Chapter 14: Price Discrimination – Microeconomics Study Notes

Price Discrimination

Overview of Price Discrimination

Price discrimination, sometimes called price differentiation, refers to the practice of charging different prices for the same product to different consumers or groups. This is a common strategy in many markets and can take several forms, each with distinct economic implications.

• Different prices in different markets: Firms may charge varying prices based on geographic location, consumer segment, or other market divisions.

• Perfect price discrimination: Each consumer is charged their maximum willingness to pay.

• Tying: Consumption of one good requires the purchase of another related good.

• Bundling: Multiple products are sold together as a package.

• Versioning: Different versions of a product are sold at different prices.

Price discrimination can increase total surplus compared to single-price monopoly pricing, potentially improving welfare and market efficiency.

Types of Price Discrimination

• First-degree (Perfect) Price Discrimination: Each consumer pays their maximum willingness to pay. Requires detailed information about each buyer.

• Second-degree Price Discrimination: Prices vary according to the quantity purchased or product version (e.g., bulk discounts, versioning).

• Third-degree Price Discrimination: Different groups (markets) are charged different prices based on their demand elasticity (e.g., student discounts, geographic pricing).

Key Assumptions and Conditions

• No Arbitrage: Resale between buyers must be impossible or difficult, otherwise price discrimination cannot be sustained.

• Market Segmentation: The firm must be able to identify and separate groups with different demand elasticities.

Profit Maximization with Price Discrimination

When a monopolist faces two markets with different demand curves and identical marginal costs (MC), they can increase profits by charging different prices in each market. The key is to set a higher price in markets with more inelastic demand and a lower price in markets with more elastic demand.

• Formula for profit maximization:

$MR_A = MC$ $MR_B = MC$

Where $MR_A$ and $MR_B$ are the marginal revenues in markets A and B, respectively.

Examples of Price Discrimination

• Pharmaceuticals (different prices in Europe, Africa, US, Canada)

• Movie theaters (matinee, student, and senior discounts)

• Books (hardback first, then paperback)

• "Pink Tax" (gender-based pricing)

• Dynamic (surge) pricing (e.g., ride-sharing apps)

Preventing Arbitrage

Firms use various strategies to prevent resale and maintain price discrimination:

• Product differentiation (e.g., color, packaging)

• Legal restrictions (e.g., prescription requirements)

• Service-based pricing (selling services instead of goods)

• Technological measures (e.g., region-locking digital goods)

Welfare Effects of Price Discrimination

Compared to a non-discriminating monopoly:

• Monopolist profits are higher (incentive to price discriminate).

• Gains from trade are higher if total quantity sold increases.

• Deadweight loss may decrease as output rises.

Perfect Price Discrimination (First-Degree)

In the limiting case, the monopolist charges each buyer their maximum willingness to pay, eliminating consumer surplus and deadweight loss. All surplus becomes producer surplus.

• Output: Equal to the competitive level ($Q_{PC}$), where $P = MC$.

• Deadweight Loss: $0$ (all mutually beneficial trades occur).

• Consumer Surplus: $0$ (all surplus captured by the firm).

Graphical Comparison

• Single-price monopoly: Lower output, higher price, deadweight loss present.

• Perfect price discrimination: Output equals competitive level, no deadweight loss, all surplus to producer.

Other Forms of Price Discrimination

Tying

Consumption of one good requires the purchase of another. Firms price the base good below cost and the variable good above cost, allowing them to extract more consumer surplus based on usage.

• Examples: Printers and ink cartridges, razors and blades, cell phones and data plans, gaming consoles and games.

Bundling

Firms sell products together as a package, often maximizing profits when consumers value the bundle similarly but differ in their valuation of individual components.

• Examples: Streaming services, software suites, newspaper subscriptions, cell phone plans.

Versioning (Quality Discrimination)

Firms offer different versions of a product at different prices, with price differences often exceeding cost differences.

• Examples: Printers (regular vs. economy), delivery options, electric car battery sizes.

Bundling Example Table

Consider two consumers, Amanda and Yvonne, and their willingness to pay for Microsoft Word and Excel:

	Amanda	Yvonne
Word	$100	$40
Excel	$20	$90
Both	$120	$130

If Microsoft bundles both products and charges $120, both consumers buy, maximizing profit and increasing total gains from trade.

Is Price Discrimination Bad?

• If price discrimination increases output, total surplus rises and deadweight loss falls.

• Perfect price discrimination eliminates deadweight loss, but all surplus goes to the monopolist.

• Price discrimination can help firms cover fixed costs and incentivize innovation.

• It may also allow regulated natural monopolies to maintain profits at efficient output levels.

Conclusion

Price discrimination is a widespread practice in many markets, with several forms including perfect price discrimination, tying, bundling, and versioning. It can increase gains from trade and welfare compared to simple monopoly pricing, but its effects on consumer surplus and market efficiency depend on the specific implementation and market conditions.