Teaching Price Discrimination - Some Clarification

Teaching Price Discrimination: Some Clarification
Author(s): Kathleen Carroll and Dennis Coates

Source: Southern Economic Journal, Vol. 66, No. 2 (Oct., 1999), pp. 466-480
Published by: Southern Economic Association
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Southern Economic Journal 1999, 66(2), 466-480
Targeting Teaching
Teaching Price Discrimination: Some

Clarification
Kathleen Carroll* and Dennis Coatest
This paper describes some common pitfalls in the teaching of price discrimination. The paper
then presents some clarification of these issues and makes suggestions for teaching price dis-
crimination to students in Principles and Intermediate Microeconomics classes.
1. Introduction
Economics is useful and important as a tool for the study of policy. Indeed, what interests
students most are those topics with direct policy relevance. We think it important that these
topics be covered with as little opportunity for confusion as possible, especially in the Principles
course, which may be the only exposure students get to many of these issues. Treatment of
price discrimination in both Principles and Intermediate texts are often laden with misleading
and even incorrect information.
We have reviewed the discussions of price discrimination in several Principles and Inter-
mediate textbooks. Principles texts we have reviewed include: Mansfield (1992), Baumol and
Blinder (1994), Miller (1994), Tresch (1994), Gwartney and Stroup (1995), Samuelson and
Nordhaus (1995), Taylor (1995), Lipsey and Courant (1996), McConnell and Brue (1996), and
Parkin (1996). Intermediate texts we have reviewed include Ekelund and Ault (1995), Mansfield
(1997), Nicholson (1997), Hirshleifer and Hirshleifer (1998), Landsberg (1998), Pindyck and
Rubinfeld (1998), Browning and Zupan (1999), and Perloff (1999). Across these texts, we have
found a wide variance in the approach and the issues raised.
In general, the discussions in Principles texts focus on either theory or antitrust policy, but
rarely link the two. Those that focus on theory scarcely mention the regulatory issues and leg-
islation. These discussions usually are part of the chapter on monopoly. Most of these texts
indicate that a downward sloping demand curve and market segmentation are required. Some
mention that prohibition of resale is a requirement. Most texts in this group define price discrim-
ination as a situation in which the same good is sold at different prices unrelated to cost differ-
ences, but there are exceptions. Almost exclusively, the graphical exposition demonstrates first-
* Department of Economics, University of Maryland, Baltimore County, 1000 Hilltop Circle, Baltimore, MD 21250,
USA.
t Department of Economics, University of Maryland, Baltimore County, 1000 Hilltop Circle, Baltimore, MD 21250,
USA; E-mail coates@umbc.edu; corresponding author.
The authors thank Michael Bradley, Jonathan Hamilton, and an anonymous referee for helpful comments on an
earlier draft of the paper.
466
Teaching Price Discrimination 467
degree price discrimination, but the examples of real-world price discrimination are of the third-
degree variety.
One major problem with these treatments is that the theoretical presentation and the ex-
amples are inconsistent. A second problem is that it is very hard to justify the examples as
coming from monopolized industries. For example, common textbook cases of price discrimi-
nation are senior citizen discounts offered by restaurants, child prices for movie theaters, and
differential pricing for business and vacation travelers on airlines. Few people would argue that
restaurants, theaters, or airlines are monopolies. Hence, texts suggest that price discrimination
is a pure monopoly phenomenon, then proceed to provide examples in which monopoly is
dubious at best and ludicrous at worst.
Those texts that focus on the antitrust issues summarize legislation pertaining to regulation
of anticompetitive behaviors and defenses that business can use if charged with illegal price
discrimination. Students reading from this group of texts get little information on the conditions
under which price discrimination may occur, that there are several varieties of price discrimi-
nation, or the likely effects of these pricing schemes on economic efficiency and income dis-
tribution. In other words, students get little indication that economic theory has anything to
contribute in this policy area.
Similar problems with the treatment of price discrimination arise in some Intermediate
microeconomics texts. For example, Landsburg (1998, p. 361) defines price discrimination as
"the act of charging different prices for identical items"; Nicholson (1997, p. 305) defines price
discrimination as "selling identical units of output at different prices"; and both suggest that
price discrimination is exclusively a monopoly phenomenon. Pindyck and Rubinfeld (1998)
make no mention of cost differences in their treatment of price discrimination, but Ekelund and
Ault (1995) do. Mansfield (1997) notes that differences in prices are not sufficient to show price
discrimination but makes no mention of efficiency effects. He also indicates that price discrim-
ination can occur whenever a firm has some market power, as do Pindyck and Rubinfeld (1998),
Browning and Zupan (1999), and Perloff (1999). Hirshleifer and Hirshleifer (1998) discuss the
importance of market segmentation, using the example of differences in the prices of Japanese
cars sold in the United States and those sold in Japan. In the context of a chapter on monopoly,
as it is presented, the discussion is likely to confuse students who are well aware of the existence
of multiple car manufacturers from both the United States and Japan.
This article provides some suggestions for teaching price discrimination and for providing
examples that should avoid confusion and give students a better understanding of the important
issues. Our discussion of price discrimination focuses on three areas: (i) the definition of price
discrimination, (ii) situations or conditions in which price discrimination occurs, and (iii) the
effects of price discrimination.
2. Definition of Price Discrimination
Popular textbooks on industrial organization define price discrimination as differences in

the ratio of price to marginal cost across buyers or units of a good.' One form of price discrim-
ination is the practice of a firm charging multiple prices for the same good where the difference
'Scherer and Ross (1990), Shepherd (1997), and Shugart (1997) each use this definition of price discrimination. In
addition, Viscusi et al. (1992) define price discrimination this way in their text on regulation and antitrust. An alternative
468 Kathleen Carroll and Dennis Coates
in price is not attributable to a corresponding difference in cost. This definition implies that
different observed prices for apparently identical goods need not be discriminatory. Another
form of price discrimination is the practice of a firm charging the same price for all units of
the same good when there are cost variations in supply. This implies that observed identical
prices for apparently identical goods may be discriminatory. Cost differences, not simply price
differences, must be considered.
Lott and Roberts (1991) make this point forcefully by carefully examining four commonly
used "examples" of price discrimination: the spreads in retail gasoline prices, the prices of
dinners at restaurants, the price of popcorn at movie theaters, and the variation of airline ticket
prices with time between ticket purchase and flight date. They show that cost differences,
particularly opportunity cost differences, may explain the price differences. Their examples may
not necessarily be convincing, however, because one can reasonably dispute whether the
"goods" sold at different prices are really the same thing. For example, Lott and Roberts (1991)
explain why the price of dinner in a restaurant may be higher than the lunch time price of the
same food; the time spent at the table is longer for dinner than for lunch, so the higher dinner
price represents the greater opportunity cost of tying up the table. Yet eating lunch, with its
particular set of accompanying services, is probably not a close substitute for eating dinner,
which may have a very different set of accompanying services. The possibility that these two
meals may be very differently bundled presents a more complicated pricing situation, along the
lines of second-degree price discrimination. In this type of situation, where marginal cost is
difficult to determine, the usual definitions of price-marginal cost ratios or differentials may be
insufficient to rule out the possibility of price discrimination.2
The more standard example of price discrimination at a restaurant is that of senior citizen
discounts. In this case, two diners at the same table ordering exactly the same meal will face
different prices if one carries an American Association of Retired Persons card but the other
does not. Lott and Roberts' opportunity cost explanation for different prices does not work for
this example. Nonetheless, Lott and Roberts (1991) have succeeded in showing that there may
be subtle cost differences that justify price differences in situations where one may be tempted
to claim the existence of price discrimination.
Even though price discrimination occurs when price-marginal cost ratios differ across either
units or buyers of a good, not all price discrimination is the same. Different types of price
discrimination have been identified, each with different implications and distinct characteristics.
In fact, two distinct, but related, taxonomies of price discrimination exist.3 The most common
taxonomy of price discrimination identifies first-, second-, and third-degree price discrimination.
First-degree price discrimination occurs when a different price is charged for each and
every unit offered for sale. The seller is able to set price on each unit at the maximum that
definition of price discrimination compares the difference between the price and the marginal cost of a good across
buyers or units of the good. If this difference is measured as a proportion of the sale price, then the resulting value is
the Lerer index. Both this definition of price discrimination and the one stated in the text may be overly restrictive.
Carlton and Perloff (1994) use the term more broadly to include any pricing scheme in which the firm is able to increase
its profit over that earned from a single price. These schemes raise profits because they enable the firm to charge more
to consumers who are willing to pay more and charge less to consumers who value the product less.
2 It is in more complex pricing situations such as this that the broader definition of price discrimination suggested by
Carlton and Perloff (1994) may be appropriate.
3 The first taxonomy, by Fritz Machlup (1952), listed several different types of price discrimination, summarized by
Shepherd (1990). The three types described by Machlup are: personal discrimination, in which the firm tailors price to
the specific buyer; group discrimination, wherein identifiable groups are charged different prices; and product differ-
entiation, which involves different prices charged for identical goods over time, say through end-of-season sales.
some buyer is willing and able to pay.4 The seller is in a position to make a "take-it-or-leave-
it" offer to the buyers of the good or to bargain the buyer to his or her reservation price. Sellers
are unlikely to have this level of information in many situations. One famous, if controversial,
example of first-degree price discrimination is William Niskanen's (1971) model of the rela-
tionship between bureaus and Congress. Niskanen gives bureaucrats the ability and the desire
to make "take-it-or-leave-it" offers to Congress. Niskanen's bureaucrats then capture all of the
surplus in the form of budget allocation associated with provision of public services.5 Another
example of individual unit pricing would be a situation where the seller deals individually with
each buyer and can "size" him up and price accordingly, such as in auto or insurance sales.
Second-degree price discrimination encompasses a variety of pricing schemes through
which the firm is able to induce consumers with high valuations to pay higher prices than
consumers with low valuations. Second-degree price discrimination schemes induce consumers
to self-select into groups based on their willingness to pay. Firms do not have the consumers'
valuation information in this case, as they do under first-degree discrimination, nor do they
have information that would enable them to identify high- versus low-demand individuals as
under third-degree discrimination. For example, the firm might know that there are two groups
of buyers of its product. The first group will buy a great deal of the good if the price for the
marginal unit is low enough; the second group will buy only a small amount of the good no
matter what the price. Unfortunately for the seller, he or she does not know which group any
specific buyer is in. One form of second-degree price discrimination is the offer of quantity or
volume discounts: the price per unit falls after the purchase of some preset number of units.6
Another form of second-degree price discrimination is the two-part tariff. Under a two-part
tariff, consumers pay a lump sum fee and a per-unit charge.7 In each of these cases, buyers
"self-select" into the pricing arrangement best for them and best for the seller, besides.
Other examples of second-degree price discrimination include tie-in sales and quality choic-
es. In these cases, the firm determines the profit-maximizing prices of multiple products si-
multaneously. For example, if a firm sells two products that are highly complementary, then it
will choose the prices on each to take advantage of that complementarity. Alternatively, the
firm might produce the same good in different qualities. By carefully choosing the quality
difference, the firm can effectively segment the market into two groups, those whose valuation
is high and those whose valuation is low. The firm can then charge a high price to the former
and a lower price to the latter, even after accounting for production and delivery cost differences.
These may be among the most frequent instances of price discrimination.
Third-degree price discrimination is based on characteristics of the consumer or group of
consumers. Firms recognize that some consumers are more sensitive to price than are others.
Moreover, firms can separate consumers into either group through some easily or costlessly
identifiable trait of the consumer. For example, students may be identified by asking for a student
identification card; senior citizens by presentation of an American Association of Retired Per-
4 This situation is much like the "personal discrimination" of Machlup (1952) and Shepherd (1990) because the seller
must know or be able to learn very specific information about every consumer to be able to set the highest attainable
price on every unit.
5 Many authors have questioned the accuracy of Niskanen's (1971) assumptions with regard to the power and information
available to Congress and the bureaus.
6 It is important to note that some discounts arise because the costs per unit of large-volume transactions are smaller than
those from small-volume transactions. Such cases are not instances of price discrimination.
7 Interestingly, Shepherd (1990) includes the case of charging heavy users more for the product as a type of second-
degree price discrimination.
sons card or a driver's license. Those whose demand for movies is insensitive to price may
show up to see first-run movies at their premiers; individuals with more sensitive demand may
wait until later to see the film in low-cost venues or on video. Prices in each of these instances
may well differ for different consumers even after accounting for cost differences.8 Third-degree
price discrimination is clearly "group discrimination."
The distinctions drawn between price discrimination of the varying degrees may seem
arbitrary, but in fact these distinctions are important for two reasons. First, they are based on
different information requirements for the seller. Second, the distinctions are important because
the different types of discrimination have different implications for economic efficiency and
income distribution. Principles textbooks frequently describe and show efficiency implications
of only one type of discrimination (first degree) then follow with an example of a different type
(third degree), as in Gwartney and Stroup (1995), Taylor (1995), Lipsey and Courant (1996),
McConnell and Brue (1996), and Parkin (1996). Students are then likely to come away with
mistaken impressions of the policy implications of price discrimination. We noted earlier that
a common textbook application of price discrimination is the difference in prices charged to
business travelers and vacation travelers who use airline services. This is clearly an example of
price discrimination by consumer group (third degree), if it is price discrimination at all.9 The
same texts, however, explain the efficiency effects of (this third-degree) price discrimination
only in terms of first-degree (perfect) price discrimination. In addition to the efficiency differ-
ences that result from output restrictions that may occur across the different types of price
discrimination, there are various inefficiencies that may result because not all consumers pay
the same price for the product. Suppose consumer A can purchase additional units of the product
at a price discount compared to consumer B. If B's willingness to pay for another unit is higher
than that of A, there exist gains to be had from A buying at the low price and selling to B at
a price below the price B faces but greater than the price A pays. Because resale is not possible,
this represents an additional efficiency loss that occurs when consumers are separated into
groups, as in second- and third-degree price discrimination. If the differences between the types
of discrimination are not presented, then students may easily be confused into believing that
second- and third-degree price discriminations are efficient.
We believe that a fruitful and less confusing approach is to give greater emphasis to the
conditions required for price discrimination to be possible. Because the conditions vary slightly
between types, students can be shown how slight differences in the economic or business
environment have repercussions for economic efficiency and policy implications. With this as
motivation, we now turn to a discussion of the conditions for price discrimination.
3. Conditions for Price Discrimination
For a firm to practice price discrimination, three conditions are necessary. First, the firm
must not be a price taker, it must have some market power.10 Even the slightest market power
implies that the firm faces a negatively sloped demand curve for its product. Consequently,
8 These examples beg the question of whether the goods are really identical. We defer discussion of this point to section 3.
9 Recall that this is one of the examples in Lott and Roberts (1991). Their argument is that the different prices faced by
different travelers may reflect cost differences and, therefore, are not necessarily evidence of price discrimination.
10 In monopolistically competitive markets, firms compete not on price but other concerns such as quality, accessibility,
or service. These firms are not price takers, however. Therefore, we describe them as having some market power.
price discrimination can occur under both oligopoly and monopolistic competition, as well as
pure monopoly. The downward sloping demand curve for the firms's product means that there
is consumer surplus arising from the transactions. Price discrimination is the firm's attempt to
capture some of this surplus for itself.
Price discrimination also requires that the firm can control the sale of its product. If ar-
bitrage is possible, the law of one price holds; that is, those who face the low price can purchase
the product and sell it at a profit to those facing the higher price. Resale may be prevented by
the nature of the commodity or via licensing agreements, copyrights, or other legal impediments
to resale. If a seller charges a higher per-unit price to large buyers than to small buyers, the
firm must prevent multiple purchases at a low price by a single buyer, say, by imposing quantity
limitations. Services such as haircuts, physical examinations, or legal advice, are likely examples
of goods for which price discrimination is possible because of the obvious difficulty in reselling
them or in making multiple purchases.
A third requirement often cited for price discrimination is that consumers have different
price elasticities of demand for the good or service. The extent to which the firm knows or
correctly infers the demand behavior of buyers largely determines which degree of price dis-
crimination is possible. For example, if the firm knows each and every individual buyer's
demand curve perfectly, then the firm can set price on each unit to entice that buyer with the
highest willingness to pay into a purchase. This is clearly first-degree price discrimination. If
the firm knows only of the existence of buyers with high willingness to pay and buyers with
low willingness to pay, then it can offer quantity discounts or use tie-in sales to capture some
of the consumer surplus created by the transactions. These are instances of second-degree price
discrimination or nonlinear pricing. Finally, if the firm knows that elasticity is related to some
identifiable group characteristic, then it can use third-degree price discrimination to induce the
price-insensitive buyers to pay a high price and price-sensitive buyers to pay a low price for
the good. This is third-degree price discrimination.
The informational requirements for the three types of price discrimination vary. Under
first-degree price discrimination a great deal of information must be known about individual
buyers. Second-degree price discrimination relaxes that assumption substantially, allowing firms
only to know that some buyers have high willingness and others low willingness to pay. By
pricing specific quantities of the good differentially or by attaching some other condition to the
purchase of the good (tie-ins, for example), second-degree price discrimination induces the
individuals to reveal to which class they belong. At the same time, second-degree price dis-
crimination does not require the seller to have sufficient information prior to the transaction to
guess which people belong in which category. Under third-degree discrimination the seller does
have that kind of information; to wit, the seller can identify those with unresponsive demand
based on some readily observable characteristic, such as some sociodemographic trait. This
characteristic separates this "group" for differential pricing.
Understanding the differential informational requirements, one can then examine how the
differences influence economic efficiency, income distribution, and policy implications. We turn
now to efficiency and distribution considerations.
4. Effects of Price Discrimination
Price discrimination affects efficiency and distribution, but the specific effects depend on
the type of price discrimination practiced by the firm. Moreover, because the type of discrimi-
nation that is possible depends on the availability of information, the efficiency and distribution
under price discrimination is linked to this availability of information. Regardless of the type
of price discrimination, however, it is profitable for a firm to engage in this practice. This
profitability arises from the seller extracting consumer surplus from the buyers that it could not
get if it did not have market power and control over sale or resale and if buyers' price elasticities
were identical.
The efficiency effects depend on the type of price discrimination practiced by the firm,
and this depends on what the firm knows, or can learn, about the buyers' price elasticities.
When a firm practices first-degree price discrimination, it is profitable to expand output to the
point where price equals marginal cost. The firm, recall, knows the maximum willingness to
pay of every individual buyer. Consequently, it offers a unit for sale only if the most anyone
will pay for it is at least the marginal cost of producing that unit. On every unit for which the
maximum willingness to pay exceeds marginal cost, the firm captures the entire difference as
its own. On the last unit offered for sale, the firm makes no profit because marginal cost equals
price. But marginal cost equal to price is precisely the condition for maximizing net social gain
from this market (that is, in partial equilibrium). In other words, when the firm has full and
perfect information about consumer demands, then price discrimination improves efficiency.
This added efficiency comes at the cost of transferring all the gains from trade from consumers
to the firm.
Under third-degree price discrimination, the firm knows that identifiable groups have dif-
ferent price elasticities of demand. The firm does not know, however, the maximum willingness
to pay of each member within each group. Therefore, the firm must select a single price for
each group. Because each group faces a given price, and assuming the group's demand curve
is downward sloping, the group members will derive consumer surplus from the purchase of
this good that the firm cannot extract. Additionally, because the firm must select a single price
for each group, it will select the price by equating marginal revenue to marginal cost. But
because marginal revenue is less than price, there is allocative inefficiency. Relative to first-
degree price discrimination then, third-degree price discrimination is less efficient but leaves
consumers with some consumer surplus.
The exact efficiency effects under third-degree price discrimination depend on the shapes
of the cost and demand curves. With straight-line demand curves and constant costs, as are
typically found in Principles books, output does not increase over the level of the nondiscri-
minating firm." Rather, relative to the nondiscriminating firm, the profit maximizing output is
simply redistributed among consumers. In this situation, any deadweight loss that had existed
with no discrimination still exists, by which we mean that the gap between marginal willingness
to pay for one more unit and marginal cost of producing one more unit is the same. There is,
however, an additional welfare cost caused by the allocation of the good from those whose
willingness to pay is higher to those whose willingness to pay is lower. In other words, in this
case, third-degree price discrimination is not only less efficient than first-degree price discrim-
ination, it is also less efficient than no price discrimination (Schmalensee, 1981; Varian, 1985).
However, social welfare may increase under third-degree price discrimination, over nondiscrim-
Lipsey and Courant (1996, p. 230), after defining price discrimination where a "seller can either distinguish individual
units bought by a single buyer or separate buyers into classes .. .," state as a proposition that "output under price
discrimination will generally be larger than under single-price monopoly" (p. 231). Students in an introductory course,
where straight-line demand curves and constant costs are employed (as in the Lipsey and Courant text) would then
believe that all types of price discrimination are efficient.
Table 1. Price Discrimination-Numerical Example

Marginal Marginal
Quantity Revenue 1 Price 1 Revenue 2 Price 2
1 24.5 24.75 46 48
2 24 24.5 42 46
3 23.5 24.25 38 44
4 23 24 34 42
5 22.5 23.75 30 40
6 22 23.5 26 38
7 21.5 23.25 22 36
8 21 23 18 34
9 20.5 22.75 14 32
10 20 22.5 10 30
11 19.5 22.25 6 28
12 19 22 2 26
13 18.5 21.75 -2 24
14 18 21.5 -6 22
15 17.5 21.25 -10 20
16 17 21 -14 18
17 16.5 20.75 -18 16
18 16 20.5 -22 14
19 15.5 20.25 -26 12
20 15 20 -30 10
Demand in market 1: Q, =100 - 4P,. Demand in market 2 2: Q2 = 25 - 0.5P,.
ination, if output increases. Note that output increasing is a necessary condition for welfare to
increase, not a sufficient condition. The intuition of this is straightforward. Inefficiency arises
under nondiscrimination because price exceeds marginal cost-output is too low. If output rises
under discrimination, then the inefficiency arising from producing too little output is reduced.
At the same time, however, price discrimination puts a wedge between the marginal valuations
of different consumers, which means that there are uncaptured gains from trade-an efficiency
loss. Whether the gain in efficiency from increased output is sufficient to offset the loss in
efficiency from the wedge between marginal valuations depends on the precise shapes of the
cost and demand curves.
Table 1 provides a numerical example that clarifies the efficiency and distributional dif-
ferences between first- and third-degree price discrimination, a nondiscriminating monopolist,
and competition. The alternative outcomes are illustrated in Figure 1.12 Assume that the marginal
cost is constant at $20. In a perfectly competitive market, output is 35 units and price is $20
per unit-equal in value to marginal cost-each firm earns zero economic profit, and consumer
surplus is $275. Consumers of type 1 get $50 of the consumer surplus, consumers of type 2
get $225. The nondiscriminating monopoly model would find a market price of $24, a total
quantity of 17.5 units, and profit of $70. Consumer surplus is reduced to about $172.70, with
consumers of type 1 getting $2.40 and consumers of type 2 getting $170.30. In this single-price
monopoly case, the sum of profit and consumer surplus is $242.70, so the dead weight loss is
$32.30.
The first-degree price discriminator would sell the first 12 units produced to buyers in
12 Algebraic solutions to this problem are presented in the appendix.
\ D2
- MR2
P2=35 -'
Pm=24
Pi=22.5 -- -A -~
Pc=20 H, : -- .-- MC
\ : ' ,: x.
"xR1 ' MR,t D

7.5 10 17.5 35
Q2 Q Qm Qc=Qlstdgree
Figure 1. Competition, Monopoly, and First- and Third-Degree Price Discrimination
market 2, where buyers are willing to pay more than are buyers from market 1. The firm sells
in market 2 at prices starting at $48 for the first unit and declining to $26 for the 12th unit,
before selling even the first unit in market 1. This is so because the price at which each of
these first 12 units can sell in market 2 is higher than the price the monopolist can get for even
the first unit in market 1. Indeed, for the first-degree discriminator, who prices each unit indi-
vidually, the market demand curve is the marginal revenue curve. The seller is thus able to
extract all of the consumer surplus on each unit sold and earn a total profit of $275. The total
sold by the first-degree discriminator is 35: 20 to market 1 and 15 to market 2. Note that the
price of the last unit sold in each market equals the marginal cost, P, = P2 = MC = $20.
Hence, the first-degree discriminator sells the efficient (competitive) quantity. Moreover, the
price charged on the last unit sold is at or above the maximum any individual is willing to pay
for another unit, so there are no uncaptured gains from trade between consumers. The firm
captures all of the consumer surplus.
The third-degree price discriminator will sell a total of 17.5 units, just as in the nondis-
criminating monopoly model. Because production is the same level as in the nondiscriminating
monopoly, there is no reallocation of resources into the production of this good, as occurs with
first-degree price discrimination, so allocative inefficiency continues. The third-degree discrim-
inator divides this 17.5 units of output across the two markets, selling 10 units in market 1 at
a price of $22.50/unit and 7.5 units in market 2 at a price of $35/unit, for a total profit of
$137.50. This profit is less than could be made if the seller was a perfect price discriminator,
but more than can be earned with no price discrimination at all. Consumer surplus is $68.75,
with type 1 consumers getting $12.50 and type 2 consumers $56.25. The total of consumer
surplus and profit in this case is $206.25. Note that the dead weight loss (= $68.75) has risen
relative to the single-price monopoly situation. In addition, there exist uncaptured gains from
trade as buyers from market 2 would gladly pay buyers from market 1 more than $22.50 to
acquire another unit of the good. Because the firm controls sale of the product, such exchanges
do not occur.'3 For this reason, greater inefficiency occurs in the third-degree case than under
the nondiscriminating monopoly model, despite the fact that the same quantity of the good is
sold in both situations. If the cost and demand curves result in an expansion of output beyond
that offered in the pure monopoly model, as might occur if marginal cost is upward sloping,
efficiency may or may not be increased, depending on the gains from increased output compared
to the losses from reallocation of output from low-valued to high-valued consumers (Schma-
lensee 1981; Varian 1985).14
The efficiency of second-degree price discrimination, relative to nondiscrimination, de-
pends on whether output increases and on the losses incurred from introducing different mar-
ginal valuations across consumers. This efficiency will also depend on what type of second-
degree discrimination is possible. Consider two examples. In the first example, firms allow
consumers to select between different two-part tariff schemes. In the second example, firms use
quantity discounts.
The first example is similar to memberships in warehouse shopping clubs. The consumer
can join with one of two different types of membership. Under the less expensive membership,
posted prices are not discounted, whereas under the more expensive membership, posted prices
are discounted at 10%. By selecting a membership, consumers reveal information about their
demand-information that the firm would not have had otherwise. The membership fees transfer
consumer surplus to the firm. The differential pricing induces inefficiency by creating a gap
between the marginal valuations of different consumers. Under this scheme, it seems probable
that sales are increased. Output will increase if the undiscounted prices are not too much higher
and the discounted prices are sufficiently lower than the nondiscriminatory prices. But if the
prices faced by those holding low-valued memberships are not lower than the nondiscriminatory
prices, which may still be available at other nonwarehouse stores, then it is unclear why anyone
would buy these memberships. Therefore, it seems likely that price under either membership
plan will be lower than under nondiscrimination and that output will increase. However, output
is not likely to rise to the competitive level. If the discounted prices equal marginal cost, then
the firm sells to the holders of high-priced memberships the same quantity they would purchase
under competition. But the holders of the low-priced memberships face a price higher than
marginal cost, so they will purchase fewer units than under competition. Sales fall short of the
competitive level. In other words, this type of second-degree price discrimination may be more
efficient than nondiscrimination but is certainly less efficient than either competition or first-
degree discrimination. This type of discrimination also enables firms to capture a large measure
of the consumer surplus-certainly more than under nondiscrimination, although whether more
than under third-degree discrimination is not generally determinable.
The second example of second-degree price discrimination is the case of quantity discounts.
The second-degree price discriminator could set the higher price at the monopoly price and the
lower price at the competitive price. Net social welfare rises because output rises relative to the
pure monopoly situation, although it still falls short of the competitive output, unless those
facing the higher price would not have purchased any additional units at the lower price. At
13 We are indebted to our colleague Mike Bradley for suggesting antiscalping laws as an example in which gains from
trade are not captured because resale is impossible. This effect is strengthened when the firm controls sale by limiting
quantities to any one original buyer.
14 In our example, where marginal cost is constant, output does not increase with third-degree price discrimination.
the same time, because not all consumers pay the same price for the product, there remain
uncaptured gains from trade-an efficiency loss. Moreover, it is uncertain whether the lost
welfare from these misallocations of the good away from high-value consumers to low-value
consumers is greater than or less than the welfare loss from the simple monopoly case. However,
under this scheme the firm is unable to capture consumer surplus that consumers derive from
purchases at these prices, unlike the two-part tariff example. This type of second-degree price
discrimination is, therefore, more akin to third- than to first-degree price discrimination.
Generally then, the efficiency and distributional effects of second-degree price discrimi-
nation, relative to the pure monopoly situation, depend on a number of factors. First, the shapes
of the cost and demand curves are important. Steeply rising marginal cost, for example, implies
smaller dead weight loss in the pure monopoly situation, all other things constant, than in the
constant marginal cost case. In this case, the difference between the pure monopoly price and
the competitive price is small, so the gap between the willingness of high-value and of low-
value consumers to pay is likely to be small. Therefore, price differentials would tend to cause
relatively little inefficiency, arising from the lack of resale possibilities. The increased net benefit
from increasing output would, therefore, tend to raise overall efficiency.
Second, the effects will vary with the specific second-degree price discrimination strategy
the seller employs. Which strategy is appropriate will depend on the nature of the good and the
number and closeness of substitutes for it. For example, in the two-part tariff case, the consumer
generally has few opportunities to decide to purchase the good, and there are few close substi-
tutes. The permanent seat license (PSL) pricing scheme used by professional sports teams is a
good example. Few cities have multiple franchises in any given sport, so there are few substi-
tutes. Season ticket purchases are rare, made only once every year in the absence of PSLs and
only once a lifetime with PSLs. Given the lack of substitutes, lumpiness of the good, and
infrequent purchases, the firm can use the two-part tariff scheme. Not too many years ago, long
distance telephone service would have been a similar example. Consumers generally selected a
long distance carrier once. Now, the competition among long distance services can have con-
sumers changing carriers frequently, with the fee portion of the two-part tariff approaching zero
for most customers.'5 In effect, the two-part tariff works well when the choice the consumer
faces is between being able to purchase the good and not being able to purchase it and there
are no close substitutes for the good.
Quantity discounts as a pricing scheme works well when there are close substitutes for the
good and consumers make repeated purchases. Frequent flyer plans are a good example. There
are several airlines from which to choose, and those who travel by plane often do so several
times a year. The consumer has several opportunities to choose, or not choose, any given airline.
Quantity discounts provide the consumer an added incentive to choose the same airline each
time.
5. Concluding remarks
We began this paper with a criticism of the style and approach of teaching price discrim-
ination found in Principles texts. In this section, we propose a method for presenting price
15 There are costs associated with switching carriers, although in some cases, these may be avoided. One of the authors
recently changed from ATT to MCI and back to ATT in less than two weeks, getting no monthly fee and 30 minutes
of free long distance service per month for six months. The companies even provided vouchers for the switching costs.
discrimination that would spark student interest in the application of economic theory to policy
and, at the same time, create the least confusion possible.
(i) Price discrimination can be defined in a more general way as a variation in the price-
cost ratio, or differentials, across units or across groups of buyers. The advantages of this
definition are, first, that it is more accurate and, second, that it encompasses alternative forms
that price discrimination may take. This definition thus incorporates examples of multiple pricing
when costs do not differ (such as selling the identical vehicle to two different buyers at two
different prices), and single pricing when costs do differ (such as shipping the same good to
two different buyers at different locations and cost but at the same delivered price).
(ii) Provide information about the three necessary conditions for price discrimination to
occur.
(iii) Explain that there are three types of price discrimination and that the type of discrim-
ination that occurs depends upon the level of information held by firms.
(iv) Emphasize that the different types of price discrimination have different implications
for economic efficiency. One way to do this is through a numerical example in the form of a
table or diagram, as presented here. In addition, use of the diagram or table emphasizes the
important differences between the competitive outcome, the monopoly outcome, and the out-
comes of the different types (degrees) of price discrimination. Moreover, the numerical example
can be used to discuss the inefficiency of third-degree discrimination that arises when buyers
pay different prices for the marginal unit purchased.
(v) Address issues of distribution, particularly since the price-discriminating firm gains
profit by acquiring surplus from consumers. This also can be illustrated through a numerical
example, as we have shown here.
(vi) Discuss the practical difficulties of identifying price discrimination. Students should
be made aware of the importance of price differences that are not explained by cost differences,
the role of opportunity cost, and the important issues of market definition.
Price discrimination is complex. Often, in the attempt to simplify, the explanation actually
provides misleading or incorrect information. We believe, however, that price discrimination
can be presented at the introductory and intermediate levels in a way that is correct, yet simpler
and less confusing than we currently observe, so that students are not faced with misleading
information.
It is clearly inappropriate to attribute the practice of differential pricing to monopoly; price

discrimination may arise in any market in which firms are not price takers and they therefore
have even a small amount of market power. Situations of multiple pricing may reflect any
number of economic situations other than price discrimination, such as problems in market
definition, the existence of opportunity costs not accounted for explicitly by the firm, a situation
of competitive behavior indicating the absence of market power, or the presence of an alternative
market imperfection, such as asymmetric information.
The treatment of price discrimination is less misleading if it is presented as both a theo-
retical issue and a policy issue. The theoretical issue is concerned with the behavior that leads
to the efficiency and distributional effects of price discrimination. This requires distinguishing
between the two basic types (price discrimination by unit and by consumer group) and clearly
stating the conditions required in each case, so that students know what the practice is and
when it can occur. The policy issue involves both antitrust and regulatory policy. Either or both
can be examined to help students understand the meaning of social efficiency and the distinction
between efficiency and distribution.
Examples of price discrimination are pedagogically helpful. Students like them and they
have most likely had some experience with many of them. Providing examples classified ac-
cording to price discrimination by unit (first and second degree), and price discrimination by
consumer group (third degree) would be consistent with presentation of theory as we outline
above, and clearer to students.
Many students do not fully understand the concept of efficiency as social efficiency. Often
students believe that if a firm increases profit it is doing better, so it must be efficient. This is
the case if a firm is able to lower its cost and thereby increase its profit; it is not necessarily
the case when profit is increased by other circumstances. Witness the increase in a firm's profit
with a collusive agreement that replaces interfirm competition, or with third-degree price dis-
crimination with no corresponding increase in output. Although this profitable behavior may be
"efficient" for the firm (i.e., privately efficient) it is not socially efficient. Discussion of price
discrimination is a good opportunity to make this distinction.
Appendix
Note: All results are rounded.
Given: Demand of type 1 buyers: Q1 = 100 - 4P,
Demand of type 2 buyers: Q2 = 25 - 0.5P2
Long-run supply (S) = marginal cost = $20
1. Perfectly competitive market
Single demand:
QT = Ql + Q2 (100 - 4P1) + (25 - 0.5P2) = 125 - 4.5P
Therefore, inverted demand (D):
P = 27.8 - 0.224QT and MR = 27.8 - 0.448QT
Perfectly competitive equilibrium:
D =S
27.8 - 0.224QT = 20
QT =35
Pc = $20
Profit = 0
Consumer surplus = $275
Dead weight loss = 0
Note that, with constant costs, economic profit for each firm is also zero.
2. Nondiscriminating firm with market power
Demand:
QT = Ql + Q2 = (100 - 4P) + (25 - 0.5P2) = 125 - 4.5P
P = 27.8 - 0.224QT and MR = 27.8 - 0.448QT
Nondiscriminating equilibrium:
MR = MC
27.8 - 0.448QT = 20
QND = 17.5
PND = $24
Profit of nondiscriminating firm = $70
Consumer surplus = $172.70
Dead weight loss = $32.30
3. First-degree (perfect) price discrimination
Demand:
QT = Ql + Q2 = (100 - 4Pi) + (25 - 0.5P2) = 125 - 4.5P
P = 27.8 - 0.224QT = MRIstPD
Perfect price-discriminating firm equilibrium:
MR,,tpD = MC
27.8 - 0.224QT = 20
QlstPD = 35
Profit for first-degree price-discriminiting firm = $275.25 (= total consumer surplus)
Consumer surplus = 0
Dead weight loss = 0
4. Third-degree price discrimination
Demand of type 1 buyers: Q, = 100 - 4P,
Demand of type 2 buyers: Q2 = 25 - 0.5P2
Inverted demand (D1): P, = 25 - 0.25Q, MR, = 25 - 0.5QI
Inverted demand (D2): P2 = 50 - 2Q2 MR2 = 50 - 4Q2
Third-degree price-discriminating equilibrium by buyer type:
MR, = MC MR2 = MC
25 - 0.5QI = 20 50 - 4Q2 = 20
Ql = 10 Q2 = 7.5
P, = $22.50 P2 = $35
Comsumer surplus (CSI) = $12.50
Comsumer surplus (CS2) = $56.25
Note that Q0 + Q2 = 17.5 = QM and that total consumer surplus = $68.75
Profit for third-degree discriminating firm:
TRi = $225 TR2 = $262.50
Total cost of all output (TC) = $20(17.5) = $350
Profit3rdPD = TR, + TR2 - TC = $225 + $262.50 - $350 = $137.50 > ProfitND = $70
Dead weight loss (DWL3rdOD) = $68.75 > (DWLND) = $32.30
Note also that Profit3rdpD = $137.50 < Profit,lsPD = $275.25
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Teaching Price Discrimination - Some Clarification

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Teaching Price Discrimination - Some Clarification

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Teaching Price Discrimination: Some Clarification

Author(s): Kathleen Carroll and Dennis Coates

Teaching Price Discrimination: Some

Kathleen Carroll* and Dennis Coatest

2. Definition of Price Discrimination

Popular textbooks on industrial organization define price discrimination as differences in

3. Conditions for Price Discrimination

4. Effects of Price Discrimination

Table 1. Price Discrimination-Numerical Example

Demand in market 1: Q, =100 - 4P,. Demand in market 2 2: Q2 = 25 - 0.5P,.

12 Algebraic solutions to this problem are presented in the appendix.

"xR1 ' MR,t D

Figure 1. Competition, Monopoly, and First- and Third-Degree Price Discrimination

It is clearly inappropriate to attribute the practice of differential pricing to monopoly; price

Note: All results are rounded.

Given: Demand of type 1 buyers: Q1 = 100 - 4P,

Demand of type 2 buyers: Q2 = 25 - 0.5P2

Long-run supply (S) = marginal cost = $20

1. Perfectly competitive market

QT = Ql + Q2 (100 - 4P1) + (25 - 0.5P2) = 125 - 4.5P

Therefore, inverted demand (D):

P = 27.8 - 0.224QT and MR = 27.8 - 0.448QT

Perfectly competitive equilibrium:

Consumer surplus = $275

Dead weight loss = 0

2. Nondiscriminating firm with market power

QT = Ql + Q2 = (100 - 4P) + (25 - 0.5P2) = 125 - 4.5P

Therefore, inverted demand (D):

P = 27.8 - 0.224QT and MR = 27.8 - 0.448QT

Profit of nondiscriminating firm = $70

Consumer surplus = $172.70

Dead weight loss = $32.30

3. First-degree (perfect) price discrimination

QT = Ql + Q2 = (100 - 4Pi) + (25 - 0.5P2) = 125 - 4.5P

Therefore, inverted demand (D):

P = 27.8 - 0.224QT = MRIstPD

Perfect price-discriminating firm equilibrium:

Profit for first-degree price-discriminiting firm = $275.25 (= total consumer surplus)

Dead weight loss = 0

4. Third-degree price discrimination

Demand of type 1 buyers: Q, = 100 - 4P,

Demand of type 2 buyers: Q2 = 25 - 0.5P2

Inverted demand (D1): P, = 25 - 0.25Q, MR, = 25 - 0.5QI

Inverted demand (D2): P2 = 50 - 2Q2 MR2 = 50 - 4Q2

Third-degree price-discriminating equilibrium by buyer type:

Comsumer surplus (CSI) = $12.50

Comsumer surplus (CS2) = $56.25

Note that Q0 + Q2 = 17.5 = QM and that total consumer surplus = $68.75

Profit for third-degree discriminating firm:

TRi = $225 TR2 = $262.50

Total cost of all output (TC) = $20(17.5) = $350

Dead weight loss (DWL3rdOD) = $68.75 > (DWLND) = $32.30

Note also that Profit3rdpD = $137.50 < Profit,lsPD = $275.25

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