L02 Price Discrimination (II)

Price Discrimination
Lecture 2
Chapter 10, Sections 10.4, 10.5, 10.6
Navin Kumar & Sheng-Hao Lo
Harris School of Public Policy
Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 1

Previously
I In the last class we talked about pricing strategy

I Firms in perfectly competitive markets have none
I Monopolists that can’t prevent resale can’t price
discriminate
I Firms with market power that can prevent resale have a
few tricks up their sleeves
I Perfect price discrimination: Charge each consumer their
willingness to pay for each unit of good
I Segmenting: Charge different groups different prices

Today
I Today, we’ll discuss a few more tricks

I Quantity discounts: Selling bundles of a good at different
per-unit prices
I Versioning: Selling similar products at vastly different
prices
I Bundling: Selling different products together as a bundle
I Block pricing: Reducing the price of a good when buyers
purchase more
I Two-part tariffs: Charging a membership fixed fee and a
per-unit fee of good or service

Main shift
I Previously the “demand curve” referred to the entire market

I Today, we’ll mostly be focusing on individual demand
curves - how much a representative consumer would
purchase at a given price

Quantity discounts
Section 10.4

Quantity discounts
I Indirect price discrimination: A pricing structure in which

consumers choose between sets of goods offered by the
firm
I Also called Second-degree price discrimination
I Quantity discount: A pricing structure in which consumers
who purchase larger quantities of a good pay a lower
per-unit price
I Arises when
I There are two or more types of consumers
I Firms cannot tell them apart
I Firms set up the pricing options and let the customers sort
themselves into the ”right” choice

The market for mystery novels
I Suppose that there are two types of mystery novel readers

I Vacationers
I They buy the occasional novel to read on a plane or beach
I They are less sensitive about the price
I Commuters
I Buy a lot of novels to read on the daily train ride
I Are willing to spend time shopping around for a good deal
I Are sensitive to price
I If the price is very high, they’ll switch to romance novels
I Sales occur online, and so publishing companies can’t tell
them apart

The two types of readers
Vacationer’s individual demand Commuter’s individual demand
curve: high intercept, low curve: low intercept, high
elasticity elasticity
Price
Price
D D
Quantity Quantity
Optimal strategy if you can tell them apart
Vacationers: high price, low Commuters: low price, high
quantity quantity
Price
Price
pv
pc
MC D MC
MR
MR D
qv Quantity qc Quantity

Optimal strategy
I Vacationers would be charged a high price & consume a

low quantity
I Commuters would be charged a low price & consumer a
high quantity
I In practice, however, the publishers can’t tell them apart
I Solution: offer only two bundles
I Vacation Bundle gives you qv goods for $pv per unit
I Commuter Bundle gives you qc goods for $pc per unit

Optimal strategy
I This will work if

I Vacationers prefer the Vacation Bundle to the Commuter
Bundle
I Commuters prefer the Commuter Bundle to the Vacation
Bundle
I This is called incentive compatibility

Incentive compatibility for commuters
Price
I What if the Commuters
bought the Commuting
Bundle?
I The green area in this
figure is the total welfare pc
gained from purchasing D
these novels
qc Quantity

Price
I The red area is the cost
paid by the commuter
pc
D
qc Quantity

Price
I The green area here is the
consumer surplus
pc
D
qc Quantity

Price
I What if commuters bought
the Vacation Bundle? pv
I The green area represents
the total benefit from
purchasing qv novels D
qv Quantity

Price
I The red area represents pv
the cost of purchasing qv
novels
D
qv Quantity

Price
I The yellow area represents
the net cost of purchasing
the vacation bundle pv
I Conclusion: commuters
will never purchase the
”expensive” vacation D
bundle
qv Quantity

Incentive compatibility for vacationers
Price
I What if the Vacationers
bought the Vacation
Bundle? pv
I The green area in this
figure is the total welfare
gained from purchasing
these novels
D
qv Quantity

Price
pv
I The red area is the cost
paid for the bundle
D
qv Quantity

Price
I The green area in this pv
figure is consumer surplus
for a vacationer
D
qv Quantity

Price
I What if the Vacationers
bought the Commuter
Bundle?
I The blue area in this figure
is the total welfare gained pc
from purchasing these
novels
D
qc Quantity

Price
I The red area in this figure
is cost of buying that
bundle
pc
D
qc Quantity

Price
I The consumer surplus is
the blue area minus the
red area
I Some of the costs and
benefits cancel out cleanly
pc
I The net consumer surplus
is what’s left here
D
qc Quantity

Price
I Let’s put it all together
I Consumer surplus from A
buying the Vacation pv
Bundle: Uv (V ) = A
I Consumer surplus from B
pc
buying the Commuter C
Bundle: Uv (C) = A + B − C
D
qc Quantity

Price
I Vacationer will prefer the
Vacation Bundle if
A
pv
Uv (V ) > Uv (C)
⇒A>A+B−C B
⇒0>B−C pc
C
⇒C>B
D
qc Quantity

I Switching to the Commuter
Price
Bundle gains them an
additional B but costs them
an additional C A
pv
I Vacationers will switch if
the benefits exceed the B
costs pc
I In this particular example, C
vacationers would rather
buy the commuter bundle D
qc Quantity

Versioning
Section 10.4

Hardcover vs paperback books
I When publishers first release a book, they release it as a

hardcover, for ∼ $26
I Six months later they will release a paperback version for
∼ $14
I It’s the same story!
I Giving a book a hardcover does not cost an extra $13!
I So why?

Hardcover vs paperback books
I Key is timing:
I Fans of the author want to read the story on the day that it
comes out; their valuation of the book is high
I Casual readers are willing to wait for the paperback; their
valuation of the book is relatively low
I Versioning: a business practice in which a firm produces
different models of the same product and then charges
different prices for each model
I Also known as “quality discrimination”

Setup
I Consider a world where

the marginal cost of
making a book is 0
I People have the Paperback Hardcover
evaluations given here Fan $17 $30
I Being able to read early is Casual $15 $20
nice - both fans and casual
readers have a higher
willingness to pay for
hardcovers

Casual readers
I Casual readers are simply

uninterested in a hardcover
that costs $26 Paperback Hardcover
I They get -$6 consumer Fan $17 $30
surplus from that Casual $15 $20
transaction Price $14 $26
I They will wait for the
paperback and earn +$1

Fans
I When fans buy a

hardcover, they get a
benefit of +$4 Paperback Hardcover
I If they wait for the Fan $17 $30
Casual $15 $20
paperback, they would get
Price $14 $26
a benefit of only +$3
I They will purchase the
hardcover!

Other examples
I Business travellers vs holiday travellers

I Business travellers tend to be less price sensitive, because
their firm is covering the expense
I Business travellers tend to book their tickets closer to the
date of travel
I Result: ticket prices tend to increase as the day of the flight
draws closer
I Ticket prices tend to be higher during the day (when
business travellers book their flights) than the evening
(when holiday travellers do)

Other examples
I First class tickets cost 214% more than economy seats,

but only provide 45% more space
I Throttling: Firms will sell the same product with some
features removed for a lower price (e.g. internet
connections, printers etc.)

Bundling
Section 10.5

Bundling
I Bundling: price-discrimination strategy in which the firm

sells two or more products together at a single price

Software
I Suppose that Microsoft sells software to two kinds of

people: writers and accountants
I They sell two kinds of software: spreadsheet software
Excel and word-processing software Word
I The willingness to pay for these groups is given below:
Word Excel
Writers $5 $2
Accountants $2 $5
I Marginal cost of production is 0
I How should Microsoft set their pricing strategy?

Software
I One solution: set a price

such that both will
purchase both goods Word Excel
seperately Writers $5 $2
I Prices: $2 for each Accountants $2 $5
software
I Total revenue = $8

Software
I Another solution: set a

price such that one of the Word Excel
two will purchase a good Writers $5 $2
I Prices: $5 for each Accountants $2 $5
software

Software
I Bundling: sell both goods

Word Excel
as a package deal Writers $5 $2
I Prices: $7 for the package Accountants $2 $5

When does this arise?
Bundling will work if:

I A firm (or partnership) has market power in two (or more)
markets
I Willingness to pay for the two (or more) goods is negatively
correlated across the consumers

Example: Negatively Correlated Valuations per
Subscriber-Month
I Madison has higher

willingness to pay for
ESPN than Dakota
I but lower willingness to
pay for truTV ESPN truTV Bundle
I If the firm sells the Dakota $9 $1.5 $10.5
channels separately: Madison $10 $1 $11
ESPN for $9, truTV $1,
total revenue = 20
I If the firm sells the
bundle for $10.5: total
revenue = 21 > 20

Mixed Bundling
I Mixed bundling: a pricing

strategy in which a firm
offers consumers the
choice of buying each Word Excel
product separately or as a Writers $5 $2
bundle Accountants $2 $5
I Firm offers different
options and lets customers
sort themselves

Mixed Bundling
I Suppose we have also

have poets, who have no
use for Excel but really Word Excel
need Word Writers $5 $2
I The revenue-maximizing Accountants $2 $5
Poets $6 $0
strategy is to offer Word
alone for $6 and the
bundle for $7

Mixed Bundling
I Fast food restaurants give you a choice between burgers,

fries, and soda, but also offer a “meal” bundle of all three

Block Pricing
Section 10.6

Buying jackets
I Every year Prof Kumar
Price
loses all of his jackets (he
does not know where they
go) and must buy new 60
ones
I He buys jackets only from
Uniqlo
MC
I He will buy two jackets
from them, at $60 each D
MR
2 Quantity

Welfare
Price
I Blue triangle is the
consumer surplus
I Green rectangle is the 60
producer surplus
I There is substantial
deadweight loss (red
MC
triangle)
D
MR
2 Quantity

Block pricing
Price
I Uniqlo has an offer: buy 2
jackets, get 33% off the
third! 60
I Will Prof Kumar take the 40
offer?
I Yes! MC
D
MR
2 3 Quantity

Welfare with block pricing
Price
I With block pricing
I Consumer surplus is
60
higher
I Producer surplus is
40
higher
I Deadweight loss is lower
MC
D
MR
2 3 Quantity

Block pricing
I Definition: The practice of reducing the price of a good

when the customer buys more of it
I Does not require that buyers have different demand curves
I Example: medium fries vs large fries

Two-Part Tariffs
Section 10.6

Two-part tariffs
I Some markets see companies charging not one, but two

prices
I A membership fee that allows consumers to purchase items
at all
I And a per-unit price for each item they buy
I Why?

Standard pricing strategy
I Consider a theme park that
Price
sells tickets to rides
I Marginal cost is $1 per ride
CS
I A representative consumer p
has the demand curve PS
shown here
I Simple solution: charge DWL
MC
the profit-maximizing price
I Welfare effects shown MR
D
q Quantity

Setup
10
I Let’s plug in some
numbers as for illustration
I Suppose that, instead, the
theme park owner charges
this consumer $1 per ride
I How much would the
1 MC
consumer consume?
D
Quantity

Quantity
I Ans: they would consume

10
up to the level of output
where the demand curve
intersects with the $1 line
I D is just the willingness to
pay
I They will consume as long
as WTP ≥ 1 1 P
I For the sake of argument,
D
let’s say that this is 10 units
10 Quantity

Consumer surplus (for now)
I What’s the consumer 10

surplus now?
I (i.e. in the absence of any
membership fee)
I Ans: Area of the triangle CS = 45
1
Area = ×B×H
2 1 P
= 0.5 × 9 × 10
= 45 D
10 Quantity

Membership fee
I Suppose that the

membership fee was $20 -
what’s the consumer 10
surplus now?
I Ans: $45 - $20 = $25
I Does it make sense for the
consumer to buy 45
membership?
I What if the fee was $30? 1 P
I What if it was $40?
D
I What if was $50?
I What if it was $44.99? 10 Quantity

Membership fee
10
I $45 (minus a penny) is the
maximum that the theme
park can charge as
membership fee 45
I The consumer will
pruchase membership
1 P
I Then buy 10 units
D
10 Quantity

Two part tariffs
Price
I In the case of two part
tariffs, firms will set two
prices
I Per unit price = the A
marginal cost c
I Membership fee = the size
c MC
of consumer surplus A
D
q∗ Quantity

Welfare
Price
Price
CS
p
PS PS
DWL
MC MC
D D
MR
q Quantity q∗ Quantity
Figure: Without two part tariffs Figure: With two part tariffs

Welfare
Price
I Deadweight loss falls
PS
I Consumer surplus falls
I Producer surplus rises
MC
D
q∗ Quantity
Figure: With two part tariffs

Examples
I Costco - cheap goods, but you need a membership

I Disneyland - rides are (mostly) free but entry is expensive
I Gym memberships

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Price Discrimination

Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 1

I In the last class we talked about pricing strategy

Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 2

I Today, we’ll discuss a few more tricks

Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 3

I Previously the “demand curve” referred to the entire market

Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 4

Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 5

I Indirect price discrimination: A pricing structure in which

Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 6

I Suppose that there are two types of mystery novel readers

Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 7

Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 9

I Vacationers would be charged a high price & consume a

Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 10

I This will work if

Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 11

Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 12

Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 13

Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 14

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Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 23

Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 24

Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 25

I Switching to the Commuter

Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 26

Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 27

I When publishers first release a book, they release it as a

Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 28

Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 29

I Consider a world where

Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 30

I Casual readers are simply

Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 31

I When fans buy a

Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 32

I Business travellers vs holiday travellers

Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 33

I First class tickets cost 214% more than economy seats,

Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 34

Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 35

I Bundling: price-discrimination strategy in which the firm

Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 36

I Suppose that Microsoft sells software to two kinds of

Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 37

I One solution: set a price

Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 38

I Another solution: set a

Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 39

I Bundling: sell both goods

Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 40

Bundling will work if:

Harris School of Public Policy PPHA32400 · Winter 2022 · Kumar & Lo · 41

I Madison has higher