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Industrial Organization

Industrial Organization. Price discrimination. Announcements. Homework # 1 is posted, due on June 7 Project # 1 is posted, due on June 11 Papers to read: Shiller and Waldfogel & Chu, Leslie + Sorensen, posted (important for project). Imperfect Competition and Market Power. Price. MC.

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Industrial Organization

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  1. Industrial Organization Price discrimination

  2. Announcements • Homework • # 1 is posted, due on June 7 • Project • # 1 is posted, due on June 11 • Papers to read: • Shiller and Waldfogel & Chu, Leslie + Sorensen, posted (important for project)

  3. 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

  4. 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

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

  6. Price Discrimination: Introduction • So far: • 1 price for all units purchased • 1 price for all consumers • Larger profits if: • Price per unit varies with quantity consumed • And/or: different consumers pay different prices (e.g. income, age, location, preferences) – as long as consumers are different

  7. 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)

  8. Assumptions • Price discrimination is legal • Firm has information on demand preferences • Ideally: know every consumer’s demand schedule • Less ideally: identify the “type” of consumer: • Example: age or income

  9. 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)

  10. Classification

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

  12. Complete Discrimination (ex. 1) • Unit demand with heterogeneous users: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

  13. Complete Discrimination (ex. 1) • Ex 1: unit demand with heterogeneous consumers 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

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

  15. Complete Discrimination (ex. 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)

  16. Complete discrimination (ex. 2) • Multi-unit demand: a simple model (with homogeneous consumers) • Utility is quasi-linear: • This simplifies to: Inverse demand

  17. 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

  18. 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”

  19. 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

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

  21. Direct Discrimination • Formally: • Monopolist solves: • FOC’s are: • After some manipulation:

  22. 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

  23. 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.

  24. 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?

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

  26. Indirect Discrimination (2nd degree) • Consumers self-select (arbitrage can not be prevented) • Firm knows about two (or more) consumer types • It is not possible (i.e. illegal) to use direct discrimination • Again, two possibilities: • Two-part tariff (A,p): e.g. $100 for a plan (“A”), and 10c/min after 1000 min (p) • Take-it-or-leave-it offer: buy one get one 50% off. (“r,q” package)

  27. Indirect Discrimination • Packages must comply with 2 constraints: • Incentive compatibility: we want groups to select the package designed for them • Participation: avoid packages that are less attractive than not buying at all

  28. Graphical Illustration: Two-part tariff pC Residential Commercial pR • Assumption: MC=0 • With 2 prices (6 & 12), commercial has no incentive to choose $12 • Solution: 2 plans: a) 12¢/min (“12 plan”), b) fixed fee (“fixed” # min at 6 ¢/min) + 6 ¢/min beyond fixed minutes (“6 plan”) • Compatibility: CSC(12 plan)>=CSC(6 plan), commercial chooses “12 plan” • “6 Plan”: fixed fee? 9 minutes? 18 minutes? • Participation: Residential must choose “6 plan” (“12 plan” is never chosen) • CSR(6)>0: 135 – 108 = 27; you can actually do better. How? 24 36 81 12 DC 12* 135 144 108 DR 108 6* qR qC 12* 18 24 6* 9 12 18

  29. Implications of ID • One consumer (or group) has marginal value that exceeds marginal cost (inefficiently small amount) • The other consumer (or group) has marginal value equal to marginal cost (efficient quantity) • Look at Varian (ch. 14) for a formal derivation in a simple model

  30. Indirect Discrimination: Example • Buy 1 at $50, get one at half price ($25) Elastic demand 50 25 1 2

  31. Indirect Discrimination: Example • Buy one, get one half price • Incentive compatible, participation constraint satisfied Consumer surplus 55 50 Inelastic demand 15 1 2

  32. Important Points • Uniform (aka linear) pricing within a segment can only be used for direct price discrimination (not for indirect PD) • For indirect discrimination to work, a package needs to be offered: (r,q) contract or a two-part tariff contract (A,p) • Two-part tariffs can be used in all three price discrimination schemes

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