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Industrial Organization

Industrial Organization. Price discrimination. Imperfect Competition and Market Power. Price. MC. Producer surplus (PC). P*. Demand. Q PC. Q. Perfect competition: Welfare is maximized, quantity is the largest and price is the lowest. Imperfect Competition and Market Power.

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Industrial Organization

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  1. Industrial Organization Price discrimination

  2. Imperfect Competition and Market Power Price MC Producer surplus (PC) P* Demand QPC Q • Perfect competition: • Welfare is maximized, quantity is the largest and price is the lowest

  3. Imperfect Competition and Market Power Producer surplus Price MC P* Market power MC* Demand Marginal Revenue (MR) QIC QPC Q • With imperfect competition (monopoly, oligopoly): • Profit maximizing rule: MR=MC • At QPC: MC>MR, not optimal • QIC<QPC, price is higher and total welfare is lower

  4. Question • If there is market power: • Can firm do better than charging the same price for all units? • Answer: yes, price discriminate

  5. Price Discrimination: Introduction • So far: • 1 price for all consumers • 1 price for all units purchased • Larger profits if: • Price per unit varies with quantity consumed • Or: different consumers pay different prices (e.g. income, age, location, preferences)

  6. Assumptions • Keys: • No arbitrage possibilities • Goods: high taxes or transportation costs, perishable products • Services (Restaurants, transportation, entertainment), e.g. 65 and over discounts, student id. • Market power (let’s assume monopoly for now)

  7. Assumptions • Price discrimination is legal (for now) • Firm has information on demand preferences • Ideally: identify the “type” of consumer: • Example: age or income

  8. Reasons for Price Discrimination • Firms with market power can do better • (Some) consumers receive a surplus with uniform pricing • Consumers are different: willingness to pay varies (price sensitivity)

  9. Classification

  10. Complete Discrimination (1st degree) • Firm extracts all consumer surplus • Each consumer pays a different price: • More price sensitive consumers pay a lower price and vice versa • Firm requires detailed information about willingness to pay • Example: high prices with bargaining • Used cars salesmen • College admission (financial aid)

  11. Complete Discrimination (case 1) • Case 1: Unit demand • Example: 2 potential used car buyers $ $ Buyer 1 Buyer 2 10,000 Uniform Price= $9,000 Profit = $ 9,000 8,000 Consumer Surplus Q Q 1 1

  12. Complete Discrimination (case 1) • Case 1: unit demand Buyer 2 Buyer 1 $ $ Price 1 = $10,000 10,000 Price 2 = $8,000 8,000 Q Q 1 1 • Complete Discrimination: Profit =10,000 (buyer 1) + 8,000 (buyer 2) = 18,000 • Consumer surplus = 0

  13. Complete Discrimination (case 2) • Case 2: Multiple-unit demand $ 800 Uniform Price 500 Q 5

  14. Complete Discrimination (case 2) Multiple-unit demand • How to achieve perfect price discrimination? • Option 1: take it or leave it price-quantity package • Option 2: two-part tariff (non-linear pricing)

  15. Complete discrimination (case 2) • Multi-unit demand: a simple model • Utility is quasi-linear: • This simplifies to: Inverse demand

  16. Multi-unit demand: a simple model • Example. Suppose: • Also, • What is the profit maximizing quantity? • What is the profit maximizing (package) price? (option 1) • What is the optimal two-part tariff? (option 2) Inverse demand

  17. Direct Discrimination (3rd degree) • Different groups of consumers pay different prices: • More price sensitive consumers pay a lower price • Less price sensitive consumers pay a higher price • Firm requires information about groups and can identify them easily/legally. • Examples: Haircuts, students, 65+, coach/business, dry cleaning, “Ladies Night”

  18. Direct Discrimination p1 p2 • Maximization rule: MR1 = MR2 = MC • Intuition: If MR1>MR2, q1 can increase & q2 decrease until MR1=MR2 • More sensitive segment (elastic) pays a lower price (group 1) • Less sensitive segment (inelastic) pays a higher price (group 2) • Π is higher than with uniform pricing p*2 D2 p*1 D1 MC=8 q*1 q1 q*2 q2 MR1 MR2

  19. Direct Discrimination • Mathematically: • Monopolist solves: • Example: P1=200-4Q ; P2=152-6Q ; MC=8 • What is P1*, Q1*, P2*, Q2*

  20. Direct Discrimination • Formally: • Monopolist solves: • Foc’s are: • After some manipulation:

  21. Direct Discrimination: Welfare p p1 p2 • In some cases, price discrimination provides goods and services to groups that would not have access under uniform pricing: • Prescription drugs: developed vs. developing countries D1 + D2 MC p*2 D2 p*1 D1 q*1 q1 q*2 q2 Q* MR Q MR1 MR2

  22. Direct Discrimination: Welfare • Firm is better off (in the worst case the firm is as well off) • Consumers in low elasticity markets are worse off • Consumers in high elasticity markets are better off • Net effect? Positive if total Q goes up.

  23. Direct Discrimination: Inter-related Demands • Direct (or group) price discrimination analysis also applies to “inter-related” demands: • Electricity (off peak v. peak) • Durable goods markets • Monday night movie discounts?

  24. Direct Discrimination: Inter-related Demands • Formally:

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