Price discrimination

1. Price discrimination The practice of charging unequal prices or fees to different buyers (or classes of buyers) is called price discrimination

2. Examples of price discrimination • Physicians charge more for an office visit if the patient has health insurance. • Magazines such as Sports Illustrated offer gifts and discounts to new subscribers. • Senior citizens may enjoy discounted rates at motels and restaurants. • Cinemas charge higher ticket prices for adults than for kids. • Japanese steel and Canadian timber producers earn sharply lower profit margins on products sold in the U.S. compared to the domestic market.

3. “Sizing up their income” pricing by plumbers, auto mechanics, . . . A Mercedes driver can pay more, so why not charge them more?

4. When is price discrimination feasible? • Price-discrimination (PD) can be a very lucrative proposition from the seller’s point of view. However, PD will not be feasible or possible unless: • The seller possesses market power—meaning, the seller faces a downward sloping demand curve. • The seller is capable of segregating buyers into groups based on differential willingness to pay, or elasticity of demand (). Hear audio explanation (wav). • The seller can prevent arbitrage or resale of the product. Her audio explanation (wav)

5. 1st Degree Price Discrimination This is referred to as “perfect” PD. The seller charges every buyer their “reservation price”—that is, the maximum price they are willing to pay rather then go without the marginal unit of the good or service

6. Notes • Perfectly discriminating monopolist charges PC for the last unit only. • Market output is equal to the competitive output (QC) • Total Surplus (TS) is equal to green shaded area APCB Price A B PC MC D MR 0 QM QC Quantity Hear audio explanation (wav)

7. 3rd degree price discrimination: the welfare effects • To illustrate these effects we use the example of Kevlar, du Pont’s patented, super-strength synthetic fiber. • We assume there are two uses for Kevlar • Undersea cables • Tires

8. Differential elasticities of demand () • Steel and fiberglass are good substitutes for Kevlar in tire production; where there are no good substitutes for Kevlar in the manufacture of undersea cable. • Let t denote the elasticity of demand for Kevlar on the part of tire makers. • c is the elasticity of demand for Kevlar for use in production of undersea cables. • Thus: t>C [1]

9. Symbols, assumptions • Let: • Pc : Price per unit of Kevlar charged to cable manufactures; • Pt: Price per unit of Kevlar charged to tire manufacturers; • qc: Quantity of Kevlar purchased by cable manufacturers; • qt: Quantity of Kevlar purchased by tire manufacturers. • We assume that MC = ATC = $20. • The demand functions are given by: qC = 100 - Pc • qt = 60 - Pt

10. Price Audio explanation (wav) Price discriminating firm sets MR = MC in each “sub”market D cable W 60 D cable + tires H 50 F N MRC D tires 40 MC J C 20 A S MRt MRC + t 20 10 0 40 50 60 Tires Cable

11. 2 scenarios • Standard monopoly pricing (single price) • PC = Pt = $50 • Q = qC + qt = 50 + 10 = 60 units •  = TR – TC = [(50)(60)] – [(60)(20)] = $1,800 • 3rd degree price discrimination • PC = $60; Pt = $40 audio explanation (wav) • Q = qC + qt =40 + 20 = 60 Units •  = TR – TC = {[(60)(40)] +[(40)(20)]} – [(60)(20)] = $2,000

12. So, du Pont can increase its profits by $200 (from $1,800 to $2,000) by practicing price discrimination

13. The welfare effects • As a consequence of P.D., cable manufacturers pay $60 per unit instead of $50. This gives rise to a welfare loss of WFSA or $350. • If du Pont discriminates, then tire manufacturers pay a lower price than they otherwise would ($40 instead of $50). This gives rise to a welfare gain of NHGJ or $250. • Thus, • TS = WFSA + NHGJ = -$250

14. Moral of the story By enforcing statutes applicable to price discrimination (specifically, section 2 of the Clayton Act) , the total surplus could be potentially increased by $250.