Week 4

Price Discrimination and Monopoly

1
• Price discrimination or price differentiation is a
pricing strategy where identical or largely similar
goods or services are transacted at different prices
by the same provider in different markets.
• Price differentiation is distinguished from product
differentiation by the more substantial difference
in production cost for the differently priced
products involved in the latter strategy.
• Price differentiation essentially relies on the
variation in the customers' willingness to pay.
Chapter 5: Price Discrimination: 2
Linear Pricing
• The term differential pricing is also used to
describe the practice of charging different prices
to different buyers for the same quality and
quantity of a product, but it can also refer to a
combination of price differentiation and product
differentiation.
• Other terms used to refer to price discrimination
include equity pricing, preferential pricing, and
tiered pricing.

Chapter 5: Price Discrimination: 3

Linear Pricing
 Commonly accepted classification

• First degree price discrimination – personalized

pricing (complete discrimination)
• Second degree price discrimination – menu
pricing (indirect discrimination)
• Third degree price discrimination – group pricing
(direct discrimination)

Chapter 5: Price Discrimination: 4

Linear Pricing
 Example of Price Discrimination
• Retail price discrimination(e.g. Manufacturers may sell their products
to similarly situated retailers at different prices based solely on the
volume of products purchased)
• Travel industry
• Segmentation by age group, student status, ethnicity and citizenship
• Discounts for members of certain occupations (e.g. police, military)
• Retail incentives (e.g. discount coupons, rebates, bulk and quantity
pricing, seasonal discounts, and frequent buyer discounts)
• Incentivize to wholesale or industrial buyer
• Gender-based examples (‘ladie’s night)
• International price discrimination (e.g. Pharmaceutical companies)
• Academic pricing (e.g. discounted goods and software to students and
faculty at school and university levels)
• Sliding scale fees (e.g. some nonprofit law firms charge on a sliding
scale based on income and family size)

5
 Part I: Linear Pricing

A pricing schedule in which there is a fixed price per unit,

such that where total price paid is represented by T(q),
quantity is represented by q and price per unit is represented
by a constant p, T(q) = pq

6
 Introduction
• Prescription drugs are cheaper in Canada than the
United States
• Textbooks are generally cheaper in Britain than the
United States
• Examples of price discrimination
– presumably profitable
– should affect market efficiency: not necessarily adversely
– is price discrimination necessarily bad – even if not seen as
“fair”?

7
 Feasibility of price discrimination
• Two problems confront a firm wishing to price
discriminate
– identification: the firm is able to identify demands of
different types of consumer or in separate markets
• easier in some markets than others: e.g tax
consultants, doctors
– arbitrage: prevent consumers who are charged a low
price from reselling to consumers who are charged a
high price
• prevent re-importation of prescription drugs to the
United States

8
 Notes
Third degree price discrimination, means charging a
different price to different consumer groups.
•For example, rail and tube (subway) travelers can be
subdivided into commuter and casual travelers, and cinema
goers can be subdivided into adults and children.
•Splitting the market into peak and off peak use is very
common and occurs with gas, electricity, and telephone
supply, as well as gym membership and parking charges.
•Third degree price discrimination is the most common type.

9
 Third-degree price discrimination
• Consumers differ by some observable characteristic(s)
• A uniform price is charged to all consumers in a
particular group – linear price
• Different uniform prices are charged to different groups
– “kids are free”
– subscriptions to professional journals e.g. American Economic
Review
– airlines
• the number of different economy fares charged can be very large
indeed!
– early-bird specials; first-runs of movies

10
 Third-degree price discrimination

• The pricing rule is very simple:

– consumers with low elasticity of demand should be
charged a high price
– consumers with high elasticity of demand should be
charged a low price

11
 Third-degree price discrimination
• Often arises when firms sell differentiated products
– hard-back versus paper back books
– first-class versus economy airfare
• Price discrimination exists in these cases when:
– “two varieties of a commodity are sold by the same seller to
two buyers at different net prices, the net price being the price
paid by the buyer corrected for the cost associated with the
product differentiation.” (Phlips)
• The seller needs an easily observable characteristic that
signals willingness to pay
• The seller must be able to prevent arbitrage
– e.g. require a Saturday night stay for a cheap flight

12
• This type of price discrimination, is based around
the idea that the firm sets prices that will
accommodate the consumer.
• The firms know broad demographics about the
particular types of consumers they will supply,
and charge prices such that everyone will be able
to consume the product.
• In order for this form of discrimination to work
the firm must be able to predict the elasticity of
demand in various consumers.
Chapter 5: Price Discrimination: Linear 13
Pricing
• This type of discrimination can be seen in the movie
theater business. Student and senior discounts are given
because these groups of consumers have more elastic
price elasticity of demand.
• It is because of this discrimination that the firm is able to
extract the consumer surplus of those who might not
otherwise pay the standard rate.
• Third degree price discrimination relies on the firm being
able to separate the segments. If separation of segments
is not possible then the product can be transferred.

14
 Example

Chapter 5: Price Discrimination: Linear 15

Pricing
• The example above shows the total market for
public transport journeys before 9.00am. The total
market demand (Dm) is the sum of the demand of
two segments, adults (Da) and students (Ds). For
adults the price of a bus ticket is only a small part
of their income and this means that their demand
(Da) is more inelastic than that of students for
whom a bus ticket is a larger part of their income,
(see the determinants of elasticity).

Chapter 5: Price Discrimination: Linear 16

Pricing
• In the figure, the firm we once again decides on
their output by equating MC with MR. However
there is not just one price. By drawing a horizontal
line through the MC=MR point until it intersects
with the MR curves for adults and students and
then reading the price off the respective demand
curves Da and Dr the price in each segment is
determined, Pa and Pr. Not surprisingly the price
in the adult market is higher.

Chapter 5: Price Discrimination: Linear 17

Pricing
 Practice problem
NonLegal Seafoods (NS) sell its excellent clam chowder in Boston,
New York and Washington. NS has estimated that the demands in
these three markets are respectively
•QB = 10,000 – 1,000 PB
•QNY = 20,000 – 2,000 PNY
•QW = 15,000 – 1,500 PW
where quantities are pints of clam chowder per day. The marginal
cost of making a pint of clam chowder in their Boston facility is $1.
In addition, it costs $1 per pint to ship the chowder to New York
and $2 per pint to ship to Washington.
a)What are the profit maximizing prices that NS should set in these
three market? How much chowder is sold per day in each market?
b)What profit does NS make in each market?

18
 Part II: Nonlinear Pricing

•Nonlinear Pricing Schedule – Nonlinear pricing is a pricing

schedule in which quantity and total price are not mapped to
each other in a strictly linear fashion.
•Affine Pricing – An affine pricing schedule consists of both
a fixed cost and a cost per unit. Using the same notation as
above, T(q) = k + pq, where k is a constant cost.

19
 Notes
• Nonlinear pricing is a broad term that covers any kind of
price structure in which there is a nonlinear relationship
between price and the quantity of goods. An example is
affine pricing.
• A nonlinear price schedule is a menu of different-sized
bundles at different prices, from which the consumer makes
his selection. In such schedules, the larger bundle generally
sells for a higher total price but a lower per-unit price than
a smaller bundle.
• In economics, affine pricing is a situation where buying
more than zero of a good gains a fixed benefit or cost, and
each purchase after that gains a per-unit benefit or cost.
• An example would be a cell phone contract where a base
price is paid each month with a per-minute price for calls
20
• Annual subscriptions generally cost less in total than one-off
purchases
• Buying in bulk usually offers a price discount
– these are price discrimination reflecting quantity discounts
– prices are nonlinear, with the unit price dependent upon the
quantity bought
– allows pricing nearer to willingness to pay
– so should be more profitable than third-degree price
discrimination
• How to design such pricing schemes?
– depends upon the information available to the seller about
buyers
– distinguish first-degree (personalized) and second-degree
(menu) pricing

21
 First-degree price discrimination
• Monopolist can charge maximum price
that each consumer is willing to pay
• Extracts all consumer surplus
• Since profit is now total surplus, find that
first-degree price discrimination is
efficient

22
 First-degree price discrimination
• Suppose that you own five antique cars
• Market research shows there are collectors of different types
– keenest is willing to pay $10,000 for a car, second keenest
$8,000, third keenest $6,000, fourth keenest $4,000, fifth keenest
$2,000
– sell the first car at $10,000
– sell the second car at $8,000
– sell the third car to at $6,000 and so on
– total revenue $30,000
• Contrast with linear pricing: all cars sold at the same price
– set a price of $6,000
– sell three cars
– total revenue $18,000

23
 First-degree price discrimination
• First-degree price discrimination is highly profitable
but requires
– detailed information
– ability to avoid arbitrage
• Leads to the efficient choice of output: since price
equals marginal revenue and MR = MC
– no value-creating exchanges are missed

24
 First-degree price discrimination
• The information requirements appear to be
insurmountable
– but not in particular cases
• tax accountants, doctors, students applying to private universities
• No arbitrage is less restrictive but potentially a
problem
• But there are pricing schemes that will achieve the
same outcome
– non-linear prices
– two-part pricing as a particular example of non-linear prices
• charge a quantity-independent fee (membership?) plus a per unit
usage charge
– block pricing is another
• bundle total charge and quantity in a package

25
 Two-part pricing
• A two-part tariff is a price discrimination
technique in which the price of a product or
service is composed of two parts - a lump-
sum fee as well as a per-unit charge. In
general, price discrimination techniques
only occur in partially or fully monopolistic
markets.

26
A two-part tariff when consumer demand is
homogeneous

27
A two-part tariff when consumer demand is
different

28
 Example of two-part tariffs
•"membership discount retailers" such as shopping clubs that charge an
annual fee for admission to the point of sale and also charge for your
purchases
•amusement parks where there are admission fees and also per-ride fees
•cover charge for bars combined with per drink fees
•credit cards which charge an annual fee plus a per-transaction fee
•loyalty cards or clubs
•landline telephones where there is a fee to use the service ('line rental')
and also a fee per call. The line rental covers the cost of providing the
service, the per minute charge covers the cost of placing the call on the
network.
•personal seat licenses in professional sports, in which fans of a team pay
an up-front lump sum fee for the right to purchase tickets at face value

29
 Block pricing

Block pricing is a pricing strategy in which

identical products are packaged together in order to
increase profits by forcing customers to make an
all or none decision. By packaging the product and
selling it as one unit the firm earns more than if it
sold all of the units at a simple per unit price.

30
Block Pricing

31
 Second Degree Price Discrimination
• In this type of discrimination the companies are actually
not able to differentiate between the different types of
consumers. This practice creates a schedule of declining
prices for different quantities.
• Using this strategy the company can extract some of the
consumer surplus without knowing much about the
individual consumer.
• The consumer chooses the amount of product they wish to
consume with the posted prices, and this allows consumers
to differentiate themselves according to preference.

32
• This type of discrimination can easily be seen in the bulk
purchases of large consumers like Walmart, who in turn pass the
savings onto the eventual consumer.
• This can also be seen in quantity discounts, the more you
purchase the more you save. A family pack of soap powder or
biscuits tends to cost less per kg than smaller packs. his of
course discriminates against people living alone, often
pensioners and students. In some supermarkets the price per kg
of product is listed, which helps the customer by providing
information on which to base decisions on.
• Examples of 2nd degree price discriminators:
Electric utilities, cable companies, water & sewage
companies, trash collect

33
• Additionally to second degree price
discrimination, sellers are not able to differentiate
between different types of consumers.
• Thus, the suppliers will provide incentives for the
consumers to differentiate themselves according to
preference, which is done by quantity "discounts",
or non-linear pricing.
• This allows the supplier to set different prices to
the different groups and capture a larger portion of
the total market surplus.

Chapter 5: Price Discrimination: Linear 34

Pricing
• In reality, different pricing may apply to
differences in product quality as well as quantity.
• For example, airlines often offer multiple classes
of seats on flights, such as first class and economy
class, with the first class passengers receiving
wine, beer and spirits with their ticket and the
economy passengers offered only juice, pop and
water.
• This is a way to differentiate consumers based on
preference, and therefore allows the airline to
capture more consumer's surplus.
Chapter 5: Price Discrimination: Linear 35
Pricing
• This price discrimination works similarly to a
two-part tariffs. However, in this case, the
monopoly won’t charge an entrance fee, but will
hide this entrance fee into part of the discounted
price offered to the consumer.

Chapter 5: Price Discrimination: Linear 36

Pricing
 Second-degree price discrimination
• What if the seller cannot distinguish between buyers?
– perhaps they differ in income (unobservable)
• Then the type of price discrimination just discussed is
impossible
• High-income buyer will pretend to be a low-income
buyer
– to avoid the high entry price
– to pay the smaller total charge

37
 Second-degree price discrimination
• First-degree price discrimination requires:
– High Income: entry fee $72 and $4 per drink or entry plus 12
drinks for a total charge of $120
– Low Income: entry fee $32 and $4 per drink or entry plus 8
drinks for total charge of $64
• This will not work
– high income types get no consumer surplus from the package
designed for them but get consumer surplus from the other
package
– so they will pretend to be low income even if this limits the
number of drinks they can buy
• Need to design a “menu” of offerings targeted at the
two types

38
 Second-degree price discrimination
• The seller has to compromise
• Design a pricing scheme that makes buyers
– reveal their true types
– self-select the quantity/price package designed for them
• Essence of second-degree price discrimination
• It is “like” first-degree price discrimination
– the seller knows that there are buyers of different types
– but the seller is not able to identify the different types
• A two-part tariff is ineffective
– allows deception by buyers
• Use quantity discounting

39
 Second-degree price discrimination
• Will the monopolist always want to supply both types
of consumer?
• There are cases where it is better to supply only high-
demand types
– high-class restaurants
– golf and country clubs

40
 Second-degree price discrimination
• Characteristics of second-degree price discrimination
– extract all consumer surplus from the lowest-demand group
– leave some consumer surplus for other groups
• the incentive compatibility constraint
– offer less than the socially efficient quantity to all groups other
than the highest-demand group
– offer quantity-discounting
• Second-degree price discrimination converts consumer
surplus into profit less effectively than first-degree
• Some consumer surplus is left “on the table” in order
to induce high-demand groups to buy large quantities

41