we get: = + Solving gives: = = .

1 2

= 0. I.e. = +
2

Both firms make a profit of . 2 Despite competing in prices.

In the Dixit-Stiglitz (1977) model firms do not choose what product to produce.

Entry automatically creates a product equally different to all other products in the market. With the models special preferences, there is just the right about of entry.

In the Hotelling (1929) model, firms can choose what product to produce on a taste continuum.
We have assumed their choice is fixed for the time being. Equilibrium is solved for by first finding the indifferent consumer.

OZ Ex. 7.6
Question 2, 3

More to follow next week.