PRICE DISCRIMINATION
How would a High value consumer react if they get more value from the basic good? How would the firm fix this?
Consumer would buy the basic good instead (incentive constraint has been voided) Producer can fix this by lowering H price so H consumer is indifferent between the two goods. However can't lower it so much that that L buys H good. Another way to fix would be to raise the price of the basic good however can't do this too much because L consumer might stop buying it (voiding participation constraint). Later option is better as it involves raising prices = more profit
What are the features of price discrimination?
- Charging different consumers different prices for the 'same' good - Monopolist is able to extract more profit - Welfare can increase relative to setting a uniform monopoly price
What is welfare under a monopoly?
- Consumer surplus lower than under perfect competition - Producer surplus = profits in absence of fixed costs - Total welfare also lower due to 'deadweight loss of monopoly
What is the difference between a two part tariff with 1 type vs 2 types when Type H can pretend to be Type L?
- Firm can no longer extract all the consumer surplus - Type H can always pretend to be Type L, hence gains an 'information rent'
What is first degree price discrimination?
- Firm sets a different price for each buyer and each unit of the good consumed by the buyer - Each unit of the good sold to the individual who values it most, at the highest price that individual is willing to pay
What are the features of monopolies?
- Firm sets prices and makes positive profits - Maximises profits when marginal revenue = marginal cost - Welfare loss due to monopoly
What are the features of perfect competition?
- Firms act as price takers and earn zero profits - Price = marginal revenue = marginal cost - Consumer welfare is maximised
How is price set in perfect competition?
- Firms act as price takers: market price independent of each firm's output decision - Under perfect competition marginal revenue is simply equal to price
What do firms want?
- Firms would like to know how much each buyer values the good, i.e. their willingness to pay - If knew each individual buyer's valuation of each unit could impose 'firstdegree price discrimination' - Also called 'perfect price discrimination'
What are profits and welfare in perfect competition?
- Free entry condition - Under perfect competition firms earn zero profits 𝜋 = 𝑝𝑞 − 𝑐𝑞 = 0 p=c - Welfare: - Producer surplus is equal to zero - Consumer surplus, and total welfare are maximised
What would the firm do if they knew some buyer characteristics related to willingness to pay are observable?
- Set different prices for different groups according to characteristics - 'Third-degree price discrimination', 'market segmentation' or 'selection by indicators' or 'group pricing'
What is the consumer surplus of the different customers in a two part tariff?
- Type H makes lots of calls/has high consumer surplus - Type L makes infrequent calls/has low surplus
What are the three ways to calculate q and p for a monopoly?
- Use demand function to make profit equation find profit maximising q or p - find marginal revenue by working out revenue function and differentiating. Set to MC
Why would the monopolist never operate on the inelastic part of the demand curve? i.e. where 𝑒<1?
- from rearranging price cost mark up/elasticity equation, and knowing that they will produce at MC=MR we know that MR=𝒑(𝟏 − 𝟏/𝒆 ) - if e is < 1, MR is negative - think of marginal revenue as the effect on revenues if the firm sells one additional unit of the good. At some point the firm would need to reduce the price so much to sell that additional unit that they would lose more revenue on the units they were already selling than they would gain from selling the additional unit. At this point marginal revenue becomes negative.
How is price set in a monopoly?
.
What is non-linear pricing?
A for of 2nd degree price discrimination in which a Seller charges a different price per unit depending on the quantity purchased
What is bundling?
A form of second degree price discrimination - By offering goods individually and / or in bundles firms can get different types of buyers to self-select different packages and can price discriminate
What is a 2 part tariff and how do they work?
A type of of non-linear pricing - Consumer pays a fixed amount f irrespective of the amount they buy AND a variable fee p proportional to the amount they buy - Amount paid = f + pq, where q is the amount of the good they buy
When does second degree price discrimination occur?
Second-degree price discrimination occurs when a firm cannot observe a consumer's type, but knows that there are different types of consumers in the market.
What happens to the seller's profits with 2 types of buyer?
Seller's profit reduced compared to case with only one type of buyer due to need to design contracts that induce the two types to self-select
How do you show 3rd degree price discrimination in terms of PED?
The firm should charge a lower price in the market with the greater price elasticity of demand - i.e. price will be lower in the market where demand is more sensitive to a change in price - LOOK AT LECTURES
In second degree price discrimination, why does the high-valuation consumer get a better deal than the low-valuation consumer?
They gain an 'information rent'. The firm cannot observe their type and they could always pretend to be a low-valuation type. In order to induce them to purchase the option intended for the high valuation consumer the firm needs to meet the incentive compatibility constraint and in doing so allows the high-valuation type to retain some consumer surplus and in that sense they 'get a better deal'.
What is the incentive compatibility constraint?
This says H consumer's utility from buying H tariff must be > than their utility if they were to lie about what type of consumer they are and bough the low type First line is binding as they don't want high valuation consumers to take advantage of lower price. Need to design options so Type H consumer have no incentive to choose package 1
What are the conditions for price discrimination?
To charge different prices for the same good to different consumers firm needs to have some market power (so they don't have to charge the uniform market price) and either: 1. Consumers are not fully aware of the price differences, or 2. Transactions costs of buying and reselling make arbitrage unprofitable 3 .Price discrimination requires no resale (Buying products with a quantity discount and then reselling unwanted goods too costly in terms of time and effort)
What is versioning?
Type of 2nd degree discrimination that involves sorting groups of customers according other elements of the good - Varying the quality of the good as well as the price. Reduce the quality of one version of the good to induce the high type to pay the higher price, with a potential loss in quality for the low type
What are the different types of bundling?
• 'pure bundling': consumer must either purchase the bundle of goods or purchase nothing • 'mixed bundling': goods can be purchased individually, or as a bundle
What are the welfare effects of a two-part tariff with one type of consumer?
• Comparison of a monopolist who sets a uniform price with a monopolist who uses a two-part tariff • Two-part tariff where variable price is equal to marginal cost ( p = c ) and set the fixed fee ( f ) at a level that extracts the entire consumer surplus as producer surplus • Two-part tariff increases welfare relative to the uniform price, but consumer welfare decreases • Trade off between total welfare and consumer welfare
What happens to welfare in 3rd degree discrimination?
• Monopolist is better off compared to a uniform price • Asymmetric effects on different types of consumers - Those in the relatively price elastic market better off - Those in the relatively price inelastic market potentially worse off • If total output does not increase total welfare will not increase • Welfare can increase if in the absence of price discrimination the monopolist only served the relatively inelastic group of consumers
Give a brief intuitive explanation of why profit is higher when the restaurant owner is able to price discriminate.
If the restaurant owner can price discriminate he has more flexibility to try and capture more surplus as profit. He can set a higher mark-up over marginal cost in the evening when he knows that demand is less price sensitive and a lower mark-up at lunchtime. More generally with third-degree price discrimination the more information the restaurant has about the willingness to pay of different groups of consumers the closer it can get to first-degree price discrimination, where a firm can extract all the surplus as profit.
How does the firm solve the issue of not being able to identify the type of consumer?
Induce consumers to sort themselves into the different packages Options need to be incentive and compatibility constraints
What is the participation constraint?
Likely to be binding on the low value consumer - design options so Type L consumers choose to purchase package 1 rather than not buy the good
How do you know what consumer surplus is?
Look at rev
When the incentive compatbility constraint is not met and the Hgh type consumer is buying the low type good, what should the firm do?
Lower the price of the high type such that the consumer surplus for the high value consumer is equal or slightly higher for the high type good Don't lower it too much so that the low type buys it OR, raise the price of the low type good, but need to careful not to break the participation constraint (bottom option is more profitable as it involves raising prices)
Why wouldn't a firm operate when e<1?
MR would be -ve at this point. The firm would need to reduce the price so much to sell that additional unit that it would lose more revenue on the units they were already selling than they would gain from selling an additional unit.
What happens to Type L's offer?
Offer to Type L is worsened to reduce its attractiveness to Type H consumers
What is the outcome of first degree price discrimination?
Output same as perfect comp (efficient) but monopolist extracts all the consumer surplus Some consumers who could not have bought at monopolist price can now get the good so more people are able to buy - is this more fair?
What is the relationship between price cost margin the elasticity of demand?
Price cost margin (or mark-up) is greater the lower is the price elasticity of demand, i.e. the steeper is the demand curve
When is bundling more beneficial?
Bundling is more beneficial for the firm (relative to not bundling) when consumers' valuations of the two goods are more negatively correlated. You can also think of bundling in this case as a way of averaging across the two valuations each consumer holds, and this becomes more worthwhile for the firm as the valuations diverge
How do monopolies set prices?
Firms choose price to maximise profits and the extent to which they are able to raise prices above MC depends on PED
What does a firm do if they know that customers have different valuations of the good, but cannot observe buyer characteristic (Asymmetric information - a buyer's type is not observable)?
Firms offer a menu of prices / options and buyers 'self-select' into groups - 'Second-degree price discrimination' or 'self selection'
What is the general form of the optimal two part tariff?
For Type L, firm extracts all surplus and price is greater than MC (ineffecient/DWL) Type H consumers pay f H < CSH ( pH ) , less than their full consumer surplus Type H consumers pay pH = c which is efficient
GRAPH
GRAPHS
When in 3rd degree price discrimination done?
Group characteristics observable - Different groups/markets charged different prices - All members of the same group/market charged the same price
If a firm has MC=0 and can sell either a H or L good, which will the sell?
H as greater profit
If a firm could only sell 1 type of good, either high value or low value, both of which had 0 MC, what would they sell?
High as profit will always be higher
What do type H consumers get?
High-use consumers (Type H) retain some consumer surplus - an information rent - they know their type but the seller does not
How do you calculate consumer surplus?
WTP-price
What are the welfare effects of versioning?
Welfare effects: potentially benefits for the firm, the low valuation customer and the high valuation customer - Suppose the firm creates a low-quality version of the good in order to induce high valuation customers to buy the higher-priced, high-quality version - Low valuation customer - may be better off if the alternative is no purchase - High valuation customer - may be better off if the price of high-quality version constrained by the existence of low-quality version • Gains an information rent, due to firm's need to meet the incentive compatibility constraint. Have the option to be a low valuation user meaning firm can't put price of high valuation too high as the H consumers would just buy the low good
Is versioning price discrimination if there are cost differences across the different versions of the good?
Yes, if the price difference between the two versions does not just reflect the cost difference
How could a two part tariff work with 2 types of consumer?
• Suppose there are two types of mobile phone user • Type H uses their phone to make calls a lot - High consumer surplus from the good • Type L makes calls on their phone infrequently - Low consumer surplus from the good • If company could observe type, optimal to extract all the consumer surplus via a fixed fee (specific to the type) and price calls at marginal cost - But seller cannot observe type, and charging different individual consumers different tariffs would likely be illegal • Seller offers consumers a choice of two-part tariffs • Offering two-part tariffs with different fixed fees and the same call rate would not work - All consumers would choose the package with the lower fixed fee → • Need to vary the packages in both dimensions
What should be considered when discussing the welfare effects of price discrimination?
• Total welfare versus consumer welfare • Total welfare increases, but consumer welfare does not necessarily increase for all groups - Although can find examples of second-degree price discrimination where everyone better off • Issues of 'fairness' - Charging everyone the same price versus serving a wider range of consumers
What is the effect of bundling?
• Welfare increased as more consumers are served
