• The most obvious way to capture more surplus is to raise prices

  • But Law of Demand $⟹$ this would turn many customers away!

• Also, we saw that if a firm wants to sell more units, it has to lower the price on all units!

• Instead, if firm could charge different customers with different WTP different prices for the same goods, firm could convert more consumer surplus into profit

• “Price discrimination” or “Variable pricing”

• Two conditions are required for a firm to engage in variable pricing:

1) Firm must have market power

• A competitive firm must charge the market price

• Two conditions are required for a firm to engage in variable pricing:

1) Firm must have market power

• A competitive firm must charge the market price

2) Firms must be able to prevent resale or arbitrage

• Clever customers buy in your lower-price market to resell it in your higher-price market

• Firm must acquire information about the variations in its customers' demands

• Can the firm identify consumers' demands before they buy the product?

• With perfect information $⟹$ Perfect or 1^st-degree price discrimination

• Charge a different price to each customer (their max WTP)

• With imperfect information $⟹$ 3^rd-degree price discrimination

• Separate customers into groups (by demand differences) and charge each group a different price

• 2^nd-degree price discrimination: More indirect forms of pricing: tying, bundling, quantity-discounts
  • Firm does not have enough information to categorize customers into groups
  • Consumers self-select into their own group

• Firms almost never have perfect information about their customers

• But they can often separate customers by observable characteristics into different groups with similar demands before purchasing

• Firms segment the market or engage in 3^rd-degree price discrimination by charging different prices to different groups of customers

• By far the most common type of price-discrimination

• Price-inelastic buyers will buy something (a necessity?) now regardless of whether or not it is “on sale”

• Price-elastic buyers will be attracted to buying something when price is lower

• Stores lower prices on rare occasions to attract price-sensitive shoppers (will lose profits on price-insensitive shoppers who buy during the sale!)

  • Black Friday: many price-insensitive shoppers stay away to avoid crowds! Better for the stores!

• Coupons also are designed to bring in more price-elastic shoppers

  • Often lower income, very sensitive to price, worth the hassle of collecting & using coupons

• Store sells at higher price (to capture profit from price-insensitive shoppers who can’t be bothered with coupons) and brings in profits from price-sensitive shoppers who use coupons to pay lower price

• By customer characteristics

  • Age
  • Gender

• Past purchase behavior

  • repeat customers (more price sensitive)

• By location

  • local demand characteristics

• Ideal competitive market, $q^{\ast }$ where $p^c=MC$

• Ideal competitive market, $q^c$ where $p^c=MC$

• A pure monopolist would produce less $q^m$ at higher $p^m$

  • reduce consumer surplus and create deadweight loss

• Transfer of some surplus from consumers to producers

• A price-discriminating monopolist transfers MORE surplus from consumers to producers

• But encourages monopolist to produce more than the pure monopoly level and reduce deadweight loss!

  • At best, also produces at competitive output level!

• Price-discrimination creates incentives for innovation and risk-taking

• Firms with high fixed costs of investment earn greater profits with price discrimination, can recover their fixed costs

• Might not invest or produce if they had to charge a uniform price

• As with markups in general, price discrimination has everything to do with price elasticity of demand

• If you are paying too much and losing consumer surplus, the real “problem” is that your demand is not very elastic

  • fewer options, a particular brand, or a necessity, limited time, etc

• If you want to pay less, buy generic (more elastic)

• Price discrimination is selling identical goods to people at different prices

• But not everytime people pay different prices means it is price discrimination

• Sometimes it is truly different goods that people are paying different prices for

  • If costs to firm are different for different versions (color, size, etc.), it is a different good, not price discrimination

• Example: bottled sparkling water often higher price than Coca Cola

• Could be because sparkling water drinkers have less elastic demand than Coke drinkers

• Or could be that it is more expensive to package sparkling water (economies of scale with greater number of Coke drinkers)

• The best way to tell the difference is to see what happens if demand changes price elasticity (and costs do not change)

  • Price discrimination requires market power, firm with market power marks up price based on $\frac{1}{ϵ}$
  • Competitive firm only sets $p=MC$, so change in elasticity has no effect on price

• See today’s class notes for a graphical demonstration

• Block Pricing/Nonlinear pricing: offer different prices for different quantities that consumers can choose

• quantity discounting: higher quantities offered at lower prices

• Example: instead of one profit-maximizing monopoly price of $p_m$ for $q_m$ units, offer:

• Example: instead of one profit-maximizing monopoly price of $p_m$ for $q_m$ units, offer:

  • $p_1$/unit for $q_1$ units
  • $p_2$/unit for $q_2$ units
  • $p_3$/unit for $q_3$ units
  • $p_4$/unit for $q_4$ units

• Converts DWL into CS and captures more of it as Profit

• Firms often tie multiple goods together, where you must buy both goods in order to consume the product

  • One good often the “base” and the other are “refills” that you may need to buy more of

• This is actually a method of intertemporal price-discrimination!

• Companies often sell printers at marginal cost (no markup) and sell the ink/refills at a much higher markup

• Reduce arbitrage:

  • printer requires specific ink
  • ink only words with that specific printer

• Segment the market into:

1. High-volume users: buy more ink over time; pay more per sheet printed

2. Low-volume users: buy less ink; pay less per sheet printed

• Indirect price-discrimination: firms don't know what kind of user you are in advance

• Again, a tradeoff:

• Increased profits and reduced consumer surplus, reduced deadweight loss

• Spreads fixed cost of research & development over more users

• If printers & ink were not tied:

  • printers would be more expensive
  • ink would be cheaper

• High-volume users would keep buying ink and save money (vs. tied)

• Low-volume users might not buy the (now expensive) printer at all!

• Firms often bundle products together as a single package, and refuse to offer individual parts of the package

• Often, consumers do not want all products in the bundle

• Or, if they were able to buy just part of the bundle, they would not buy the other parts

• Again, a tradeoff:

• Increased profits and reduced consumer surplus, reduced deadweight loss

• Spreads fixed cost of research & development over more users

• Goods with high fixed costs and low marginal costs (software, TV, music) increase profits from bundling

  • increases innovation and investment in these industries