Digital Basics
Lecture 2 - Price discrimination
VUONG Hung Cuong
AEI-UPEC
September 9, 2023
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What is price discrimination
• In markets where linear prices are set, all consumers pay the same price per unit of
the good, regardless of who they are and regardless of how many of the goods they
choose to purchase
• Price discrimination involves selling the same good at different prices, adjusted for
differences in costs.
• Example?
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Examples
• Local telephone service is provided at a flat monthly fee, independent of how many
calls you make. So the average price per call is lower for frequent users than for
infrequent users
• Donuts are cheaper when you buy them by the dozen than when you purchase them
individually.
• If you tried to resell your student discount SNCF ticket to your boss, so that she
could travel at the student price, the airline company would get upset and perhaps
refuse to sell you any more tickets.
• A lunch in a fine restaurant will cost you 20 dollars but almost exactly the same meal
enjoyed at dinner time might cost you 40 dollars.
• Students and university staff pay different tariff when having lunch in a Crous
restaurant
• Your local cable TV station most likely allows you to buy ”packages” of channels,
perhaps two or three choices, but will not sell you each station separately.
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Numerical example
• Assuming the cost of producing a pair of sunglasses is 100 euros
• The willingness to pay (WTP) of Edmond, Marc and Philippe are 150,200,250
respectively.
• How much would the firm set?
• Lower than 100 ? - No
• Higher than 250 ? - No
• If it is set at 250, only Phlippe buys. The firm earns 250-100=150 euros
• If it is set at 200, Marc and Phlippe buy. The firm earns 200+200-100-100=200
euros
• If it is set at 150, all of them buy. The firm earns 150+150+150-100-100-100=150
euros
• Thus, the firm is interested in setting at 200 euros
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What is price discrimination
• Proof
• Let p be the price of the sunglasses, n is the number of buyers
• The firm’s profit is (p-100)n(p)
• If price is from 100 to 150, then n=3
• In this case, profit=(p-100)3. Thus, p=150;profit=150
• If price is from 150 to 200, then n=2. Thus, p=200;profit=200
• If price is from 200 to 250, then n=1. Thus, p=250;=150
• Can the firm do better?
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What is price discrimination
• Just thinking in two steps:
• Step 1: set price at 200, two persons buy. The firm earns 200
• Step 2: reduce the price of the third pair to 150, the last person buys. The firm
earns an extra 50.
• Totally the firm earns 250
• Can the firm do better?
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What is price discrimination
• Three steps:
• Step 1: 250. Sells to Philippe
• Step 2: 200. Sells to Marc
• Step 3: 150. Sells to Edmond
• The firm earns 300
• Is this example realistic?
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What is price discrimination
• In principle, non-linear price strategies are attempts to capture more of the surplus
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What is price discrimination
• In order to price discriminate, a seller must satisfy two conditions: it must possess
market power and it must be able to prevent arbitrage, or resale
• Without market power, the price of all units of all goods will be driven down to the
level of costs by competition, and price discrimination cannot arise.
• The latter implies that the consumers of the low-priced goods may be tempted to
resell them to consumers who were intended to buy the high-priced goods, and
unravel the firm’s careful price discrimination scheme
• Gray markets: Many branded electronic goods, for example Sony cameras and personal
audio units, were at one time available at New York discount stores in either the ”made
for U.S. market” version (which carried the full warranty) or a cheaper version which
had been originally manufactured for a different, lower-priced market (China, for
example) and imported into the U.S., and usually sold without the full U.S. warranty
• A variety of strategies can help a firm to prevent arbitrage. Good examples are the use
of territory-specific warranties and vertical integration.
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What is price discrimination
• Price discrimination is important in high-tech industries for two reasons.
• First the high-fixed-cost, low-marginal-cost technologies commonly observed in these
industries often lead to significant market power, with the usual inefficiencies due to
the fact that price will often exceed marginal cost
• Second, information technology allows for fine-grained observation and analysis of
consumer behavior. This permits various kinds of marketing strategies that were
previously extremely difficult to carry out, at least on a large scale
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First-degree price discrimination
• In the most extreme case, information technology allows for a ”market of one,” in
the sense that highly personalized products can be sold at a highly personalized price.
This phenomenon is also known as ”mass customization” or ”personalization.”
• Example: personally configured computer from Dell, individual discount...
• Internet retailers revise their prices much more often than conventional retailers, and
that prices are adjusted in much finer increments (e.g.: AirBnB)
• The theory of monopoly first-degree price discrimination as represented in the
previous slide is fairly simple: firms will charge the highest price they can to
each consumer, thereby capturing all the consumer surplus.
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First-degree price discrimination
• Properties: Since the firm has extracted all of the consumer surplus, profits are equal
to total net surplus, or the sum of consumer and producer surplus.
• The marginal consumer, that is, the consumer with the lowest reservation price who
actually buys the good, will be the one whose reservation price just equals marginal
cost.
• A non-discriminating monopolist will tend to omit some products because even
though they would generate a positive net surplus, they cannot be produced
profitably. The same conclusion can be drawn for product quality; that is, a perfectly
discriminating monopolist has exactly the right incentives to produce goods of
optimal quality.
• Thus, a monopolist can capture all economic surplus implies first-degree price
discrimination is Pareto optimal
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First-degree price discrimination
• Formally, perfect, or first-degree, price discrimination also refers to a situation where
consumers have identical demands for a particular product, and the firm prices so as
to extract all the surplus
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First-degree price discrimination
• Marginal costs are assumed to be constant. If the firm sets a two-part tariff p, A,
where p = c, and A equals the consumer surplus generated at a price equal to
marginal cost, then the firm will extract all the surplus, and we will also get efficient
pricing and output
• This type of pricing is sometimes known as ”Disneyland pricing” (Walter Oi (1971) -
suggested that theme parks could use a strategy of charging an entry fee plus a
variable price for rides to achieve exactly the sort of profitability and efficiency
outcomes)
• How do the firm know how much each person is willing to pay for the good?
• If you have the highest WTP, would you wish to reveal such information?
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First-degree price discrimination
• Application: Suppose inverse demand is given by P = 1 - Q, and costs are C = 0.2Q.
• The monopolist can practice first-degree price discrimination
• Calculate the surplus received by consumers and the monopolist in this case.
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First-degree price discrimination
• Competition with price discrimination is hard to analyze
• There can be ”enhanced surplus extraction effect” - allowing firms to charge
prices closer to the reservation price for each consumer and the ”intensified
competition effect.” - implying that each consumer is a market to be contested
• Competition between new entrant vs a long-time suppliers of consumers who is
”owning the consumer and understand ”their” consumers’ purchasing habits and
needs better than potential competitors.
• Amazon’s personalized recommendation service is an excellent example. A new seller
would not have this extensive experience with large customer base with purchase
history, and would therefore offer inferior service.
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First-degree price discrimination
• A digital platform can provide better analysis and forecasts of their customers’
needs than could the customers themselves due to this superior information. Thus, it
can offer services to their customers such as recommended orders for restock.
This allows the firms to charge a premium for providing this service, either via a flat
fee or via higher prices for their products.
• However, personalized pricing obviously raises privacy issues. A seller that knows its
customers’ tastes can sell them products that fit their needs better but it will also be
able to charge more for the superior service.
• Finally, Internet retailers revise their prices much more often than conventional
retailers, and that prices are adjusted in much finer increments. This is also true for
platform sellers who allow the platform set their prices based on AI recommendations
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Third-degree price discrimination
• Third-degree price discrimination is selling at different prices to different groups. It
is, of course, a classic form of price discrimination and is widely used.
• In the real world, the seller will know some characteristics of buyers that are likely to
affect their demand. For example, students are likely to respond in a very elastic way
to discounts on air travel.
• Third-degree price discrimination (also called group price discrimination) occurs
when a firm divides its customers into two or more groups based on their price
elasticity of demand and charges them different prices.
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Third-degree price discrimination
• Formally, third-degree price discrimination or market segmentation can be
implemented when the monopolist knows the market demand curve for different
groups and can stop arbitrage between the two groups.
• The monopolist charges the same uniform price for units sold within a group, but
differentiates the linear price between groups or markets.
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Third-degree price discrimination: Example
• Let’s consider AryaSoft, a developer of a premium movie-editing software, which
engags in third degree price discrimination based on intended use of its software:
personal vs. commercial
• Assume the demand and marginal revenue functions are:
• Price P1=50-5Q1. Marginal revenue MR1=50-10Q1
• Price P2=75-15Q2. Marginal revenue MR2=75-30Q2
• Marginal cost: MC=3.
• How much should the firm charge each group?
• Note that two groups are independent.
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Third-degree price discrimination
• The commercial demand curve is steeper than the personal demand curve precisely
because the commercial segment has lower elasticity of demand.
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Third-degree price discrimination
• General rules: If demand for good 1 is more elastic than demand for good 2, profit
maximization requires that price for group 1 is lower than that of group 2
• Intuition: The monopolist charges higher prices in inelastic markets since demand is
less responsive to higher prices.
• Charging high prices in the more elastic market is not profit maximizing since
quantity falls substantially as consumers reduce their demands.
• Compared with non-price discrimination, consumers in the market with the lower
elasticity are worse off, since the price in this market has increased.
• However, consumers in the market with the higher elasticity are better off, since the
price in this market has decreased.
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Second-degree price discrimination
• Second-degree price discrimination refers to a situation where everyone faces the
same menu of prices for a set of related products. It is also known as ”product line
pricing,” ”market segmentation,” or ”versioning.”
• The idea is that sellers use their knowledge of the distribution of consumer tastes to
design a product line that appeals to different market segments.
• Books are available in hardback or paperback, in libraries, and for purchase. Movies
are available in theaters, on airplanes, on tape, on DVD, and on TV. Newspapers are
available online and in physical form.
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Second-degree price discrimination
• Information versioning has also been adopted on the Internet. For example,
20-minute delayed stock prices are available on Yahoo free of charge, but real-time
stock quotes cost 9.95 dollar a month. In this case, the providers are using ”delay”
to version their information.
• Information technology is helpful in collecting information about consumers, helping
design product lines, and in actually producing the different versions of the product
itself
• The basic problem in designing a product line is ”competing against yourself.” Often
consumers with a high willingness to pay will be attracted by lower-priced products
that are targeted toward consumers with less willingness to pay. This ”self-selection
problem” can be solved by lowering the price of the high-end products, by lowering
the ”quality” of the low-end products, or by some combination of the two.
• Ex: airplane seats
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Second-degree price discrimination
• Versioning is being widely adopted in the technology-intensive information goods
industry. Intuit sells three different versions of their home accounting and tax
software, Microsoft sells a number of versions of its operating systems and
applications software,
• Usually, the price differences between the two versions is much greater than the
difference in marginal cost
• Both first- and third-degree price discrimination require that the seller be able to
identify characteristics of different consumers (if only between groups), on which
discrimination can be profitably based
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Second-degree price discrimination
• Formally, second-degree price discrimination is the name given to price discrimination
schemes in which the firm knows that consumers differ in ways that are important to
the firm but it is unable to identify individual consumers so as to be able to
discriminate directly.
• The simplest case arises where some consumers have a stronger or less elastic
demand, and others weaker or more elastic demand.
• Obviously, since the firm does not know the identity of any individual customer, it
cannot segment the market as third-degree price discrimination schemes do, but
must offer the same price, menu of prices, or pricing schedule to all consumers.
• The consumers then ”self-select” by opting for different menu choices, and by their
self-selection the monopolist is able to discriminate profitably between them. The
discrimination is only partial, however: it is a basic principle of economics that
information is valuable, so that we would not expect the uninformed monopolist to
be as profitable as the perfectly discriminating firm.
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Second-degree price discrimination
• Logic of second-degree price discrimination:
• The law of diminishing marginal utility: it tells us that the reservation price for the first
unit must be higher than the second unit and so on because marginal utility decreases
with an increase in consumption
• Second-degree price discrimination uses this insight in that it charges different prices for
different number of units that a consumer buys.
• Examples of second-degree price discrimination include quantity discounts, when
more units are sold at a lower per-unit price; and block-pricing, when the consumer
pays different price for different blocks of a product say electricity, gas, internet, etc
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Second-degree price discrimination: More examples
• ”Membership discount retailers” such as shopping clubs that charge an annual fee
for admission to the point of sale and also charge for your purchases
• Amusement parks where there are admission fees and also per-ride fees
• Cover charge for bars combined with per drink fees
• Credit cards which charge an annual fee plus a per-transaction fee
• Loyalty cards or clubs
• Mobile phone services where there is a fee to use the service and also a fee per
minute of call. The line rental covers the cost of providing the service, the per
minute charge covers the cost of placing the call on the network.
• In professional sports, in which fans of a team pay an up-front lumpsum fee for the
right to purchase tickets at face value pay for play games
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Second-degree price discrimination: Application
• Let’s consider Varys Communications, a telecommunication company. The
company’s inverse demand function (showing price per GB of data) is P=5-0.25Q
• Revenue: R=PQ=(5-0.25Q)Q
• Marginal revenue: MR=(dR)/(dQ)=5-0.5Q
• Note: The slope of the marginal revenue curve is double that of the demand curve
• If the marginal cost of a GB of data is constant 2, optimal output occurs when P =
3.5 and quantity is 6 GB
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Second-degree price discrimination
• The following graph shows what happens when there is no price discrimination
• The green-dashed rectangle shows total revenue (which is 21 on average) and the
blue-shaded rectangle shows profit of 9 (=21-6×2).
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Second-degree price discrimination
• Additional Profit: Let’s see what happens if Varys charges 4.25/GB for 1-3 GB,
3.5/GB for 4-6 GB and 2.5/GB for 7-10 GBs.
• Under new block-pricing, total revenue is 33.25 (=3 × 4.25 + 3 × 3.5 + 4 × 2.5)
• Since the marginal cost for 10 GB is 20(=2×10), profit is 13.25 (=33.25 - 20)
• The following graph shows how second-degree price discrimination works
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Second-degree price discrimination
• Change in Consumer and Producer Surplus: The grey, blue and red shaded areas
show revenues from the first, second and third blocks of the data plan. Additional
profit equals the sum of the areas of rectangles P1 and P2.
• You can verify that it equals 4.25 (=13.25 - 9).
• Rectangle P1 represents the consumer surplus which has been captured by the
producer. P3 shows the net increase in welfare due to price discrimination.
• The white unshaded triangles under the demand curve show consumer surplus which
still remains. In perfect first-degree price discrimination, however, all the consumer
surplus is converted to producer surplus.
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Second-degree price discrimination with two part
tariff
• The other popular second-degree price discrimination scheme is a two-part tariff,
used to discriminate profitably between high- and low-demand users of a product.
• In other words, firm can use two-part tariff when consumer demand is different.
• Illustration: We now consider the case where there are two consumers, X and Y.
Consumer Y’s demand is exactly twice consumer X’s demand, and each of these
consumers is represented by a separate demand curve, and their combined demand
• We assume that the firm cannot separately identify each consumer - it cannot
therefore price discriminate against each of them individually.
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Second-degree price discrimination with two part
tariff
•
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Second-degree price discrimination with two part
tariff
• The firm would like to follow the same logic as before and charge a per-unit price of
Pc while imposing a lump-sum fee equal to area ABCD - the largest consumer
surplus of the two consumers.
• In so doing, however, the firm will be pricing consumer X out of the market, because
the lump-sum fee far exceeds his own consumer surplus of area AC. Nevertheless,
this would still yield profit equal ABCD from consumer Y.
• A solution to pricing consumer X out of the market is to instead charge a lump-sum
fee equal to area AC, and continue to charge Pc per unit. Profit in this instance
equals twice the area AC (two consumers): 2 x AC.
• As it turns out, since consumer Y’s demand is twice consumer X’s, ABCD = 2 x AC.
The profit is the same and the producer is indifferent to either of these pricing
possibilities, although consumer Y is better off this way since she gets consumer
surplus BD.
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Second-degree price discrimination
• However, it is possible for the firm to earn even greater profits. Assume it sets the
unit price equal to Pm, and imposes a lump-sum fee equal to area A. Both consumers
again remain in the market, except now the firm is making a profit on each unit sold
- total market profit from the sale of Qm units at price Pm is equal to area CDE.
• Profit from the lump-sum fee is 2 x A = AB. Total profit is therefore area ABCDE
• Thus, by charging a higher per unit price and a lower lump-sum fee, the firm has
generated area E more profit than if it had charged a lower per-unit price and a
higher lump-sum fee.
• Note that the firm is no longer producing the allocatively efficient output, and there
is a deadweight loss experienced by society equal to area F - this is a result of the
exercise of monopoly power.
• Consumer X is left with no consumer surplus, while Consumer Y is left with area B.
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Bundling
• Bundling refers to the practice of selling two or more distinct goods together for a
single price.
• This is particularly attractive for information goods since the marginal cost of adding
an extra good to a bundle is negligible.
• There are two distinct economic effects involved: reduced dispersion of willingness to
pay, which is a form of price discrimination, and increased barriers to entry, which is
a separate issue.
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Bundling
• To see how the price dispersion story works, consider a software producer who sells
both a word processor and a spread sheet.
• Mark is willing to pay 120 dollars for the word processor and 100 dollars for the
spreadsheet.
• Noah is willing to pay 100 dollars for the word processor and 120 dollars for the
spreadsheet.
• How much should you set the price of each software?
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Bundling
• If the vendor is restricted to a uniform price, it will set a price o 100 for each
software product, realizing revenue of 400.
• But suppose the vendor bundles the products into an ”office suite.” If the willingness
to pay for the bundle is the sum of the willingness to pay for the components, then
each consumer will be willing to pay 220 for the bundle, yielding a revenue of 440 for
the seller.
• The enhanced revenue is due to the fact that bundling has reduced the dispersion of
willingness to pay: essentially it has made the demand curve flatter.
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Bundling
• More example on bundling: Suppose that a cable TV company, PrintMoney
Cablevision, has basically two types of program to distribute, network television and
sports and special interest. Also there are two types of viewer in the monopoly cable
market, each having a relative preference for opposite program types.
• Monthly reservation prices for each program type and for each viewer type are shown
in the following table.
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Bundling
• If the cable company could perfectly price discriminate, it could charge both types
their reservation prices for both program packages, yielding a monthly revenue of 45.
• Most likely because of information and legal reasons, the cable company will have no
choice but to charge uniform prices, either for the two program types separately or
for the bundle of both program types.
• Comparing these two options, the company could charge separate fees of 8 for
Network Television, and 10 for Sports and Special Interest, making a total monthly
revenue of 36. But by bundling the two program types, the cable company could
charge 20 a month to both consumer types, yielding a revenue of 40.
• Why is the bundling solution superior? Because bundling helps to average the
reservation values of the two consumer types, whereas in the unbundled case, the
company is forced to price to the lowest valuation consumers, in order to get them to
purchase the good.
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Bundling vs Tying
• Tying refers to conditioning the sale of one good on the purchase of another. In a
classic early case IBM was convicted of tying the purchase of tabulating cards to its
patented computation machines
• Bundling refers to tying in fixed proportions. For example, each left shoe is normally
bundled with a right shoe, car bodies are bundled with engines and tires, etc., and
cable television is sold in ”bundles” of channels, rather than each channel having an
individual price.
• From the outset we should stress that there are many efficiency or cost side
justifications for bundling: cars are bundled with engines and tires because it would
be very costly for (nonspecialized) consumers to assemble them from their
components.
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