Price Discrimination

1
Price Discrimination

• A monopoly engages in price discrimination if it
  is able to sell otherwise identical units of
  output at different prices
• Whether a price discrimination strategy is
  feasible depends on the inability of buyers to
  practice arbitrage
• profit-seeking middlemen will destroy any
  discriminatory pricing scheme if possible
• price discrimination becomes possible if resale
  is costly

2
Perfect Price Discrimination

• If each buyer can be separately identified by the
  monopolist, it may be possible to charge each
  buyer the maximum price he would be willing to
  pay for the good
• perfect or first-degree price discrimination
• extracts all consumer surplus
• no deadweight loss

3
Perfect Price Discrimination
Under perfect price discrimination, the
monopolist charges a different price to each
buyer
Price
D
Quantity
Q
4
Market Separation

• Perfect price discrimination requires the
  monopolist to know the demand function for each
  potential buyer
• A less stringent requirement would be to assume
  that the monopoly can separate its buyers into a
  few identifiable markets
• follow a different pricing policy in each market
• this is known as third-degree price discrimination

5
Market Separation

• All the monopolist needs to know in this case is
  the price elasticity of demand for each market
• If the marginal cost is the same in all markets,
  The profit-maximizing price will be higher in
  markets where demand is less elastic

6
Market Separation
If two markets are separate, a monopolist can
maximize profits by selling its product at
different prices in the two markets
Price
The market with the less elastic demand will be
charged the higher price
MC
MC
D
D
MR
MR
Quantity in Market 2
Quantity in Market 1
0
7
Third-Degree Price Discrimination

• Suppose that the demand curves in two separated
  markets are given by
• Q1 24 P1
• Q2 24 2P2
• Suppose that marginal cost is constant and equal
  to 6
• Profit maximization requires that
• MR1 24 2Q1 6 MR2 12 Q2

8
Third-Degree Price Discrimination

• The optimal choices are
• Q1 9
• Q2 6
• The prices that prevail in the two markets are
• P1 15
• P2 9

9
Third-Degree Price Discrimination

• The allocational impact of this policy can be
  evaluated by calculating the deadweight losses in
  the two markets
• the competitive output would be 18 in market 1
  and 12 in market 2
• DW1 0.5(P1-MC)(18-Q1) 0.5(15-6)(18-9) 40.5
• DW2 0.5(P2-MC)(12-Q2) 0.5(9-6)(12-6) 9

10
Third-Degree Price Discrimination

• If this monopoly was to pursue a single-price
  policy, it would use the demand function
• Q Q1 Q2 48 3P
• So marginal revenue would be
• MR 16 (2/3)P
• Profit-maximization occurs where
• Q 15
• P 11

11
Third-Degree Price Discrimination

• The deadweight loss is smaller with one price
  than with two
• DW 0.5(P-MC)(30-Q) 0.5(11-6)(15) 37.5

12
Discrimination Through Price Schedules

• An alternative approach would be for the monopoly
  to choose a price schedule that provides
  incentives for buyers to separate themselves
  depending on how much they wish to buy
• again, this is only feasible when there are no
  arbitrage possibilities

13
Two-Part Tariff

• A linear two-part tariff occurs when buyers must
  pay a fixed fee for the right to consume a good
  and a uniform price for each unit consumed
• T(Q) A PQ
• The monopolists goal is to choose A and P to
  maximize profits, given the demand for the product

14
Two-Part Tariff

• Because the average price paid by any demander is
• T/Q A/Q P
• this tariff is only feasible if those who pay
  low average prices (those for whom Q is large)
  cannot resell the good to those who must pay high
  average prices (those for whom Q is small)

15
Two-Part Tariff

• One feasible approach for profit maximization
  would be for the firm to set P MC and then set
  A so as to extract the maximum consumer surplus
  from a set of buyers
• This might not be the most profitable approach
• In general, optimal pricing schedules will depend
  on a variety of contingencies