LOVELY PROFESSIONAL UNIVERSITY

Term Paper

School of Business Department of Management

Name of the Student: Azhar Shokin Regd. No.: - 11000968

Course Code: ECO515 Course Title: Managerial Economics
Course Instructor: Mr. Mandeep Singh Course Tutor: Mr. Mandeep Singh
Class: MBA Semester: 1st
Section: S1001 Batch 2010-12

Student’s Signature
Azhar Shokin

Topic: - Price Discrimination: Optimum Utilization of

resources or way of market penetration
 Contents

 Introduction
 Necessary Conditions
 Ways Of Discrimination
 Modern Taxonomy
 Explanation
 Consequences
 Real World Example (An Article By Phillip Leslie)
 Conclusion
 References
Introduction

Price discrimination or price differentiation exists when sales of identical goods or services

are transacted at different prices from the same provider. In a theoretical market with perfect
information, perfect substitutes, and no transaction costs or prohibition on secondary
exchange (or re-selling) to prevent arbitrage, price discrimination can only be a feature
of monopolistic and oligopolistic markets, where market power can be exercised. Otherwise,
the moment the seller tries to sell the same good at different prices, the buyer at the lower
price can arbitrage by selling to the consumer buying at the higher price but with a tiny
discount. However, product heterogeneity, market frictions or high fixed costs (which make
marginal-cost pricing unsustainable in the long run) can allow for some degree of differential
pricing to different consumers, even in fully competitive retail or industrial markets. Price
discrimination also occurs when the same price is charged to customers which have different
supply costs.

The effects of price discrimination on social efficiency are unclear; typically such behavior
leads to lower prices for some consumers and higher prices for others. Output can be
expanded when price discrimination is very efficient, but output can also decline when
discrimination is more effective at extracting surplus from high-valued users than expanding
sales to low valued users. Even if output remains constant, price discrimination can reduce
efficiency by misallocating output among consumers.

Price discrimination requires market segmentation and some means to discourage discount

customers from becoming resellers and, by extension, competitors. This usually entails using
one or more means of preventing any resale, keeping the different price groups separate,
making price comparisons difficult, or restricting pricing information. The boundary set up
by the marketer to keep segments separate is referred to as a rate fence. Price discrimination
is thus very common in services, where resale is not possible; an example is student discounts
at museums. Price discrimination in intellectual is also enforced by law and by technology. In
the market for DVDs, DVD players are designed - by law - with chips to prevent use of an
inexpensive copy of the DVD (for example legally purchased in India) from being used in a
higher price market (like the US). The Digital Millennium Copyright Act has provisions to
outlaw circumventing of such devices to protect the enhanced monopoly profits that
copyright holders can obtain from price discrimination against higher price market segments.

Price discrimination can also be seen where the requirement that goods be identical is
relaxed. For example, so-called "premium products" (including relatively simple products,
such as cappuccino compared to regular coffee) have a price differential that is not explained
by the cost of production. Some economists have argued that this is a form of price
discrimination exercised by providing a means for consumers to reveal their willingness to
pay.
Necessary Conditions for Price Discrimination

Essentially there are two main conditions required for discriminatory pricing

o Differences in price elasticity of demand between markets: There must be a different

price elasticity of demand from each group of consumers. The firm is then able to
charge a higher price to the group with a more price inelastic demand and a relatively
lower price to the group with a more elastic demand. By adopting such a strategy, the
firm can increase its total revenue and profits (i.e. achieve a higher level of producer
surplus). To profit maximise, the firm will seek to set marginal revenue = to marginal
cost in each separate (segmented) market.
o Barriers to prevent consumers switching from one supplier to another: The firm must
be able to prevent “market seepage” or “consumer switching” – defined as a process
whereby consumers who have purchased a good or service at a lower price are able to
re-sell it to those consumers who would have normally paid the expensive price. This
can be done in a number of ways, – and is probably easier to achieve with the
provision of a unique service such as a haircut rather than with the exchange of
tangible goods. Seepage might be prevented by selling a product to consumers at
unique and different points in time – for example with the use of time specific airline
tickets that cannot be resold under any circumstances.

Different Ways To Discriminate In The Pricing

Price discrimination is an extremely common type of pricing strategy operated by virtually

every business with some discretionary pricing power. It is a classic part of price competition
between firms seeking a market advantage or to protect an established market position.

Perfect Price Discrimination

Charging whatever the market will bear Sometimes known as optimal pricing, with perfect
price discrimination, the firm separates the whole market into each individual consumer and
charges them the price they are willing and able to pay. If successful, the firm can extract all
consumer surplus that lies beneath the demand curve and turn it into extra producer revenue
(or producer surplus). This is impossible to achieve unless the firm knows every consumer’s
preferences and, as a result, is unlikely to occur in the real world. The transactions costs
involved in finding out through market research what each buyer is prepared to pay is the
main block or barrier to a businesses engaging in this form of price discrimination.

If the monopolist is able to perfectly segment the market, then the average revenue curve
effectively becomes the marginal revenue curve for the firm. The monopolist will continue to
see extra units as long as the extra revenue exceeds the marginal cost of production.

The reality is that, although optimal pricing can and does take place in the real world, most
suppliers and consumers prefer to work with price lists and price menus from which trade can
take place rather than having to negotiate a price for each unit of a product bought and sold.
Second Degree Price Discrimination

This type of price discrimination involves businesses selling off packages of a product
deemed to be surplus capacity at lower prices than the previously published/advertised price.

Examples of this can often be found in the hotel and airline industries where spare rooms and
seats are sold on a last minute standby basis. In these types of industry, the fixed costs of
production are high. At the same time the marginal or variable costs are small and
predictable. If there are unsold airline tickets or hotel rooms, it is often in the businesses best
interest to offload any spare capacity at a discount prices, always providing that the cheaper
price that adds to revenue at least covers the marginal cost of each unit.

There is nearly always some supplementary profit to be made from this strategy. And, it can
also be an effective way of securing additional market share within an oligopoly as the main
suppliers’ battle for market dominance. Firms may be quite happy to accept a smaller profit
margin if it means that they manage to steal an advantage on their rival firms.

The expansion of e-commerce by both well established businesses and new entrants to online
retailing has seen a further growth in second degree price discrimination.

Early-bird discounts – extra cash-flow

The low cost airlines follow a different pricing strategy to the one outlined above. Customers
booking early with carriers such as Easy Jet will normally find lower prices if they are
prepared to commit themselves to a flight by booking early. This gives the airline the
advantage of knowing how full their flights are likely to be and a source of cash-flow in the
weeks and months prior to the service being provided. Closer to the date and time of the
scheduled service, the price rises, on the simple justification that consumer’s demand for a
flight becomes more inelastic the nearer to the time of the service. People who book late
often regard travel to their intended destination as a necessity and they are therefore likely to
be willing and able to pay a much higher price very close to departure.

Airlines call this price discrimination yield management – but despite the fancy name, at the
heart of this pricing strategy is the simple but important concept – price elasticity of demand!
Peak and Off-Peak Pricing

Peak and off-peak pricing and is common in the telecommunications industry, leisure
retailing and in the travel sector. Telephone and electricity companies separate markets by
time: There are three rates for telephone calls: a daytime peak rate, and an off peak evening
rate and a cheaper weekend rate. Electricity suppliers also offer cheaper off-peak electricity
during the night.

At off-peak times, there is plenty of spare capacity and marginal costs of production are low
(the supply curve is elastic) whereas at peak times when demand is high, we expect that short
run supply becomes relatively inelastic as the supplier reaches capacity constraints. A
combination of higher demand and rising costs forces up the profit maximising price.

Third Degree (Multi-Market) Price Discrimination

This is the most frequently found form of price discrimination and involves charging
different prices for the same product in different segments of the market. The key is that third
degree discrimination is linked directly to consumers’ willingness and ability to pay for a
good or service. It means that the prices charged may bear little or no relation to the cost of
production.

The market is usually separated in two ways: by time or by geography. For example,
exporters may charge a higher price in overseas markets if demand is estimated to be more
inelastic than it is in home markets.

MC=AC
�

Suppose that a firm has separated a market by time into a peak market with inelastic demand,
and an off-peak market with elastic demand. The demand and marginal revenue curves for
the peak market and off peak markets are labelled A and B respectively. This is illustrated in
the diagram above. Assuming a constant marginal cost for supplying to each group of
consumers, the firm aims to charge a profit maximising price to each group.

In the peak market the firm will produce where MRa = MC and charge price Pa, and in the
off-peak market the firm will produce where MRb = MC and charge price Pb. Consumers
with an inelastic demand for the product will pay a higher price (Pa) than those with an
elastic demand who will be charged Pb.

The internet and price discrimination

A number of recent research papers have argued that the rapid expansion of e-commerce
using the internet is giving manufacturers unprecedented opportunities to experiment with
different forms of price discrimination. Consumers on the net often provide suppliers with a
huge amount of information about themselves and their buying habits that then give sellers
scope for discriminatory pricing. For example Dell Computer charges different prices for the
same computer on its web pages, depending on whether the buyer is a state or local
government, or a small business.
Two Part Pricing Tariffs

Another pricing policy common to industries with pricing power is to set a two-part tariff for
consumers. A fixed fee is charged (often with the justification of it contributing to the fixed
costs of supply) and then a supplementary “variable” charge based on the number of units
consumed. There are plenty of examples of this including taxi fares, amusement park
entrance charges and the fixed charges set by the utilities (gas, water and electricity). Price
discrimination can come from varying the fixed charge to different segments of the market
and in varying the charges on marginal units consumed (e.g. discrimination by time).

Product-line pricing

Product line pricing is also becoming an increasingly common feature of many markets,
particularly manufactured products where there are many closely connected complementary
products that consumers may be enticed to buy. It is frequently observed that a producer may
manufacture many related products. They may choose to charge one low price for the core
product (accepting a lower mark-up or profit on cost) as a means of attracting customers to
the components / accessories that have a much higher mark-up or profit margin.

Good examples include manufacturers of cars, cameras, razors and games consoles. Indeed
discriminatory pricing techniques may take the form of offering the core product as a “loss-
leader” (i.e. priced below average cost) to induce consumers to then buy the complementary
products once they have been “captured”. Consider the cost of computer games consoles or
Mach3 Razors contrasted with the prices of the games software and the replacement blades!

Price skimming
In price skimming, price varies over time. Typically a company starts selling a
new product at a relatively high price then gradually reduces the price as the low price
elasticity segment gets satiated. Price skimming is closely related to the concept of yield
management.

Combination
These types are not mutually exclusive. Thus a company may vary pricing by location, but
then offer bulk discounts as well. Airlines use several different types of price discrimination,
including:

 Bulk discounts to wholesalers, consolidators, and tour operators

 Incentive discounts for higher sales volumes to travel agents and corporate buyers
 Seasonal discounts, incentive discounts, and even general prices that vary by location.
The price of a flight from say, Singapore to Beijing can vary widely if one buys the ticket
in Singapore compared to Beijing (or New York or Tokyo or elsewhere). In online ticket
 sales this is achieved by using the customer's credit card billing address to determine his
location.
 Discounted tickets requiring advance purchase and/or Saturday stays. Both
restrictions have the effect of excluding business travellers, who typically travel during
the workweek and arrange trips on shorter notice.
 First degree price discrimination based on customer. It is not accidental that hotel or
car rental firms may quote higher prices to their loyalty program's top tier members than
to the general public.

Modern Taxonomy

 Complete discrimination -- where each user purchases up to the point where the
user's marginal benefit equals the marginal cost of the item;
 Direct segmentation -- where the seller can condition price on some attribute (like
age or gender) that directly segments the buyers;
 Indirect segmentation -- where the seller relies on some proxy (e.g., package size,
usage quantity, coupon) to structure a choice that indirectly segments the buyers.
The hierarchy—complete/direct/indirect—is in decreasing order of

 profitability and
 Information requirement.
Complete price discrimination is most profitable, and requires the seller to have the most
information about buyers. Indirect segmentation is least profitable, and requires the seller to
have the least information about buyers.
Explanation

Sales revenue without and with Price Discrimination

The purpose of price discrimination is generally to capture the market's consumer surplus.

This surplus arises because, in a market with a single clearing price, some customers (the
very low price elasticity segment) would have been prepared to pay more than the single
market price. Price discrimination transfers some of this surplus from the consumer to the
producer/marketer. Strictly, a consumer surplus need not exist, for example where some
below-cost selling is beneficial due to fixed costs or economies of scale. An example is a
high-speed internet connection shared by two consumers in a single building; if one is willing
to pay less than half the cost, and the other willing to make up the rest but not to pay the
entire cost, then price discrimination is necessary for the purchase to take place.

It can be proved mathematically that a firm facing a downward sloping demand curve that is
convex to the origin will always obtain higher revenues under price discrimination than under
a single price strategy. This can also be shown diagrammatically.

In the top diagram, a single price (P) is available to all customers. The amount of revenue is
represented by area P, A,Q, O. The consumer surplus is the area above line segment P, A but
below the demand curve (D).

With price discrimination, (the bottom diagram), the demand curve is divided into two
segments (D1 and D2). A higher price (P1) is charged to the low elasticity segment, and a
lower price (P2) is charged to the high elasticity segment. The total revenue from the first
segment is equal to the area P1,B, Q1,O. The total revenue from the second segment is equal
to the area E, C,Q2,Q1. The sum of these areas will always be greater than the area without
discrimination assuming the demand curve resembles a rectangular hyperbola with unitary
elasticity. The more prices that are introduced, the greater the sum of the revenue areas, and
the more of the consumer surplus is captured by the producer.

Note that the above requires both first and second degree price discrimination: the right
segment corresponds partly to different people than the left segment, partly to the same
people, willing to buy more if the product is cheaper.

It is very useful for the price discriminator to determine the optimum prices in each market
segment. This is done in the next diagram where each segment is considered as a separate
market with its own demand curve. As usual, the profit maximizing output (Qt) is determined
by the intersection of the marginal cost curve (MC) with the marginal revenue curve for the
total market (MRt).

Multiple Market Price Determination

The firm decides what amount of the total output to sell in each market by looking at the
intersection of marginal cost with marginal revenue (profit maximization). This output is then
divided between the two markets, at the equilibrium marginal revenue level. Therefore, the
optimum outputs are Qa and Qb. From the demand curve in each market we can determine
the profit maximizing prices of Pa and Pb.

It is also important to note that the marginal revenue in both markets at the optimal output
levels must be equal, otherwise the firm could profit from transferring output over to
whichever market is offering higher marginal revenue.

Given that Market 1 has a price elasticity of demand of E1 and Market of E2, the optimal
pricing ration in Market 1 versus Market 2 is P1 / P2 = [1 − 1 / E2] / [1 − 1 / E1]
Consequences of Price Discrimination - Welfare and Efficiency Arguments
To what extent does price discrimination help to achieve a more efficient allocation of
resources? There are arguments on both sides of the coin – indeed the impact of price
discrimination on welfare seems bound to be ambiguous.

The impact on consumer welfare

Consumer surplus is reduced in most cases - representing a loss of consumer welfare. For the
majority of consumers, the price charged is significantly above marginal cost of production.
Those consumers in segments of the market where demand is inelastic would probably prefer
a return to uniform pricing by firms with monopoly power! Their welfare is reduced and
monopoly pricing power is being exploited.
However some consumers who can buy the product at a lower price may benefit. Previously
they may have been excluded from consuming it. Low-income consumers may be “priced
into the market” if the supplier is willing and able to charge them a lower price. Good
examples to use here might include legal and medical services where charges are dependent
on income levels. Greater access to these services may yield external benefits (positive
externalities) which then have implications for the overall level of social welfare and the
equity with which scarce resources are allocated.

Producer surplus and the use of profit

Price discrimination is clearly in the interests of businesses who achieve higher profits. A
discriminating monopoly is extracting consumer surplus and turning it into extra supernormal
profit. Of course businesses may not be driven solely by the aim of maximising profit. A
company will maximise its revenues if it can extract from each customer the maximum
amount that person is willing to pay.
Price discrimination also might be used as a predatory pricing tactic – i.e. setting prices
below cost to certain customers in order to harm competition at the supplier’s level and
thereby increase a firm’s market power. This type of anti-competitive practice is difficult to
prove, but would certainly come under the scrutiny of the UK and European Union
competition authorities.
A converse argument to this is that price discrimination may be a way of making a market
more contestable in the long run. The low cost airlines have been hugely successful partly on
the back of extensive use of price discrimination among consumers.
The profits made in one market may allow firms to cross-subsidise loss-making
activities/services that have important social benefits. For example profits made on commuter
rail or bus services may allow transport companies to support loss making rural or night-time
services. Without the ability to price discriminate these services may have to be withdrawn
and employment might suffer. In many cases, aggressive price discrimination is seen as
inimical to business survival during a recession or sudden market downturn.
An increase in total output resulting from selling extra units at a lower price might help a
monopoly supplier to exploit economies of scale thereby reducing long run average costs.
Real World Example
Price Discrimination In Broadway Cinema (Article By Phillip Leslie)
Broadway theatre refers to all plays and musicals performed in theatres in the Times
Square region of Manhattan, New York, with seating capacities in excess of 499. Typically,
the owner of a Broadway theatre rents the theatre to a show producer who decides, among
other things, the ticket prices for the show. In contrast to most performing arts organizations
the objective of Broadway theatre producers is to maximize profit. Ticket prices are not
subject to any specific regulation. The majority of tickets are sold over the phone. Some
tickets are also sold at the box-offices located at the theatres, or through a discount-booth
known as the TKTS. The Broadway play that is the focus of this study is Seven Guitars. Each
Broadway show develops its own idiosyncratic approach to the marketing of their product,
with respect to price discrimination; however, Seven Guitars is a typical example of behavior
in the industry. Seven Guitars provides a good example of discriminatory pricing. There is
little doubt that the price differences which are evident in a given performance cannot be
explained by differing costs—the marginal cost of every ticket sold for a given performance
is effectively zero. Moreover, while the number of seats in the theatre presents a capacity
constraint for the firm, suggesting the presence of a variable shadow cost of capacity, this
constraint is rarely binding for Seven Guitars. With a maximum seating capacity of 947, the
show sold out for 12 of the 199 performances, achieving an average attendance of 75% of
capacity, or 707 people per performance (with a standard deviation of 157.15). Balcony
seating is the only individual ticket category to be sold out in more than 12 performances, in
that case selling out 23 times. Hence, congestion is not a significant issue in the data,
although ex-ante it might have been. The primary source of data for this study is the box
office report for Seven Guitars from which I observe price and quantity sold in each mutually
exclusive sales category for every performance. In a single performance there could be
attendees from all 17 categories, though on average only 8.7 of the categories are
represented in a given performance. A total of 140,782 people saw the Broadway production
of Seven Guitars. An important distinction among ticket categories is between full-price
tickets and discount- price tickets. Full-price tickets are for a specific area of seating, namely
orchestra, mezzanine, rear-mezzanine, balcony, boxes and standing room. These regions are
differentiated by the average quality of the seating, or view, that is offered. All full-price
options are available to all potential consumers and are sold via telephone. Discount-price
tickets are available under various conditions. Some discount-price tickets are only available
to individuals who receive a coupon in the mail or happen to come across one in a restaurant
or some other chosen location. Another kind of discount, while available to all potential
consumers, requires consumers to incur a non-pecuniary cost of having to wait in line at a
discount booth. For discount-price tickets, the buyers are seated in the high quality region of
the theatre, such as the orchestra, though generally not in the best seats within that region.
Table 1 presents summary statistics for prices, quantities and revenues of each ticket
category. The mean prices for all ticket sales in all performances are $36.43 with a standard
deviation of $15.11. The average Gini coefficient is .201 (standard deviation .040), indicating
that the expected absolute difference between any two ticket prices selected at random is 40
per cent of the mean price. By way of comparison, in a study of prices in the airline industry
by Bronstein and Rose (1994), they find an average (across flights) Gini coefficient of .181
(standard deviation.063) which implies the expected absolute difference between any two
fares selected at random is 36 per cent of the mean fare.
 Price Variation and Demand Identification

Table also indicates the different kinds of price variation that serve to identify
demand. There are two types of price variation. First, prices vary across the different ticket
categories. The mean price for orchestra tickets is $55.08. Other categories have lower
average prices, such as the balcony with an average price of $16.93. The second type of price
variation is changes over time (across performances) in the prices of each ticket category.
This variation is reflected in the second column of numbers in Table 1, showing the standard
deviation of prices for each ticket category.
As usual with demand estimation, there is a question about the endogeneity of prices. What
explains the observed variation in prices, and is it sufficient to identify the effect of price on
demand? Consider first the price variation across the full-price ticket categories. The price of
an orchestra ticket is higher than a balcony ticket because seat quality is higher in the
orchestra than in the balcony. As explained in the next section, I estimate the different seat
qualities in the demand system. Seat quality is therefore not contained in an error term,
precluding this particular source of correlation between prices and a residual. But functional
form assumptions are now relied on to utilize this source of variation to identify the effect of
price on demand. Next, consider the time-series variation in prices for the full-price tickets.
Prices for full-price ticket categories vary across performances due to pre-determined peak-
load pricing—performances for different times in the week are priced differently. For
example, Saturday evening orchestra tickets are priced higher than Sunday matinee orchestra
tickets. This price variation is decided by the producer prior to the first performance and is
not changed over the life of the show. Analogous to the price variation across seat qualities,
in this case I estimate time-of-week effects as part of the demand specification. Again, this
precludes the usual endogeneity concern, but limits identification of the price effect from this
source of variation to rely on functional form. While every seat in the theatre may differ in
quality, the firm used only three seat quality categories for the purpose of setting different
prices (at full-price). But for most of the performances, only two quality categories were
used. The medium-quality region was offered at a different price in only 50 of the 199
performances, the first time in the 133rd performance. This provides a useful source of price
variation. For a given seat quality, for given time-of-week, there is variation in the ticket
price. Furthermore, while the introduction of the medium-quality tickets is correlated with the
time-trend (presumably it was done as a response to dwindling demand over time), the time-
trend is a smooth process, while this variation is discrete. For these reasons, variation in the
availability of medium-quality tickets provides a useful source of
price variation to identify the demand system. There is also price variation in the discount-
price ticket categories. Rather than attempt to estimate demand for all ten of the discount
ticket categories, I distinguish only two types of discounts: coupon and booth. I define the
coupon category as the aggregation of all discount categories except TKTS. The key feature
of the coupon category is that it includes all discount categories that are restricted to
individuals who either received an actual coupon or are members of specific organizations or
groups. That is to say, these categories are interpreted as a form of third-degree price
discrimination. Given this aggregation, the mean coupon ticket price in the data is $31.01,
with a standard deviation of $8.71. The mean number of coupon tickets sold is 252.63, with a
standard deviation of 167.62. What explains the time-series variation in the coupon price? It
is partly driven by time-of-week peak load pricing, as with the time-series variation for the
full-price tickets. But unlike the full-price tickets, day-of-week dummies explain relatively
little of the variation in the coupon price. The coupon price variation is mainly due to the firm
trying different ways of offering targeted discounts. For example, targeted direct-mail
coupons were used in the early performances, while two-fer one tickets were not introduced
until mid-way during the run of the show. According to the producer of Seven Guitars, this
variation in coupon availability reflects standard marketing practices for Broadway shows,
than any deliberate technique for changing price in the face of fluctuating demand. In other
words, there is some reason to view this source of price variation as being exogenous. To the
extent that the time-series variation in the coupon price is not exogenous, the demand
specification includes time-of-week dummies, a quadratic time trend and a dummy for after
the Tony Awards which took place in the middle of Seven Guitars run. These variables
should control for many of the obvious explanations of this price variation. The remaining
variation in the coupon price over time may be an exogenous component. The second type of
discount is the booth ticket category, which corresponds to the TKTS category in the data.
Below I explain the interpretation of this category. TKTS tickets were available for Seven
Guitars in 197 of the 199 performances. The number of tickets made available at the TKTS
booth varied from day to day, based on the number of unsold tickets up until the morning of
the performance. In terms of price variation, note that booth tickets are sold at a 50% discount
off the top full-price (plus a $2.50 service charge). Consequently, the same issues
arise as with the price variation in the full-price ticket categories, described above. In
summary, there are several kinds of price variation in the data that serve to identify the
demand system. Some of this variation is helpful only in conjunction with functional form
assumptions, which will be detailed in the next section. To what extent the particular
functional form assumptions which are used can be motivated by economic considerations,
will also be discussed at the next section. Meanwhile, there are other components of the price
variation that should provide identification independently of functional form.

Day-of-Performance Booth Ticket Sales as a Damaged Good

The defining characteristic of booth ticket sales that I seek to incorporate in the
demand model is that consumers must physically attend the booth on the day of the
performance to purchase tickets. It is interesting that firms choose to sell tickets via this
method. Despite having an effective telephone sales mechanism already available for the sale
of tickets, the theatre producer chooses not to use this mechanism for discount sales on the
day of the performance, instead forcing consumers to incur the disutility associated with
purchasing a ticket at the booth. I interpret this ticket category as a deliberately damaged
version of the product. The firm chooses to make the good less attractive than it would
otherwise be. This would be an example of a damaged good, as modelled by Deneckere and
McAfee (1996). However, the conventional damaged goods explanation is not entirely
adequate in this case, for the following reason. There is actually significant variation in seat
quality within the orchestra region of the theatre, which I discuss below. Despite this quality
variation, there is no variation in price for full-price tickets in the orchestra (for a given
performance). One consumer may buy a full-price ticket over the phone for the orchestra, pay
$55 and get the best seat in the orchestra. Another consumer may also buy a full-price ticket
over the phone for the orchestra, pay $55 and get the worst seat in the orchestra. While this
may seem puzzling, note that discount ticket purchasers will generally obtain a seat in the
orchestra. In particular, booth ticket buyers (i.e. TKTS sales) tend to be seated in the
orchestra, typically in the lower quality seats within the orchestra. Hence, there is variation in
prices paid by people seated in the orchestra at a given performance, but this is due to the
pricing of discount ticket categories rather than variation in the price of full-price tickets. An
alternative to selling booth discount tickets and seating the buyers in the orchestra would be
to sub-divide the orchestra into high and low quality seats, set two different prices, and sell
tickets over the phone. This would accomplish the same goal in terms of having multiple
prices for orchestra seats and using quality differences to facilitate sorting of consumers.
Moreover, this alternative may be preferred, since consumers are not required to incur any
disutility from having to line-up at a booth on the day of performance, providing a greater
overall surplus. To provide a justification for the firm preferring booth ticket sales over
orchestra-sub-division, I allow for the possibility that the disutility of attending the booth
depends on consumer’s willingness to pay for seat quality (i.e., their income). By
incorporating type-dependent disutility into the damaged-goods framework, there is now the
potential for the firm to prefer booth ticket sales over orchestra-sub-division. While booth
ticket sales and orchestra-sub-division would provide tickets in the lower quality seats within
the orchestra, the booth has the added advantage of being even less attractive to high income
people.
Conclusion

1. Price discrimination is clearly in the interests of businesses who achieve

higher profits.

2. Price discrimination also might be used as a predatory pricing tactic – i.e.

setting prices below cost to certain customers in order to harm competition at
the supplier’s level and thereby increase a firm’s market power.

3. The purpose of price discrimination is generally to capture the

market's consumer surplus. This surplus arises because, in a market with a
single clearing price, some customers (the very low price elasticity segment)
would have been prepared to pay more than the single market price.

4. Price discrimination transfers some of this surplus from the consumer to the
producer/marketer.

5. Complete price discrimination is most profitable, and requires the seller to

have the most information about buyers.

6. Price discrimination is an extremely common type of pricing strategy operated

by virtually every business with some discretionary pricing power.

7. It is a classic part of price competition between firms seeking a market

advantage or to protect an established market position.

8. The effects of price discrimination on social efficiency are unclear; typically

such behavior leads to lower prices for some consumers and higher prices for
others.

9. Output can be expanded when price discrimination is very efficient, but output
can also decline when discrimination is more effective at extracting surplus
from high-valued users than expanding sales to low valued users.
 References

http://en.wikipedia.org/wiki/Price_discrimination.
http://tutor2u.net/economics/revision-notes/a2-micro-price-discrimination.html
www.benafrica.org/downloads/Elegido,%20Juan.pdf
www.ask.com/questions-about/Examples-of-Price-Discrimination
R. Preston McAfee, Price Discrimination, in 1 ISSUES IN COMPETITION LAW AND POLICY 465 (ABA Section of Antitrust Law 2008)
Borenstein, S. “Selling Costs and Switching Costs: Explaining Retail Gasoline Margins,” RAND Journal of Economics, Vol. 22
(1991), pp. 354–369.
Borenstein, S. and N.L. Rose “Competition and Price Dispersion in the U.S. Airline Industry,” Journal of Political Economy,
Vol. 102 (1994), pp. 653–683.