Industrial organization

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Lecture 3: Price Discrimination (Church-Ware textbook, Ch. 5)
BU31010 - Competition and Market Regulation
Week 6: 31st October 2022
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Non-linear pricing
and price discrimination
Main reference and source of figures:
Church-Ware textbook, Ch. 5
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Non-linearity and price discrimination
Linear pricing: any buyers purchasing Q units spend PQ
Examples where this does not happen?
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Non-linearity and price discrimination
Linear pricing: any buyers purchasing Q units spend PQ
Examples where this does not happen?
 Quantity discount
 Students’ discounts
 Flat fee
 Subscription plus monthly fee
 Different price due to different cost (eg insurance premium based on risk)
is NOT per se price discrimination
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Deadweight loss and price discrimination
Recall that monopolies create deadweight loss, unlike perfect competition
Why?
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Deadweight loss and price discrimination
Recall that monopolies create deadweight loss, unlike perfect competition
Monopolists restrict the quantity brought to the market, as MR < P
That occurs as, in order to sell a higher Q, the monopolist needs to lower P. Which is why we express the
inverse demand function as P(Q), whereas in perfect competition MR = P (each single firm is a “price-taker”)
Can price discrimination reduce DWL?
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First-degree (“perfect”) price discrimination
Suppose that the monopolist knows exactly how much each consumer is willing to pay, i.e. each consumer’s
reservation price v (v1 being the highest)
Also assume that consumers cannot resell goods to other consumers (why?)
Then the monopolist can indeed “extract” the whole surplus out of the exchange!
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First-degree (“perfect”) price discrimination (cont’d)
Suppose you are willing to pay £10max for an Italian lesson of one hour and I know that. Then I’ll charge you
£10! And I’ll charge £20 to a Dante lover willing to pay that (and not one pence more)!
-> the monopolist gets the whole gain from trade, consumer surplus is zero
Is it Pareto efficient? (Poll)
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First-degree (“perfect”) price discrimination (cont’d)
Suppose you are willing to pay £10max for an Italian lesson of one hour and I know that. Then I’ll charge you
£10! And I’ll charge £20 to a Dante lover willing to pay that (and not one pence more)!
-> the monopolist gets the whole gain from trade, consumer surplus is zero
Is it Pareto efficient? (Poll)
How does the quantity sold compare with the perfect competition case? And with monopoly with linear
price and no discrimination?
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First-degree (“perfect”) price discrimination – selling to six consumers
(or consumer segments)
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Perfect discrimination with common demand
With a two-part tariff, per-unit expenditure decreases with the quantity purchased
Suppose for simplicity that all individual consumers are characterised by the same demand function Q(P),
negatively sloped: you buy a higher (lower) amount if the price is lower (higher)
With linear pricing, the monopolist would restrict the quantity sold, with P > MC and potential, mutually
advantageous exchanges do not occur
A tariff including a fixed amount and a per-unit price set at MC results in the same quantity sold as with
perfect competition, and the monopolist extracting the whole surplus (gain from trade)
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Second-degree price discrimination
Suppose (more realistically) that the monopolist cannot identify consumers’ willingness to pay. If able to
segment consumer groups -> third-degree price discrimination
When firms are unable to identify low/high demand consumers -> second
Hence need to provide “menus” so that consumers have incentives to self-select by opting for the most
suitable choice
A common example: discount for units above a certain level
This allows to increase profits and the surplus accruing to high-demand consumers, reducing DWL
Another form is to reduce the quality of a product to keep selling the “good” one to high-demand
consumers and get low-demand consumers to buy the “damaged good”. Why?
In the following figure, high-demand consumers buy additional units, effectively paying an overall lower per-
unit price in comparison to low-demand consumers
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Third-degree price discrimination
Suppose again that the monopolist is not able to identify each single consumers’ willingness to pay
A frequent case occurs when it is possible to establish a relationship between consumers’ characteristics
and willingness to pay
Hence one can identify different segments and attempt to estimate separate demand functions for the
same product
The monopolist maximise profits separately in correspondence to the different demand functions
(Yes: when you get student discounts it is not (only) because cinema owners are nice, they are still profit-
maximisers!)
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Third-degree price discrimination (cont’d)
In practice, the monopolist solves two separate maximisation problems as with two separate market
demands, as total profits can be expressed as:
𝜋 = 𝑝1𝑞1 + 𝑝2𝑞2 − 𝐶 𝑞1 + 𝑞2
From which we get:
𝑀𝑅 𝑞1 = 𝑀𝑅 𝑞2 = 𝑀𝐶 𝑞1 + 𝑞2
Or:
𝑝1 1 −
1
𝜀1
= 𝑝1 1 −
1
𝜀2
= 𝑀𝐶(𝑞1+𝑞2)
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Third-degree price discrimination (cont’d)
If 𝜀1 > 𝜀2, which of the two prices is higher?
Are profits higher or lower than without discrimination?
Are consumers in group 1 better off than without discrimination? And consumers in group 2?
Total welfare variation could go either way but:
1. If total quantity is not higher, total welfare is lower than with uniform pricing – with equal quantity,
some buyers value the product less than some who do not buy
2. If uniform price was excluding the low demand consumers, then total welfare increases with
discrimination
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Third-degree price discrimination (cont’d)
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Tying and bundling
Tying: to get good A, you need to buy also good B
 Eg: photocopy machines and cartridges, coffee machines and capsules
In absence of tying: perfect competition drives prices of tied goods (cartridges, capsules) down to MC. With
tying, consumers get the machine at a lower price (than without tying) but need to get overpriced
secondary goods
Bundling: effective with consumers with different reservation prices
 Consumer X value monthly access to films £15 and to sport £5, consumer Y vice-
versa. How much revenues (assume MC=0) do you get by selling subscriptions
separately? And bundling, ie offering a subscription including both?
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