Price

Discrimination
Chapter 13
Slides by Pamela L. Hall

Western Washington University

2005, Southwestern

Introduction

Price discrimination is legal unless it substantially limits

competition
Firms will actively price discriminate in an effort to enhance profits
A firm with monopoly power has some control over output
price when it is facing a negatively sloping demand curve
May be able to increase profits by discriminating among consumers
For example, a bar may sell drinks at a lower price per unit during happy
hour

Generally, a firm desires to sell additional output if it can find

a way to do so without lowering price on units it is currently
selling
By separating market into two or more segments
Called price discrimination (or Ramsey pricing)

Analogous to a multiproduct firms supplying products in different markets

Introduction

Our aim in this chapter is to illustrate how firms are always probing
market for ways to enhance profits
For a firms long-run survival, it must constantly devise novel pricing
techniques for enhancing profits

Firms who first develop such pricing techniques can earn pure profits

Firms who do not will, in the long run, fail

We first state underlying market conditions required for price
discrimination

We develop categories of first-, second-, and third-degree price

discrimination

Evaluate efficiency and welfare effects of each type

First-degree price discrimination includes pricing strategies such as twopart tariffs

Tie-in-sales and bundling are discussed as an alternative to this type of price

discrimination

Introduction

Second-degree price discrimination offers potential social benefits

If a firm did not price discriminate it might not be able to produce a desired
commodity

Third-degree price discrimination segments the market

For instance, into a foreign and a domestic market

We discuss quality discrimination

Generally, same implications associated with price discrimination hold for

quality discrimination as well

In all large companies, applied economists are actively developing

methods for price discrimination

For example, after deregulation of airline industry in 1978, airline economists

developed price-discriminating techniques for improving profit

Such as requiring a Saturday night stay or 14-day advance bookings

Conditions for Price

Discrimination

In terms of demand elasticities, if elasticities

associated with market segments are the same
No incentive on part of a firm to price discriminate
Because profit-maximizing output and price are identical in both
markets

Two necessary conditions for price discrimination

are
Ability to segment market
Exists if resales become so difficult that it becomes impossible to
purchase a commodity in one market and sell it in another market

When resale is possible, arbitrage will eliminate any price

discrepancies and Law of One Price will hold

Existence of different demand elasticities for each market

segment

Conditions for Price

Discrimination

A firm may price discriminate across any category

of consumers
Such as income level, type of business, quantity
purchased, geographic location, time of day, brand
name, or age
For example, doctors may charge less for treatment of lowincome patients, and a defense contractor may charge military
$500 for a hammer that costs other costumers only $20

Depending on how a market can be segmented,

economists have categorized various types of price
discrimination into
First-, second-, and third-degree price discrimination
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First-degree Price Discrimination

Complete price discrimination, perfect price discrimination, or firstdegree price discrimination

Occurs when it is possible to sell each unit of product for maximum price a
consumer is willing to pay

Table 13.1 lists characteristics and examples of first-, second- and thirddegree price discrimination
First-degree price discrimination involves tapping demand curve

Illustrated in Figure 13.1

First unit of commodity is sold to a consumer willing to pay highest price,

0A

Second unit to a consumer willing to pay at a slightly lower price

And so on until demand curve intersects SMC
In this case, demand or AR curve becomes MR curve

As firm increases supply, price declines only for additional commodity sold, not for all
commodities supplied

Table 13.1 Characteristics of First-, Second-,

and Third-Degree Price Discrimination

Figure 13.1 First-degree price

discrimination

First-degree Price Discrimination

As shown in figure, firm equates MR to SMC and supplies a

level of output Q1
Results in TR being represented by area 0ABQ1
STC by area 0FEQ1
Pure profit by area FABE
Each consumer who purchases commodity is paying his or
her maximum willingness-to-pay, WTP, for commodity
Receives zero consumer surplus from purchasing commodity
Area FABE contains total consumer surplus, for an output level of Q1

Which firm captures

Since all of consumer surplus is captured by firm, all consumers are
indifferent between buying commodity or not

Lowest price offered by firm is p1 = SMC(Q1)

Because additional revenue generated by selling an additional unit of
output is less than additional cost SMC
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First-degree Price Discrimination

Last consumer willing to purchase commodity pays this lowest price, p1

Consumers who are not willing to pay p1 do not purchase the commodity
All other consumers who do purchase commodity pay a price higher
than p1 equivalent to their maximum WTP

Thus, at p1 and Q1, what consumers (society) are willing to pay for an

additional unit of commodity is equivalent to what it costs society to produce

this additional unit, SMC(Q1)

Represents a Pareto-efficient allocation

With first-degree price discrimination there is no deadweight loss (inefficiency)

However, distribution of wealth between consumers and owners of firms may be
questionable for maximizing social welfare

First-degree price discrimination is difficult to attain

One example is a roadside produce stand

Prices vary depending on type of automobile consumer is driving and where he is
from

Person driving a Lincoln with New York plates will probably pay a premium for boiled
peanuts at a roadside stand in Georgia

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Intertemporal Price
Discrimination

Type of first-degree price discrimination

Products price is based on different points in
time

Price is initially set high

To capture consumer surplus from those
consumers willing to pay high price rather than
wait

Price is lowered over time

To capture further consumer surplus from those
consumers unwilling to pay high price and willing
to wait
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Two-Part Tariffs

Consumers pay for ability to purchase a commodity and

possibly again for actual commodity
E.g., pay a membership fee for joining a country club in addition to
any greens fee
E.g., pay an entrance fee to get into a bar and then pay for drinks

Firm will price discriminate on entrance fees to extract as

much of a consumers WTP as possible
Commodity being sold is priced so it will maximize
admission
Subject to constraint that additional output cannot be sold below cost
At p = SMC

Will expand number of consumers paying entrance fees compared with no

price discrimination condition of MR = SMC

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Two-Part Tariffs

Price discrimination on entrance fees is achieved

through coupons and discounts by age or for
membership in certain organizations
For example, in 1955 Disneyland opened in rural
Anaheim, California
In 1950s and 1960s, Disneyland employed a two-part tariff

Admission price was charged along with a cost for each attraction
Cost of tickets for attractions varied
Rides like Dumbo cost the least (an A ticket) and rides like
Pirates of the Caribbean cost the most (an E ticket)

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Two-Part Tariffs

A two-part tariff assuming only one consumer is also illustrated in Figure

13.1

Firm sets an entrance fee that takes all consumer surplus

Where p = SMC at p1, area p1AB

Sets a price of p1 that results in output Q1

Firms profit is same as first-degree price discrimination, FABE

No deadweight loss exists

However, may be social-welfare implications from transfer of surplus from

consumers to firms

Firms will also use a two-part tariff in pricing tie-in sales

Firm with monopoly power will require consumers to purchase two or more
commodities that are complementary goods

For example, up until late 1960s, IBM required consumers who purchased an IBM
computer to also purchase their punch cards

Priced computer at a perfectly competitive price

Employed monopoly pricing for punch cards, where MR = SMC < p

15

Bundling

In many cases firms are unable to practice first-degree price

discrimination
Because consumer preferences are not completely revealed
Cost of revealing these preferences may be prohibitive
In such cases, difference in consumers willingness- to-pay
for commodities and marginal cost of producing
commodities can be exploited
By selling commodities in bundles
Bundling exists when a firm requires consumers to
purchase a package or set of different commodities rather
than some subset of commodities
For example, many portrait studios will sell a package of photos in
different sizes and poses rather than each photo separately

16

Bundling

Effective method for enhancing profit when

consumers have heterogeneous demands
But firm is unable to effectively separate consumers by
their preferences and then price discriminate

Specifically, bundling is an alternative when firms

are unable to perfectly price discriminate
For example, automobile dealers often offer a package
containing a number of options, such as leather seats
and antilock brakes
Consumers can purchase package containing leather seats and
antilock brakes

Cannot purchase leather seats or antilock brakes separately

17

Bundling

Suppose Robinson is willing to pay more for leather seats than Friday

Friday is willing to pay more for antilock brakes than Robinson

As shown in Table 13.2, if options were sold separately, maximum price that
could be charged is $1300 for leather seats and $1000 for antilock brakes

Revenue would be $2300 from each consumer, with TR = $4600

If dealer could perfectly price discriminate and charge each consumer

their maximum WTP for each option

First-degree price discrimination would yield TR = 2000 + 1000 + 1300 +

2500 = $6800

However, since dealer cannot do this, it bundles leather seats with antilock
brakes

Robinson is willing to pay $3000 and Friday $3800

By charging each consumer $3000, TR = $6000

Greater than revenue derived from not bundling but lower than revenue from perfect
price discrimination

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Table 13.2 Bundling

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Bundling

Bundling is most effective when demands of two

consumers are highly negatively correlated
See Table 13.3
Local governments have recently adopted bundling
in an effort to entice voters to pass local-option tax
measures
Targeting tax revenue to a bundle of specific projects
Such as school improvements, a retirement center, a sports

complex, and a transit facility improves likelihood of tax passing

Negative correlation of these projects makes bundling a very

attractive method for funding
If voters had to consider each project separately, probability of
all projects receiving majority support would decrease

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Table 13.3 Bundling with

Positively Correlated Demands

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Second-degree Price
Discrimination

Cost of a 1-ounce letter is 22.2 using Standard Class (bulk mail)

Compared with 37 for regular First Class mail

Bulk rate discount is an example of second-degree price discrimination

Commonly used by public utilities

For example, per-unit price of electricity often depends on how much is used

Second-degree price discrimination (also known as nonlinear pricing)

occurs

Where a firm with monopoly power sells different units of output for different per-unit
prices

Every consumer who buys same unit amount of commodity pays same per-unit price
Price differs across commodity units and not across consumers
Same price schedule is offered to all consumers and consumers self-select which price per
unit they will pay

Mixed bundling is an alternative type of bundling associated with second-degree

price discrimination

Firm will offer commodities both separately and as a bundle

With bundled price below sum of individual prices

22

Second-degree Price
Discrimination

In some cases it may be possible for a firm with

monopoly power to earn a pure profit only if it price
discriminates
Consider second-degree price discrimination where a
monopoly establishes two prices for a commodity
A higher per-unit price for the commodity offered in a smaller size
and a lower per-unit price for a larger size
As illustrated in Figure 13.2, monopoly would be operating at a
loss if it offers a single (linear) per-unit price for commodity

SATC curve does not cross AR curve at any output level

No single price will yield a positive pure profit

If firm price discriminates, it will earn a pure profit by selling Q1

units of commodity in smaller unit size at a price of p1 and Q2 - Q1
units of commodity in larger unit size at a price of p2

23

Figure 13.2 Second-degree price

discrimination yielding a pure profit

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Second-degree Price
Discrimination

Pure profit from selling smaller unit size is represented by

area (SATC2)p1AB
Greater than loss (negative pure profit) from selling larger unit size,
area EBCD

Consumers can now consume a commodity that would not

be available if firm did not price discriminate
Firm can earn a pure profit
Both consumers and firm are better off by price
discrimination
Implies a Pareto improvement and an associated increase in social
welfare

One justification for allowing a regulated monopoly to practice price

discrimination

25

Second-degree Price
Discrimination

If consumers who are willing to pay for larger size units pay a price in
excess of marginal cost

Firm could lower p2 by some amount to induce consumers to buy more

Price is still greater than marginal cost

Firm will still make a profit on these sales

Profit occurs because, given price discrimination, such a policy would not affect
profits from any other consumers

As indicated in Figure 13.2, we determine optimal price for larger size

units, p2, and total quantity sold of both small and large sizes, Q2

By setting p = SMC

Determine optimal quantity of smaller size units, Q1, and associated

price, p1

By maximizing revenue from smaller size units minus lost revenue from not
quantity at bulk price per unit, p2

26

Second-degree Price
Discrimination
F.O.C. is
MR1(Q1) p2 = 0
Solving for Q1 yields optimal quantity for firm
to supply in smaller units
Firm can sell this level of output at p1
In Figure 13.2, maximization problem results
in additional revenue above bulk price p2 of
[(p1 - p2)Q1], represented by area p2p1AE

27

Self-Selection Constraint

One problem with a firm maximizing smaller-unit revenue

Consumers rather than firm determine who will purchase smaller
versus larger sizes of commodity

Nothing to prevent a consumer who usually purchases

commodity in bulk from purchasing smaller size unit
If firms price/quantity solution of p1 and Q1 yields
unintended result of consumers shifting from purchasing
larger size units to smaller size units
Will not be profit-maximizing solution
Firm instead must determine optimal price and quantity that
will provide incentive for consumers to purchase unit size
that maximizes firms profit

28

Self-Selection Constraint

If consumer surplus for consumers purchasing larger size

unit is greater than their surplus from purchasing smaller
size unit
Consumers will self-select and purchase larger size unit
Otherwise, self-selection will not occur and bulk purchasers
will switch to purchasing smaller size unit
Considering self-selection constraint on determining profitmaximizing price and quantity
Maximization problem is

Where CS1 and CS2 are bulk consumers surplus from instead
purchasing smaller size unit and their surplus from purchasing in bulk,
respectively

29

Self-Selection Constraint

If at unconstrained optimal solution, where MR1(Q1)

- p2 = 0, self-selection constraint holds
Firm will maximize profits by setting MR1 = p2
If CS1 > CS2 at MR1(Q1) - p2 = 0, firm would further
increase price of smaller size unit until CS1 = CS2
For a linear demand curve the condition of CS1 =
CS2 corresponds to revenue-maximizing condition
MR1(Q1) = p2 = 0

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Self-Selection Constraint

Can demonstrate this condition with Figure 13.2

Let p = a - bq be inverse linear demand function faced by firm

Then CS1 = CS2

(a p1)Q1 2 = (p1 p2)(Q2 Q1) 2

Multiplying both sides by 2 and substituting linear demand function for p1 and p2
yields

Q1 = Q2/2

Result is equivalent to F.O.C. for maximizing revenue MR1(Q1) - p2 = 0

Solving for Q1 yields this equivalence

a 2bQ1 (a bQ2) = 0

Illustrated in Figure 13.2

Q1 = Q2/2

Area p1aA representing CS1 is equivalent to area EAD representing CS2 at MR1(Q1) - p2
=0

Thus, for a linear demand curve, self-selection constraint is always

satisfied

31

Third-degree Price
Discrimination

Some managers believe only reason a firm would sell its product at a lower price
in its foreign market

To drive competing firms out of business and then exercise monopoly power by
increasing price

However, in many cases, reason is that firm is practicing third-degree price discrimination

Common form of price discrimination

Examples include senior-citizen discounts, lower prices in foreign versus domestic markets, and
happy hours at bars

Whenever markets have different demand elasticities and arbitrage among

markets is impossible

Firm can engage in third-degree price discrimination

Occurs when a firm with monopoly power sells output to different consumers for different
prices

Every unit of output sold to a given category of consumers sells for same price
For example, nonprofit rate for Standard Class (bulk) mail is 12.7 compared to 22.2 charged
to for-profit consumers

In contrast to second-degree price discrimination, where price differs across

commodity unit and not across consumers

In third-degree price discrimination price differs across consumers and not across
commodity unit

32

Third-degree Price
Discrimination

Consider two markets each with different demand

elasticities
Assume demand curves are independent, so no leakage exists
among markets

Thus, consumers in market with a lower price cannot resell product in

another market with a higher price

For determining optimal selling prices and outputs, let pj(qj)

be inverse demand function in jth market segment and
express revenue in jth market segment by
TRj(qj) = pj(qj)qj, j = 1, 2,
Where qj is quantity sold in jth market segment

Total revenue is

TR(Q) = TR1(q1) + TR2(q2)

Where total quantity sold, Q is

Q = q 1 + q2

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Third-degree Price
Discrimination

Letting STC(Q) be short-run total cost function, firm

maximizes profits by

Partial differentiation yields F.O.C.s

If MR1 > MR2, total revenue and profit can be

increased by shifting output from market 2 to
market 1
Enhancement in total revenue can continue until
marginal revenues in both markets are equal

34

Third-degree Price
Discrimination

In general, for k markets MRj(qj*) = SMC(Q*) for all k

markets
If a monopoly can divide its market into k independent submarkets
It should divide overall output among k markets in such a way that it
equalizes marginal revenue obtained in all markets

MR1(q1*) = MR2(q2*) = = MRk(qk*)

This common marginal revenue should be equal to marginal cost of

overall output

MR1(q1*) = MR2(q2*) = MRk(qk*) = SMC(Q*)

Price charged in each market is determined by substituting qj* into

markets average revenue function, pj* = ARj(qj*)

A graphical illustration for two markets (say, foreign and

domestic) is provided in Figure 13.3

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Figure 13.3 Third-degree price

discrimination for two markets

36

Third-degree Price
Discrimination

Consider a level of MR = MR*

This value of marginal revenue is attained in both markets only if
quantities sold in two market segments are q1* and q2*

Remaining F.O.C. requires that this common MR in two

market segments be equated to SMC
Determines optimal (Q, MR) combination
By summing horizontally MR curves in each of two markets, we
determine total output for a given level of MR, qj|MR

Equating qj|MR with SMC determines optimal level of total output, Q*

Optimal quantities and prices in the two markets are q1*, q2*,
p1*, and p2*
Determined by demand curve in each market given optimal output
levels

37

Third-degree Price
Discrimination

Price is highest in market segment with more steeply sloped

demand function
Domestic market with more inelastic demand
Can investigate relationship of prices in separate markets
and elasticity by recalling that
MRj(qj) = pj[1 + (1/Dj)]
Where Dj = (qj/pj)(pj/qj) is own-price elasticity of demand in market j

Can relate prices charged in separate markets to own-price

elasticities of demand in each of these markets
Given that condition for the two markets is

38

Third-degree Price
Discrimination

Relationship indicates that prices in any two

markets are equivalent if own-price
elasticities of demand are equal
If D2 > D (demand is more elastic in foreign
market, market 1), then
1 + (1/D2) < 1 + (1/D1)

Which implies
p1/p2 < 1 or p2 > p1

39

Third-degree Price
Discrimination

Foreign market is charged lower price

More price sensitive due to a greater degree of competition from
other firms (more elastic demand)

Prices will be lower in market where demand is more elastic

and arbitrage is not possible
For example, elasticity of demand for movie matinees is more elastic
than evening movies

Matinee prices are lower because opportunity cost of going to a matinee

is higher

Working and going to school coincide with matinee time

Similarly, senior citizens and college students are groups with relatively
lower incomes

Resulting in a more elastic demand for commodities

If a firm is able to segment its market based on these

demographics
It can price discriminate and potentially enhance its profits
40

No Price Discrimination

Figure 13.3 illustrates relationship between ordinary monopoly (no price

discrimination, where full arbitrage exists among consumers) and price
discrimination
A horizontal summation of individual market demand curves, qj|AR

Is market demand curve facing firm if no price discrimination exists

Note discontinuity of MR curve associated with this market demand curve

Due to kink in market demand curve

Optimal output is where SMC = MR at output Q' associated with

common price p'

Common price is between prices charged in the two market segments when
price discrimination is practiced

At this common price, firm sells q1' in market 1 and q2' in market 2
MR1 > MR2

Firm could increase profits by practicing price discrimination

41

No Price Discrimination

Effect of third-degree price discrimination on social welfare is ambiguous

Social welfare could be enhanced or reduced

Depending on consumers preferences and wedge between price and marginal
costs

Sufficient condition for social welfare to decline is

If total output from price discrimination does not increase

Sufficient condition for a social-welfare gain is

If third-degree price discrimination results in satisfying demand in a market

where zero output would be supplied with no price discrimination

For example, prior to airline deregulation, airlines could not compete in

terms of price and were required to service certain routes

Resulted in many empty seats on flights and airlines competing for

passengers in terms of service and meals

Since deregulation, airlines compete in terms of price

They generally fill every seat

Resulted in greatly expanded airline travel

Satisfying markets (particularly vacation traveling) that were small or nonexistent before

42

Combination of Discrimination
Techniques

In an effort to earn short-run pure profits, firms will employ

combinations of these three price discrimination techniques
Will constantly be devising new methods for price discrimination
For example U.S. Post Office uses both second- and third-degree price
discrimination in pricing mail delivery

In long-run, costs will adjust to any short-run profits from

price discrimination
Leading to long-run equilibrium with associated normal profits
Firms failing to engage in price discrimination will
experience declining revenue
Be forced out of business

43

Combination of Discrimination
Techniques

Individual consumer can increase her utility by shifting

consumption patterns and capturing lower price per unit
offered by price-discriminating firms
By doing so consumer is able to recoup some of surplus
appropriated by firms

Unfortunately, firms constantly change their prices or quantity as market

conditions change

For example, candy manufacturers will alter number of ounces in different

sizes of candy bars
Changes per-unit price for each size but keeps prices the same

Changes in price discrimination have resulted in a whole

industry developing for assisting consumers
For example, travel agents will assist consumers in finding lowest
fares for particular destinations

44

Quality Discrimination

There is a difference in consumers willingness-to-pay for a

given quality rather than quantity of a commodity
For example, manufacturer of DVD players is practicing quality
discrimination

By offering a range of different physical components and different

warranties for its DVDs

Fundamentally, price discrimination and quality

discrimination are identical models
Same implications associated with various degrees of price
discrimination hold for quality discrimination

Actual commodity may be the same with a difference only in

service
Or commodity itself may be altered
45

Quality Discrimination

Product quality can also take form of determining

level of its durability
A highly durable product, such as a new consumer
appliance designed to last a lifetime, may result in market
saturation
Once most consumers have purchased product there remains
only limited product demand

A firm may also face competition from resale of durable

goods it produced previously
For example, if product (such as aluminum) can be recycled at a
competitive price

Monopoly power of firm could be eroded away

46

Quality Discrimination

Number of strategies firms can use to

counter product durability problem
Build in planned obsolescence of product by
Marketing an improved version of product
Changing its physical appearance

For example, automobile manufactures generally change

their vehicle models appearance and market models
improvements on an annual basis

Lease their products instead of selling them

Maintains a firms market power by giving it control

over new market and market for resales

47