The practice of charging unequal prices or fees to different buyers (or classes of buyers) is called price discrimination

Examples of price discrimination

Physicians charge more for an office visit if the patient has health insurance. Magazines such as Sports Illustrated offer gifts and discounts to new subscribers. Senior citizens may enjoy discounted rates at motels and restaurants. Cinemas charge higher ticket prices for adults than for kids.

Japanese steel and Canadian timber producers earn sharply lower profit margins on products sold in the U.S. compared to the domestic market.

Sizing up their income pricing by plumbers, auto mechanics, . . . A Mercedes driver can pay more, so why not charge them more?

When is price discrimination feasible?

Price-discrimination (PD) can be a very lucrative proposition from the sellers point of view. However, PD will not be feasible or possible unless: 1. The seller possesses market powermeaning, the seller faces a downward sloping demand curve.

2. The seller is capable of segregating buyers into groups based on differential willingness to pay, or elasticity of demand (). Hear audio explanation (wav).
3. The seller can prevent arbitrage or resale of the product. Her audio explanation (wav)

This is referred to as perfect PD. The seller charges every buyer their reservation pricethat is, the maximum price they are willing to pay rather then go without the marginal unit of the good or service

Notes Price A

Perfectly discriminating monopolist charges PC for the last unit only. Market output is equal to the competitive output (QC) Total Surplus (TS) is equal to green shaded area APCB B
MC MR D QC Quantity

PC

QM

Hear audio explanation (wav)

3rd degree price discrimination: the welfare effects

To illustrate these effects we use the example of Kevlar, du Ponts patented, superstrength synthetic fiber. We assume there are two uses for Kevlar 1. Undersea cables 2. Tires

Differential elasticities of demand ()

Steel and fiberglass are good substitutes for Kevlar in tire production; where there are no good substitutes for Kevlar in the manufacture of undersea cable. Let t denote the elasticity of demand for Kevlar on the part of tire makers.

c is the elasticity of demand for Kevlar for use in production of undersea cables.
Thus:

t > C

[1]

Symbols, assumptions
Let:
Pc : Price per unit of Kevlar charged to cable manufactures; Pt : Price per unit of Kevlar charged to tire manufacturers; qc: Quantity of Kevlar purchased by cable manufacturers; qt: Quantity of Kevlar purchased by tire manufacturers.

We assume that MC = ATC = $20.

The demand functions are given by:

qC = 100 - Pc
qt = 60 - Pt

Price discriminating firm sets MR = MC in each submarket

H

Price

Audio explanation (wav) D cable

60 50

D cable + tires
F

D tires

N J C

40 MRC
20
0 A

MC
S

MRt Tires
20 10

MRC + t Cable

40 50 60

2 scenarios
Standard monopoly pricing (single price)
PC = Pt = $50

Q = qC + qt = 50 + 10 = 60 units
= TR TC = [(50)(60)] [(60)(20)] = $1,800

3rd degree price discrimination

PC = $60; Pt = $40 audio explanation (wav) Q = qC + qt = 40 + 20 = 60 Units

= TR TC = {[(60)(40)] +[(40)(20)]}
[(60)(20)] = $2,000

So, du Pont can increase its profits by $200 (from $1,800 to $2,000) by practicing price discrimination

As a consequence of P.D., cable manufacturers pay $60 per unit instead of $50. This gives rise to a welfare loss of WFSA or $350.
If du Pont discriminates, then tire manufacturers pay a lower price than they otherwise would ($40 instead of $50). This gives rise to a welfare gain of NHGJ or $250. Thus,

TS = WFSA + NHGJ = -$250

By enforcing statutes applicable to price discrimination (specifically, section 2 of the Clayton Act) , the total surplus could be potentially increased by $250.