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. 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 highvalued 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. Price discrimination is thus very common in services where resale is not possible; an example is student discounts at museums. Prie discrimination in intellectual property is also enforced by law and by technology. In the market for DVDs, DVD players are designed - by law - with chips to prevent an inexpensive copy of the DVD (for example legally purchased in India) from being used in a higher price market (like the US). Forms of price discrimination There are numerous business practices which fall under the heading of price discrimination. First, consider static situations in which consumers buy all relevant products in a single period. In most markets, firms set the charge for purchase of their products by means of a simple price per unit for each product, where these prices do not depend on who makes the purchase. Such tariffs (i) are anonymous (they do not depend on the identity of the consumer), (ii) do not involve quantity discounts for a specific product (i.e., there are no “intraproduct” discounts), (iii) do not involve discounts for buying a range of products (i.e., there are no “inter-product” discounts) Types of price discrimination 1.First degree price discrimination

3. A customer with low price elasticity is less deterred by a higher price than a customer with high price elasticity of demand. price varies by attributes such as location or by customer segment. sellers are not able to differentiate between different types of consumers. if one is willing to pay less than half the cost. is inversely proportional to one minus the reciprocal of the price elasticity of that customer at that price. price varies according to quantity sold. Examples of this differentiation are student or senior discounts. by the individual customer's identity. quantity "discounts". Additionally to second degree price discrimination. For example. where the attribute in question is used as a proxy for ability/willingness to pay. Thus. This allows the supplier to set different prices to the different groups and capture a larger portion of the total market surplus. This is particularly widespread in sales to industrial customers. it is very advantageous to increase the price: the seller gets more money for fewer goods. 2. As above. Second degree price discrimination In second degree price discrimination. Value-based pricing). Additionally to third degree price discrimination. the supplier sets a lower price for that consumer because the student or senior has a more elastic price elasticity of demand (see the discussion of price elasticity of demand as it applies to revenues from the first degree price discrimination. Larger quantities are available at a lower unit price. As long as the price elasticity (in absolute value) for a customer is less than one. or non-linear pricing. above). An example is a high-speed internet connection shared by two consumers in a single building. This arises from the fact that the value of goods is subjective. With an increase of the price elasticity tends to rise above one. is a means by which suppliers use consumer preference to distinguish classes of consumers. The supplier is once again capable of capturing more market surplus than would be possible without price discrimination. . price varies by customer's willingness or ability to pay (cf. a student or a senior consumer will have a different willingness to pay than an average consumer. where the reservation price is presumably lower because of budget constraints. Thus. or in the most extreme case. the suppliers will provide incentives for the consumers to differentiate themselves according to preference. One can show that in the optimum the price.In first degree price discrimination.Third degree price discrimination In third degree price discrimination. where bulk buyers enjoy higher discounts. as it varies by customer. The purpose of price discrimination is generally to capture the market's consumer surplus. the supplier(s) of a market where this type of discrimination is exhibited are capable of differentiating between consumer classes.

The amount of revenue is represented by area P. A but below the demand curve (D). then price discrimination is necessary for the purchase to take place. A. 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. O. a single price (P) is available to all customers. This can also be shown diagrammatically.and the other willing to make up the rest but not to pay the entire cost. Q. The consumer surplus is the area above line segment P. . In the top diagram.

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. since the discriminating-pricing firm does not have to lower its price for all units just to sell one more unit. The total revenue from the first segment is equal to the area P1. Because the single-pricing firm must charge the same price for all buyers. Psp < MC. its marginal revenue (MRdp) is equal to MWP. Because it must lower the uniform price for every unit just to sell just one more unit. The more prices that are introduced. C. marginal benefit to the consumer is always equal to marginal cost to the . Maximum-profit output Just like the single-pricing firm. So when MRsp = MC. and a lower price (P2) is charged to the high elasticity segment. TWP reaches its maximum when price charged is equal to zero. MR < P. And because MWP is the reservation price paid by each buyer (Pdp). But the single-pricing price (Psp) applies to all units sold. Since MRdp = Pdp. MRdp = Pdp. And under discriminating pricing. The pricediscriminating price (Pdp) applies to only the additional unit sold. Profit and Efficiency Maximization under single vs discriminating pricing Single-pricing firm A single-pricing firm sells every unit at a uniform price. Marginal willingness to pay (MWP) is measured by the slope of tangent to TWP.e. the total revenue generated will be much larger.. and the more of the consumer surplus is captured by the producer. the greater the sum of the revenue areas. A higher price (P1) is charged to the low elasticity segment. MWP coincides with the demand curve itself. the reservation price). P along the same demand curve for the same output is identical.Q1. In addition. Its total revenue (TR) reaches a maximum when the elasticity of demand = |1| before price falls to zero. But it is MRdp = MC. This total revenue generated through perfect price discrimination can be called total willingness to pay (TWP)*. Q1. The total revenue from the second segment is equal to the area E.Q2. (the bottom diagram). so Pdp = MC at the maximum-profit output. the demand curve is divided into two segments (D1 and D2).B. the maximum-profit output under discriminating pricing is always larger than the maximum-profit output under single pricing. Discriminating-pricing firm If the price searcher can sell each unit of output according the buyer's willingness to pay (i. the discriminating-pricing firm produces at an output level where MR = MC to maximize profit.O. Therefore.With price discrimination. MRsp < Psp. When the single-pricing firm and the discriminating-pricing firm are faced with the same demand curve. Since each buyer is charged its reservation price.

maximum profit for the discriminating-pricing firm is much higher and output is much larger. all economic surplus becomes economic profit to the producer. – Instances when we might expect it to decrease with output (economies of scale) Profit Maximization: The General Rule π=R–C .TR) and economic profit (TR . This condition translates into P = MC where P is taken to mean the marginal benefit of the last unit bought. Marginal Cost (MC) is the "additional cost of an additional unit of output" – Generally we argue that for the "relevant" range of output. Marginal Revenue (MR) is "the additional revenue from an additional unit of output". maximizing profit will also maximize efficiency under discriminating pricing. When the single-pricing maximum-profit output produces positive profit. – Total cost is increasing with output. Distribution of economic surplus Economic surplus is the difference between what buyers are willing to pay (TWP) and what it costs sellers to produce (TC) under both single pricing and discriminating pricing. Economic surplus is maximized when MB (marginal benefit) = MC (marginal cost). R/Q. Economic efficiency is maximized when economic surplus is maximized. both consumer surplus and economic profit are positive. When profit is zero/negative under single pricing vs discriminating pricing Even when the single-pricing firm is just earning zero profit. the discriminating-pricing firm can still manage to earn positive profit by charging each unit according to the buyer's reservation price. In fact. the discriminating-pricing firm may still be able to produce at a profit by capturing the entire consumer surplus. And when the single-pricing firm can no longer afford to stay in business. But more units can also be bought at different affordable prices by consumers. – MR decreases with Q Total Cost=C(Q) depends on output. So the higher output under price discrimination comes at the expense of consumer surplus.producer (MB = MC). Under perfect price discrimination.TC). Consumer surplus is equal to zero. Conditions for Profit Maximization Revenue (R) = price•quantity = P•Q. is simply price. Because every unit is sold at the buyer's reservation price. – Formally we have MR =dR/dQ. output exceeds the ATCmin level. Under single pricing. – Note that "average revenue". economic surplus is divided between consumer surplus (TWP . MC is increasing in output . In other words.

– (Profit = Revenue – Cost) Then π-maximization occurs at: – ∆π/∆Q = 0 → – ∆R/∆Q – ∆C/∆Q = MR – MC=0 Profit Maximization Figure 1b 5000 4500 4000 3500 R(Q) 3000 C(Q) $ 2500 2000 1500 1000 500 0 0 50 100 150 200 250 Q 300 350 400 450 500 .

R 6M 4 2 0 0 50 100 150 200 250 300 350 400 450 500 Figure 1c MC MR Q Graphical Example of MR=MC .Profit Maximization (2) 20 18 16 14 12 10 8C M .

We can solve this algebraically MR = MC--> 10.(1/10)(35) = 6. • Given no marginal costs.Figure 3 10 9 8 7 D ) $ ( P 6 5 MR MC 4 3 2 1 0 0 10 20 30 40 50 60 70 80 90 100 Q Solving for Profit-Maximizing Price and Quantity In the figure given the MR and MC depicted the profit maximizing Q and P are 35 and 6. it turns out: . When to Sell Out • No marginal costs associated with selling an extra ticket. • Then why don’t promoters set the price to sell out all concerts (or games)? • Simple explanation: The price needed to sell out the arena may be below the revenue maximizing price. so what conditions must a situation meet in order for the firm to pull of price discrimination successfully? Three.(1/5)Q = 3 or Q =35 and P = 10.5. Necessary conditions for price discrimination OK. profit maximization= revenue maximization.50.

000 profit = TR . price discrimination) TR = Psqs + Pgqg = $900*40 + $250*80 = $ 56.000 38. (2) You must be able to charge each consumer this price at a reasonable cost. (“Reasonable” means that the cost is less than the extra revenue you earn as a result of price discriminating. (This explains why new car dealers practice price discrimination shamelessly.) How price discrimination can raise profits and increase production--the case of high fixed costs Product: Round-trip flight from Huntsville to NYC/LaGuardia Assume 2 sets of customers: Suits Grannies 40 willing to pay $900 80 willing to pay $250 TFC for flight MC (constant) of a customer 1. Set price at $250 (both Suits and Grannies will fly) TR = Pq = $250 * 120 = $ 30.000 $ (2.000 TVC = MC * q = $75 * 120 9.000 TC = TFC + TVC = 44.(1) You must be able to identify each consumer’s maximum willing-to-pay price at a reasonable cost.000 Profit at last! . Set price at $900 (Suits only will fly) TR = Psqs = $900 * 40 TVC = MC * qs = $75 * 40 TC = TFC + TVC = profit = TR .TC = $ (14.000) EEK again 3.000 TVC = MC*q = $75*120 = 9.TC = $ 12..000) $ $ 35. Now--charge Suits $900 and Grannies $250 (i.000 TC = TFC + TVC = 44.) (3) Customers must not be able to resell the goods easily.000 profit = TR .000 75 EEK 2.TC = = $ 36.000 3.e.

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