What is Price Discrimination?

1. What is Price Discrimination? • Price discrimination involves market segmentation • Practiced by monopolists or any firm with price setting power • Does not occur in perfectly competitive markets • A firm price discriminates when it charges different prices to different consumers for reasons that do not reflect cost differences • This involves extracting consumer surplus from buyers and turning this into additional revenue and profit • A business is exploiting the fact that consumers have a different willingness and ability to pay for goods and services

2. Conditions Required for Price Discrimination • The firm must have some price-setting power in at least one market (I.e. operating in an imperfectly competitive market) • There must be at least two consumer groups a with different price elasticity of demand • The firm should be able to identify consumers in each group, and set prices differently for consumers in the groups (requires sufficient information) • The firm must prevent consumers in one group selling to consumers in the other (no market arbitrage or market seepage)

3. 1st Degree (Perfect) Price Discrimination • Involves perfect segmentation of the market by the supplier • Every customer is charged his or her “willingness to pay” • So there is no consumer surplus in the transaction • The monopolists’ demand curve becomes the marginal revenue curve, i.e. you do not have to lower the price to the higher value customers in order to sell more! • More goods are sold; but price is higher to some customers • Total output is higher than under normal profit-maximization

4. 1st Degree Price Discrimination Price P1 AC = MC AR (Market Demand) Marginal Revenue Quantity Q1 Normal profit maximising price and output is P1 and Q1 (where marginal revenue meets marginal cost)

5. 1st Degree Price Discrimination – Equilibrium Output Price Pmon AC = MC AR= market demand MR Quantity Qm Qe Normal profit maximising price and output is P1 and Q1 (where MR=MC) With perfect price discrimination, output may rise to Qe where MC meets the demand curve

6. Extracting the Consumer Surplus Price (P) P2 P1 AC = MC P3 AR (Market Demand) MR Q2 Q1 Q3 Quantity of Output (Q)

7. Extracting the Consumer Surplus Price (P) Equilibrium output with perfect price discrimination – the monopolist will sell an extra unit providing that the next unit adds as much to revenue as it does to cost P2 P1 AC = MC P3 AR (Market Demand) MR Q2 Q1 Q3 Quantity of Output (Q) Each consumer is charged what they are willing to pay – the market is segmented and the seller aims to extract the consumer surplus and turn this into revenue and extra (marginal) profit

8. Examples of 1st Degree Discrimination • First degree discrimination takes place when bartering exists between buyers and sellers • The bid and offer system in the housing market where potential home buyers put in an offer on an individual property • Negotiating prices with dealers for second hand cars • Haggling for the price of a hotel room • Antiques fairs and car boot sales!

9. Excess Capacity Pricing? • Excess capacity pricing exists when sellers try to off-load their spare output to buyers • Examples • Cheaper priced restaurant menus at lunchtime • Cinema and theatre tickets for matinees • Hotels offering winter discounts • Car rental firms reducing prices at weekends • Not always the case that prices are lower if consumers delay their purchases • Advance discounts on season tickets for soccer clubs • Discounts for early booking of package holidays

10. 3rd Degree : Market Separation • Separate markets based on some identifiable characteristic • Monopolist seeks to maximize profits in each sub-market • Sell additional output in elastic market (lower price) • Reduce sales in inelastic market (increase price) • Prevent resale of the good or service • Examples of Market Separation / Segmentation • Discounts to Seniors / Senior Citizens • Different prices for students and adults for bus travel • Gender pricing in some bars/night clubs

11. Third Degree Price Discrimination Market A Market B Price Price ARa MRa MRb ARb Quantity Quantity

12. Third Degree Price Discrimination Market A Market B Price Price MC=AC ARa MRa MRb ARb Quantity Quantity

13. Third Degree Price Discrimination Market A Market B Price Price Pb Pa MC=AC ARa MRa MRb ARb Quantity Quantity

14. Third Degree Price Discrimination Market A Market B Price Price Pa MC=AC ARa MRa MRb ARb Quantity Quantity

15. Third Degree Price Discrimination Market A Market B Price Price Profit from selling to market A – relatively elastic demand – lower price Pa MC=AC ARa MRa MRb ARb Quantity Quantity

16. Third Degree Price Discrimination Market A Market B Price Price Profit from selling to market B – relatively inelastic demand – higher market price Profit from selling to market A – relatively elastic demand – lower price Pb Pa MC=AC ARa MRa MRb ARb Quantity Quantity