ECON 115. Industrial Organization

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1 ECON 115 Industrial Organization

2 1. Linear (3rd Degree) Price Discrimination

3 First Hour QUIZ Second Hour Introduction to Price Discrimination Third-degree price discrimination Two Rules Examples of price discrimination One Problem

4 Last week we completed the background portion of the course: the origins of the industrial organization in antitrust policy (Week 1), basic micro theory (Week 2) and finally the time value of money, measuring market structure and cost (Week 3). This week we begin the meat of the course, using economic theory to understand how firms and industries are organized.

5 Over the next 12 weeks we will investigate: Monopolies; capturing the consumer surplus Oligopolies; how they interact Monopolies; methods of limiting competition This week we begin with monopolies capturing some of the consumer surplus through price discrimination. `

6 Price discrimination is common in the real economy. These are examples of price discrimination: Prescription drugs are cheaper in Canada than the United States. Textbooks are generally cheaper in Britain than the United States. Effects of price discrimination presumably profitable may affect efficiency: not necessarily adversely

7 Price discrimination means charging different prices to different consumers for the same good. Recall that a monopolist facing a downward sloping demand curve and employing nondiscriminatory pricing must reduce its price to all consumers in order to sell more product.

8

9 If price discrimination allows a monopolist to sell more product, it may be seen as increasing total surplus, thus improving efficiency. We will look at how that might happen at the end of the next lecture.

10 Two issues confront a firm wishing to price discriminate: 1. Identification: can the firm identify demands of different types of consumer or in separate markets easier in some markets than others: e.g tax consultants, doctors 2. Arbitrage: can the firm prevent consumers charged a low price from reselling to consumers charged a high price prevent re-importation of prescription drugs to the United States

11 The firm then must choose the type of price discrimination first-degree or personalized pricing second-degree or menu pricing third-degree or group pricing

12 There are three types of price discrimination: Type Name Example First Degree Personalized Pricing Maximum price charged to each consumer Second Degree Menu Pricing Quantity discounts Third Degree Group Pricing Group discounts ( early bird special senior discount )

13 Third-degree price discrimination: Group pricing. Consumers differ by some observable characteristic(s). A uniform price is charged to everyone in the group. This is linear pricing. Different uniform prices are charged to different groups: children under 12 are free senior discounts high variety of airline ticket prices early-bird specials 13

14 The pricing rule is very simple: consumers with low elasticity of demand should be charged a high price. consumers with high elasticity of demand should be charged a low price. 14

15 An example of 3 rd Degree Price Discrimination: Assume the sellers of the last Harry Potter book face the following demand curves in the United States and Europe respectively. Demand: United States: P U = 36 4Q U Europe: P E = 24 4Q E Marginal cost constant in each market MC = $4 15

16 We begin with NO PRICE DISCRIMINATION, i.e., the same price is charged in both markets. Use the following procedure to determine price: 1. Determine aggregate demand in the two markets. 2. Determine marginal revenue for that aggregate. demand 3. Equate marginal revenue with marginal cost to identify the profit maximizing quantity. 4. Identify the market clearing price from the aggregate demand. 5. Calculate demands in each market from the individual market demand curves and the equilibrium price. 16

17 United States: P U = 36 4Q U Invert this: Q U = 9 P/4 for P < $36 Europe: P U = 24 4Q E Invert this Q E = 6 P/4 for P < $24 1. Determine aggregate demand: At these prices only the US market is active Q = Q U + Q E = 9 P/4 for $36 < P < $24 Q = Q U + Q E = 15 P/2 for P < $24 Now both markets are active 17

18 RE-Invert the direct demands P = 36 4Q for Q < 3 P = 30 2Q for Q > 3 2. Determine marginal revenue: MR = 36 8Q for Q < 3 MR = 30 4Q for Q > 3 3. Set MR = MC: Q = The Market Clearing Price from the demand curve: $/unit MR P = $ Demand MC 15 Quantity 18

19 5. Calculate demands in each market from the individual market demand curves and the equilibrium price : Q U = 9 P/4 = 9 17/4 = 4.75 million Q E = 6 P/4 = 6 17/4 = 1.75 million Aggregate profit = (17 4)x6.5 = $84.5 million These are the results WITHOUT PRICE DISCRIMINATION. 19

20 The firm can improve on this outcome by using 3 rd degree price discrimination. Note that MR is not equal to MC in both markets: MR > MC in Europe MR < MC in the US Therefore, the firms should transfer some books from the US to Europe. 20

21 This requires that different prices be charged in the two markets. Procedure: 1. Evaluate each market separately. 2. Identify equilibrium quantity in each market by equating MR and MC. 3. Identify the price in each market from market demand. 21

22 1. Evaluate each market separately. Start with US demand function: 36 $/unit P U = 36 4Q U 2. Identify the equilibrium quantity by equating MR = MC: 20 MR Demand MR = 36 8Q U 4 MC MC = Quantity At MR = MC, Q U = 4 3. Identify the price in each market from market demand: P U = $20 22

23 1. Now use Demand in the Europe... P E = 24 4Q U $/unit 24 to calculate marginal revenue: 14 MR = 24 8Q U 2. Equate MR and MC = 4 to determine quantity: Q E = MR 2.5 Demand 6 MC Quantity 3. Again, identify the price in each market from market demand: P E = $14 23

24 In this case, the firm enjoys a significant advantage from price discrimination. Aggregate sales are 6.5 million books, which is the same with no price discrimination. However, Aggregate profit is (20 4)x4 + (14 4)x2.5 = $89 million. $4.5 million greater than without price discrimination 24

25 With price discrimination the procedure is: 1. Identify marginal revenue in each market. 2. Identify equilibrium MR from the aggregate MR curve. 3. Equate this MR with MC in each market to give individual market quantities. 4. Identify equilibrium prices from individual market demands. 25

26 RULE: If demands are linear price discrimination results in the same aggregate output as no price discrimination. price discrimination increases profit because allocated more profitably across two markets. For any demand specifications two rules apply: marginal revenue must be equalized in each market. marginal revenue must equal aggregate marginal cost. 26

27 Suppose that there are two markets with the same MC. MR in market i is given by MR i = P i (1 1/h i ) where h i is (absolute value of) elasticity of demand From rule 1 (above) MR 1 = MR 2 so P 1 (1 1/h 1 ) = P 2 (1 1/h 2 ) Therefore: 1 P 1 = (1 ) h 2 = h h h P 2 ( ) h h 1 h 2 h 2 1 Price is lower in the market with the higher demand elasticity 27

28 Third Degree Price Discrimination often arises when firms sell differentiated products: hard-back versus paperback books first-class versus economy airfare Price discrimination exists in these cases when: two varieties of a commodity are sold by the same seller to two buyers at different net prices, the net price being the price paid by the buyer corrected for the cost associated with the product differentiation. (Phlips, 1983) The seller needs an easily observable characteristic that signals willingness to pay and must be able to prevent arbitrage. 28

29 NEXT WEEK: Exploring 3 rd Degree Price Discrimination Further: disaggregating the demand function. Nonlinear Price Discrimination (1 st and 2 nd Degree Price Discrimination) Bonus Lecture on Standard Oil 29

30 Please make sure you have read Chapters 5 and 6 in the text. Start reading Chapter 7 (Sections 7.1 and 7.2)

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