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Key issues
1. why and how firms price discriminate
2. perfect price discrimination
3. quantity discrimination
4. multimarket price discrimination
5. two-part tariffs6. tie-in sales
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Nonuniform pricing
prices vary across customers or units
noncompetitive firms use nonuniform
pricing to increase profits
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Single-price firm
nondiscriminating firm faces a trade-off
between charging
maximum price to consumers who really wantgood
low enough price that less enthusiastic
customers still buy as a result, single-price firm usually sets
an
intermediate price
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Price-discriminating firm
avoids this trade-off
earns a higher profit by charging
higher price to those willing to pay more than
the uniform price: captures their consumer
surplus
lower price to those not willing to pay as muchas the uniform
price: extra sales
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Extreme examples of tradeoff
maximum customers will pay for a movie:
college students, $10
senior citizens, $5
theater holds all potential customers, soMC
= 0
no cost to showing the movie,
so = revenue
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Example 12.1a
Pricing
Profit from 10
College Students
Profit from
20 Seniors
Total
Profit
Uniform, $5 $50 $100 $150
Uniform, $10 $100 $0 $100
Pricediscriminate
$100 $100 $200
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Broadway theaters
increase their profits 5% by price
discriminating rather than by setting
uniform prices
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Geographic price discrimination
admission to Disneyland is $38 for out-of-
state adults and $28 for southern
Californians
tuition at New Yorks Fordham University
is $4,000 less for commuting first-yearstudents than for
others
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Successful price discrimination
requires that firm have market power
consumers have different demand
elasticities, and firm can identify howconsumers differ
firm must be able to prevent or limit
resales to higher-price-paying customersby others
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Preventing resales
resales are difficult or impossible when
transaction costs are high
resales are impossible for most services
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Prevent resales by raising
transaction costs price-discriminating firms raise
transaction
costs to make resales difficult
applications:
U.C. Berkeley requires anyone with a student
ticket to show a student picture ID
Nikon warranties cover only cameras sold inthis country
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Prevent resales by vertically
integrating VI: participate in more than one successive
stage of the production and distribution
chain for a good or service VI into the low-price purchasers
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Prevent resales by government
intervention governments require that milk producers charge
higher price for fresh use than for processing
(cheese, ice cream) and forbid resales governments set tariffs
limiting resales by making
it expensive to import goods from lower-price
countries
governments used trade laws to prevent sales of
certain brand-name perfumes except by their
manufacturers
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Flight of the Thunderbirds
2002 production run of 25,000 new Thunderbirds includedonly
2,000 for Canada
potential buyers are besieging Ford dealers in Canada
many hope to make a quick profit by reselling these cars in
theUnited States
reselling is relatively easy and shipping costs are relatively
low
why a T-Bird south? Ford is price discriminating between U.S.
and Canadian customers
at the end of 2001, Canadians were paying $56,550
Cdn.(Thunderbird with the optional hardtop), while U.S.
customerswere spending up to $73,000 Cdn.
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Thunderbirds (cont.)
Canadian dealers try not to sell to buyers who will exportthe
cars
dealers have signed an agreement with Ford that explicitly
prohibits moving vehicles to the United States dealers try to
prevent resales because otherwise Ford may cut off
their Thunderbirds or remove their dealership license
one dealer said, Its got to the point that if we havent soldyou
a car in the past, or we dont otherwise know you,
were not selling you one. nonetheless, many Thunderbirds were
exported: eBay
listed dozen of these cars on a typical day
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3 types of price discrimination
perfect price discrimination (first-degree): sell
each unit for the most each customer is willing to
pay quantity discrimination (second-degree): charges
a different price for larger quantities than for
smaller ones
multimarket price discrimination (third-degree):
charge groups of customers different prices
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Perfect-price-discriminating
monopoly has market power
can prevent resales
knows how much each customer is willing
to pay for each unit purchase (all knowing)
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All-knowing monopoly
sells each unit at its reservation price
maximum price consumers will pay (captures
all possible consumer surplus) height of demand curve
MR is the same as its price (AR)
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Figure 12.1 Perfect Price Discrimination
p, $ per unit
6
5
4
3
2
1
Q, Units per day6543210
MCe
Demand, Marginal revenueMR1
= $6MR2
= $5MR3= $4
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Perfect price discrimination
properties perfect price discrimination is efficient
competition and a perfectly discriminating
monopoly sell the same quantity
maximize total welfare: W = CS + PS
have no deadweight loss
consumers worse off (CS= 0) than withcompetition
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s c d
p, $ per unit
E
D
CB
A
Q, Units per dayQ Q=Q
MCs
Demand,MR
MRs
pc=MCcec
esps
p1
MC1
MC
d
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Amazon
in 2000, Amazon revealed that it used dynamicpricing: gauges
shoppers desire and means,charges accordingly
example
a man ordered DVD of Julie Taymors Titus at$24.49
checks back next week and finds price is $26.24
removes cookie: price fell to $22.74
after newspaper articles, Amazon announced ithad dropped this
policy
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Botox revisited
how much more would Allergan earn from
Botox if it could perfectly price
discriminate?
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Application Botox Revisited
p, $pervial
1.30 2.612.75
A $187.5million
C$187.5 million
B$375 million
Demand
Q, Million daily doses of Botox
75.0
7.5
0
es
e
MC
MR
143.0
c
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Solved problem
How does welfare change if firm in Table
12.1 goes from charging a single price to
perfectly price discriminating?
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Table 12.1a
Pricing
Profit from 10
College Students
Profit from
20 Seniors
Total
Profit
Uniform, $5 $50 $100 $150
Uniform, $10 $100 $0 $100
Pricediscriminate
$100 $100 $200
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Answer: Panel a
welfare is same with single price or price
discrimination because output unchanged
single price: if theater sets a single price of $5 it sells 30
tickets and = $150
20 seniors pay their reservation price so CS= 0
10 college students (reservation prices of $10) have CS
= $50 welfare = $200 = profit ($150) + consumer surplus
($50)
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If firm perfectly price
discriminates it charges all customers their reservation
price so theres no consumer surplus
seniors pay $5 and college students, $10 firm's profit rises to
$200
welfare
W= $200 = profit ($200) + CS($0)is same under both pricing
systems whereoutput stays the same
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Table 12.1b
PricingProfit from 10
College StudentsProfit from
5 SeniorsTotal
Profit
Uniform, $5 $50 $25 $75
Uniform, $10 $100 $0 $100
Pricediscriminate $100 $25 $125
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Answer: Panel b
welfare is greater with perfect price discriminationwhere output
increases
if theater sets single price of $10 only college students attend
and have CS= 0
= $100
W= $100
if it perfectly price discriminates: CS= 0 =$125
W= $125
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Quantity discrimination
firm does not know which customers have highestreservation
prices
firm might know most customers are willing topay more for first
unit (demand slopes down)
firm varies price each customer pays with numberof units
customer buys
price varies only with quantity: all customers pay thesame price
for a given quantity
note: not all quantity discounts are a form of
pricediscrimination
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Utility block pricing
public utility (electricity, water, gas)
charges
one price for the first few units (a block) ofusage
different price for subsequent blocks
both declining-block and increasing-blockpricing are common
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p1, $ per unit
30
50
70
90
Q, Units per day
20 40 900
m
(a) Quantity Discrimination
Demand
A=$200
C=$200
B=$1,200 D=$200
p2, $ per unit
30
60
90
Q, Units per day
30 900
m
(b) Single-Price Monopoly
Demand
F= $900
G= $450
MR
E= $450
Figure 12.3 Quantity Discrimination
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Multimarket price discrimination
firm knows only which groups of customers
are likely to have higher reservation prices
than others firm divides potential customers into two or
more groups
firms set a different price for each group
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Theater
senior citizens pay a lower price than
younger adults at movie theaters
by admitting people as soon as theydemonstrate their age and buy
tickets,
theater prevents resales
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International price
discrimination: Cars even including shipping and customs,
European price for BMW 750IL
price is 13.6% more from an American firm
than imported from Europe
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International price
discrimination: Software Australia's Prices Surveillance
Agency
criticized American software industry for
charging Australians 49% more thanAmericans,
then, Agency called for an end to import
restrictions so that Australian retailers couldimport software
directly
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Price discriminating: 2 groups
marginal cost = m
monopoly charges Group i memberspi for
Qi units
profit from Group i is
i=piQimQi
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To maximize total profit
monopoly sets its quantities so that
marginal revenue for each group i,MRi,
equals common marginal cost, m:MR1 = m =MR2.
example: Sonys Aibo robot dog
Fi 12 4 M lti k t P i i f Aib
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pJ, $ per unit
QJ, Units per year
DWLJ
DJ
CSJ
J
MRJ
pJ
= 2,000
500
3,500
0
MC
QJ
= 3,000 7,000
(a) Japan
Figure 12.4 Multimarket Pricing of Aibo
pUS
, $ per unit
QUS
, Units per year
DWLUS
DUS
CSUS
US
MRUS
pUS
= 2,500
500
4,500
0
MC
QUS
= 2,000 4,500
(b) United States
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Profit-maximizing condition
MRi =pi(1 + 1/i), so
MR1=p1(1 + 1/1) = m =p2(1 + 1/2) =
MR2
21
2
1
11
.1
1
p
p
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Solved problem
monopoly sells in two markets
constant elasticity of demand is
1 = -2 in first market
2 = -4 in second market
MC= $1
resales are impossible
what prices should monopoly charge?
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Answer
p1 = 1/(1) = 2
p2 = 1/(1) = 4/3
p1/p2 = 2/(4/3) = 1.5
11 1i
i
p MC
11/ 1i
i
p
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Coca-Cola Version 1
a two-liter bottle of Coke costs 50% more in
the U.K. than in EU nations (SF Chronicle, May
17, 2000: D2) if Cokes marginal cost is the same for all
European nations, how does the demand in
the U.K. differ from that in the EU?
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Answer
pUK/pEU = 1.5
an example that is consistent with this ratio
is UK= - 2 and EU = -4
generally:
or 1.5EU - UK= 0.5 UKEU
1 11 / 1 1.5
EU UK
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Entry of generics
generics enter when patent for profitable drug
expires
generics: 40% of U.S. pharmaceutical sales by volume name-brand
drugs with sales of about $20 billion went
off patent by 1997
most states allow/require pharmacist to switch
prescription from more expensive brand-nameproduct to generic
unless doctor or patient object
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Price effects
18 major orally-administered drug productsthat faced generic
competition 1983-1987
on average for each drug, 17 generic brandsentered and captured
35% of total sales in firstyear
price effects
brand-name drug prices rose an average of 7% but average market
price fell over 10%
because generic price was only 46% of brand-nameprice
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Why firms use self-identification
each price discrimination method requiresthat, to receive a
discount, consumers incur
some cost, such as their time otherwise, all consumers would get
adiscount
by spending extra time to obtain a discount,price-sensitive
consumers differentiatethemselves from others
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Getting consumers to identify
themselves: Coupons self-selection: people who spend their
time
clipping coupons buy goods at lower prices
than those who value their time more coupon-using consumers paid
$24 billion
less than other consumers in the first half of
1990s
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Reverse Auctions
priceline.com uses a name-your-own-price
or reverse-auction to identify price sensitive
customers a customer enters a relatively low price bid
for a good or service, such as airline tickets
merchants decide whether to accept that bidor not
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Why priceline works
to keep their less price-sensitive customers from using
thismethod, airlines force successful Priceline bidders to
beflexible:
to fly at off hours
to make one or more connection to accept any type of
aircraft
when bidding on groceries, a customer must list two ormore
brands you like.
as Jay Walker, Pricelines founder said, The
manufacturers would rather not give you a discount, ofcourse,
but if you prove that youre willing to switch
brands, theyre willing to pay to keep you.
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Welfare effects of multimarket
price discrimination multimarket price discrimination results
in
inefficient production and consumption
welfare under multimarket pricediscrimination is lower than
undercompetition or perfect price discrimination
welfare may be lower or higher withmultimarket price
discrimination than witha single-price monopoly
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Gray markets
producers of recordings, books, sunglasses,
and shampoo, price discriminate by selling
these goods for higher prices in U.S. than inforeign markets
if the price differential is great enough,
some goods are reimported into U.S. andsold in a $130
billion-a-year "gray market"
by discounters (Costco, Target, Wal-Mart)
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Gray markets (cont.)
1995 federal court decision:
copyright owners has exclusive right to controlmarketing
can prevent reimportation
1998 Supreme Court decision reversed:
discount retailers had the legal right to sell copyrightedU.S.
goods in U.S.
once sold, "lawfully made" copies can be resoldwithout the
permission of copyright holder
reduces firms ability to price discriminate
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Two-part tariff
firm charges a consumer
lump-sum fee (first tariff) for right to buy any
units constant price (second tariff) on each unit
purchased
because of lump-sum fee, consumers paymore, the fewer units they
buy
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Two-part tariff examples
telephone service: monthly connection fee,
price per minute of use
car rental firms: charge per-day, price permile
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Two-part tariff with identical
consumersmonopoly that knows its customers' demand
curve can set a two-part tariff that has same
properties as perfect-price-discriminatingequilibrium
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Figure Two-Part Tariff with Identical Consumers
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g
p, $ per unit
q1, Units per day
60 70 80
D1
80
2010
0
mB1=$600
C1=$50
A1=$1,800
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Cannot distinguish/discriminate
monopoly cannot distinguish between types of
customers or cannot charge them different prices
monopoly has to charge each consumer the samelump-sum fee and
samep
due to legal restrictions, telephone company
charges all residential customers same monthly fee
and same fee per call, even though companyknows that consumers'
demands vary
Figure 12.5 Two-Part Tariff
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p, $ per unit
q1, Units per day607080
D1
80
20
10
0
m
(a) Consumer 1
B1=$600C1=$50
A1=$1,800
g
p, $ per unit
q2, Units per day9010080
D2
20
10
0
m
(b) Consumer 2
B2=$800
C2=$50
A2=$3,200
100
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Monopoly doesnt capture all CS
monopoly charges lump-sum fee equal topotential CS1 orCS2
because CS2 > CS1 both customers buy if lump-sum fee = CS1
Consumer 2 buys if monopoly charges lump-
sum fee = CS2
in Figure 12.5, monopoly maximizes itsprofit by setting lower
lump-sum fee andchargingp = $20 >MC
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Why is price > marginal cost?
by raising its price, monopoly earns more
per unit from both types of customers but
lowers its customers potential CS if monopoly can capture each
customer's
potential CSby charging different lump-
sum fees, it setsp = MC
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Tie-in sales
customers can buy one product only if they
purchase another product as well
most tie-in sales increase efficiency bylowering transaction
costs
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Requirement tie-in sales
firm cannot tell which customers are going
to use its product most (highest willing to
pay) firms uses requirement tie-in sale to identify
heavy users
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IBM requirement tie
1930s: IBM produced card punch machines,sorters, and tabulating
machines thatcomputed using punched cards
IBM leased (rather than sold) punchmachines; lease would
terminate ifcustomer used non-IBM card
by leasing, IBM avoided resale problemsand forced customers to
buy cards from it
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Bundling
bundling allows firms that can't directly
price discriminate to charge customers
different prices profitability of bundling depends on
customers tastes and ability to prevent
resales
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Selling Raiders' season tickets
suppose stadium can hold all potential
customers, soMC= 0 for selling one more
ticket should Raiders bundle tickets for preseason
(exhibition) and regular-season games, or
sell separately?
Table 12.3 Bundling of Tickets to Football Games
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When bundling increases profit
bundling likely to increase profit if consumers'
demands are
negatively correlated:
consumers who value one good much more than other
customers value other good less
here, bundling pays only if customers willing to
pay relatively more for regular-season tickets arenot willing to
pay as much as others for preseason
tickets and vice versa
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Supreme Court on tie-in sales
Kodak was prohibited by the SupremeCourt from using certain
tie-in sales in 1992
Kodak sells photocopiers and Kodak partsand service to its
customers
Kodak refused to supply some parts toindependent repair firms -
effectively
forcing customers to buy those parts andassociated service from
Kodak
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Charge and response
company was charged with illegally tying sale ofits photocopiers
with its parts and service
Kodak argued that case should be dismissed because both sides
agreed
Kodak faced substantial competition in initial sale
ofphotocopiers
customers would not buy from Kodak if they knew that
they would be overcharged on repair parts and service because
Kodak didn't have market power in copier
market, it couldn't price discriminate or extend itsmarket power
to another market
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Supreme Court rejects Kodak
consumers may be uninformed (cant forecastrepair cost)
even if Kodak lacks market power in
photocopiers, its a monopoly supplier of itsunique repair
parts
factual investigation needed to determine ifconsumers are
ignorant and have to be protected
(Court did not explain consumer benefit if Kodakforced to sell
repair parts to independent repairshops at prices set by Kodak)
1 Wh d h fi i
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1. Why and how firms price
discriminate to successfully price discriminate a firm needs
market power
to know which customers will pay more for each unit of
output to prevent resales
firm earns a higher profit from pricediscrimination than uniform
pricing because it
captures some or all of the CS of customers who arewilling to
pay more than uniform price
sells to some people who wont buy at uniform price
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2. Perfect price discrimination
to perfectly price discriminate, firm must knowmaximum amount
each customer is willing to payfor each unit of output.
perfectly price discriminating firm captures allpotential
consumer surplus
sells efficient (competitive) level of output
compared to competition
welfare is same
consumers are worse off
firms are better off
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3. Quantity discrimination
some firms charge customers different
prices depending on how many units they
purchase doing so raises their profits
4 M lti k t i
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4. Multimarket price
discrimination firm does not have enough information to
perfectly price discriminate but knows relative
elasticities of demand of groups of customers
firm charges each group a price in proportion to its
elasticity of demand
welfare under multimarket price discrimination is
< under competition/perfect price discrimination
> or < under single-price monopoly
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5. Two-part tariffs
by charging consumers a fee for the right to
buy and a price per unit, firms may earn
higher profits than from charging only foreach unit sold
if a firm knows demand curves of its
customers, it can use two-part tariffs(instead of perfectly
price discriminating) to
capture all consumer surplus
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6. Tie-in sales
firm may increase its profit by using a tie-in sale:customers
can buy one product only if they also
purchase another one
requirement tie-in sale: customers who buy onegood must make all
of their purchases of anothergood or service from that firm
bundling (package tie-in sale): firm sells only a
bundle of two goods together prices differ across customers
under both types of
tie-in sales
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Docking Their Pay
2002 dispute between
the International Longshore and Warehouse Union(ILWU)
shipping companies, represented by the PacificMaritime
Association
led to the closure of 29 west coast ports for 12days and
significant damage to U.S. and foreign
economies these docks handle about $300 billion worth of
goods per year
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Lockout
shippers locked out 10,500 union workers
lockout: an action by the employers that
causes a work stoppage similar to whatwould happen if the union
called a strike
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Damages
by one estimate, the shutdown inflicted up to $2billion a day in
damages of the U.S. economy
revenues fell 80% at West Coast Trucking
one of Hawaiis largest moving companies declaredbankruptcy as a
consequence
Singapores Neptune Orient Lines said that theshutdown cost it $1
million a day
Had the shutdown lasted longer, vast amounts offood and other
perishables waiting to be shippedwould have spoiled.
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Why
these events were triggered by the
expiration of a union contract
dispute had more to do with employmentissues than wages
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Background
number of dock workers has shrunk over
the years as firms have used automation to
become more efficient 10,500 registered union workers averaged
at
least $80,000 (some estimates set the figure
at $100,000) a year with benefits and otherperks worth about
$42,000 under the
previous contract
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Offer
Pacific Maritime Association negotiators
had offered
$1 billion worth of new pension benefitslifetime benefits of
$50,000 a year
higher salaries of $114,500 a year for longshore
workers and $137,500 for marine clerks
health care plan with no deductibles
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Union Concerns
use of new technologies
potential loss of 400 longshore positions
wanted guarantees that new clericalpositions would be filled by
their union
members
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Take-it-or-leave it
Traditionally, longshore unions offered employers
a take-it-or-leave-it choice:
union specified both a wage and a minimum
number of hours of work that the employers had to
provide
1975 U.S. Department of Labor study found 2/3 of
transportation union contracts (excluding railroadsand
airplanes) had wage-employment compared to
only 11% of union contracts in all industries
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Task
Compare equilibrium where a union
specifies both wages and hours of work to
the perfect price discrimination equilibrium
w, wage per hour
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w
w*
H* H
w, wage per hour
B C
Demand
Supply
A
