EconS 305 - Pricing and Advertising - Part 1 Eric Dunaway Washington State University eric.dunaway@wsu.edu October 29, 2015 Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 1 / 50
Introduction Our next unit is going to cover price discrimination and advertising. Price discrimination is a method for a monopolist to charge di erent prices to di erent people based on their characteristics. We see it all the time. Today, we will cover rst and third degree price discrimination. Don t forget, exam 2 is a week from today. Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 2 / 50
Price Discrimination Just what is price discrimination? It can take two forms: either a temporary sale, or a permanent discount on the price of a good. Up until now, we have been using uniform pricing. This is where a rm can only select one price to charge to an entire market. Now we will consider nonuniform pricing, where a rm can charge di erent prices to di erent people. The key is how the rms di erentiate their customers. Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 3 / 50
Price Discrimination Why price discriminate? To increase pro ts, of course! By price discriminating, the rm, acting as a monopolist, can "steal" even more of the consumer surplus from the consumers. At the same time, the monopolist can also turn some of the dead weight loss back into producer surplus. Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 4 / 50
Price Discrimination A quick example from Perlo : A theater in town is holding a showing of a new movie this weekend. Students will see the movie if the price is 10 dollars or less. Senior Citizens will see the movie if the price is 5 dollars or less. We would say that the students willingness to pay is $10, whereas the senior citizens willingness to pay is $5. Let s say that there are 10 students and 5 seniors. Depending on what price the theater charges, the movie theater s pro ts look like Price Student π Senior π Total π $5 50 25 75 $10 100 0 100 In this case, the rm would do better by charging a higher price and losing the senior market. Could they do better? Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 5 / 50
Price Discrimination Certainly! What if the theater charged $10 to students and $5 to seniors? It s pro t would be Price Student π Senior π Total π $5 50 25 75 $10 100 0 100 $10/$5 100 25 125 this way, the rm could increase its pro ts by charging less to the seniors and getting them to come see the movie, too. In this case, we would say that the seniors have more elastic demand They aren t willing to pay as much as the students, so a discounted price is necessary to get them in to the market. Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 6 / 50
Price Discrimination Real world example: Disneyland. They charge $199 to out of state residents for a 3 day pass. But they only charge $154 to California residents. Why? People who are travelling from out of state are likely on vacation and are planning on going to Disneyland regardless. They are less sensitive to the price than the local residents who have already been several times. The locals are likely more sensitive to the price. Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 7 / 50
Price Discrimination How can rms establish price discrimination? First, the rm has to have market power. If a market were perfectly competitive, there would be no room for price discrimination. Second, they need to have ways to di erentiate customers. This could be by age, occupation, location, etc. More importantly, these groups need to have di erent demand curves, as well. Lastly, the rm has to have some way to prevent resale (arbitrage). If they can t a person could get a discounted price, then sell it to a higher priced group for a pro t. Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 8 / 50
Price Discrimination Let s talk a little bit about preventing resale. This is probably the most essential component to price discrimination. If consumers could resale (arbitrage) the market, the people who can get a cheaper price can buy the item, then resell it to people who would have to pay a higher price, stealing the pro ts from the monopolist. In our theater example, the senior citizens could pay $5 for a ticket, then sell it to a student for less than $10, making both the senior citizen and the student better o, but the monopolist worse o. Practically, the theater can prevent arbitrage by having the ticket holder show proof that they belong to their respective age group to get the price discount (identi cation). Likewise, Disneyland checks the identi cation of those who want a local discount. Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 9 / 50
First Degree Price Discrimination Let s start with rst degree price discrimination. Also known as perfect price discrimination. In this case, the rm is able to identify every single customer as an individual group. In order to do this, the rm must be able to identify every consumer s willingness to pay, or reservation price. Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 10 / 50
First Degree Price Discrimination The reservation price is the highest price a consumer is willing to pay for a good or service. If the monopolist could identify this, they could maximize their pro ts by charging that person exactly that price. In this case, the rm captures all of the surplus that would be shared between the producer and the consumer. Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 11 / 50
First Degree Price Discrimination We can show graphically what would happen using a supply and demand curve. Recall that we can think of the demand curve as having many di erent consumers distributed across the line, with those with a higher reservation price higher on the demand curve. In this case, the rm charges every person the price where they land on the demand curve. Let s look at it graphically. Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 12 / 50
First Degree Price Discrimination p D S Q Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 13 / 50
First Degree Price Discrimination p D S Producer Surplus Q Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 14 / 50
First Degree Price Discrimination It s interesting to see that there is no dead weight loss under rst degree price discrimination. Every consumer who should enter the market enters the market. Everyone pays their maximum willingness to pay, meaning that there is no consumer surplus. Is this e cient? Yes, becuase there is no dead weight loss. Is this fair? That s an opinion. Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 15 / 50
First Degree Price Discrimination Why don t we see more of rst degree price discrimination? It s not feasible. First of all, rms don t know every consumer s reservation price. Furthermore, it would be in the interest of consumers to hide their true reservation price in order to get a better deal. The costs involved to actually determine these values are huge, and would eat up the majority of the monopolist s pro ts. Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 16 / 50
First Degree Price Discrimination A quick example. Consider a banana market where a single rm acts as a monopolist. There are three consumers, Stuart, Kevin and Bob. Stuart values a banana at 5, Kevin values a banana at 3, and Bob values a banana at 1. It costs 2 to make a banana. If the banana monopolist knew all the reservation prices and could prevent the consumers from reselling bananas, what price would it charge to each of them? Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 17 / 50
First Degree Price Discrimination The banana monopolist would charge Stuart 5, Kevin 3, and wouldn t sell a banana to Bob. Poor Bob. The banana monopolist captures all of the surplus from Stuart and Kevin, and lives happily ever after. Let s look at another type of price discrimination. Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 18 / 50
Let s talk about third degree price discrimination. This is also known as group price discrimination. In this case, the rm seperates the consumers into di erent groups with di erent demand functions, then charges individual prices for those groups. Figuring out groups is much easier than guring out every single individual. Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 19 / 50
Let s go back to our example with movie theaters. Suppose the demand for students (t) and the demand for seniors (e) were as depicted on the next slide. For simplicity, we will assume that the supply curve is at (This is actually very close to reality for a movie theater). Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 20 / 50
p D t D e S Q Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 21 / 50
As we can see, the demand for the elderly is atter than the demand for the students. They are more elastic, and more sensitive to the price of a movie ticket. If the monopolist were only able to charge one price to the entire market, it would have to aggregate the demand curves and then solve. Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 22 / 50
p D t D e S Q Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 23 / 50
p D S Q Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 24 / 50
p D MR S Q Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 25 / 50
In this case, we see our standard kinked demand curve. This results in a jump (discontinuity) in the marginal revenue curve. Otherwise everything else remains the same. Like before in monopoly, we nd where marginal revenue equals marginal cost, then set the price based on the aggregate demand curve. Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 26 / 50
p D p * MR Q * S Q Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 27 / 50
Now, let s consider a situation where the monopolist could pick a di erent price for both groups of consumers. It could enforce this price by checking identi cation at the door. In this case, the monopolist would set its price and quantity level for each group seperately. Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 28 / 50
p D t S Q Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 29 / 50
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p D t p t MR t Q t S Q Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 31 / 50
p D e S Q Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 32 / 50
p D e MR e S Q Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 33 / 50
p D e p e MR e Q e S Q Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 34 / 50
p D t D e p t p e Q t Q e S Q Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 35 / 50
p D t D e p t p * e D Q t Q e Q * S Q Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 36 / 50
As we can see, the monopolist will charge a lower price to the elderly, but a higher price to the students. Comparing this with the uniform price equilibrium, we would nd that the single price would be somewhere inbetween the two. Intuitively, the monopolist gives up a small amount of quantity by charging a higher price to students, but gains a large quantity by charging a lower price to seniors. In the end, the monopolist s pro ts increase. Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 37 / 50
What about welfare? This depends. We will still have dead weight loss. Welfare might go up or down from the monopoly level. It depends a lot on the shape of the curves and how much the quantities vary. It s also nearly impossible to draw. Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 38 / 50
Example from Perlo (12.3) A monopoly book publisher is selling in two di erent countries that have inverse demand curves of 1 p 1 = 6 2 q 1 p 2 = 9 q 2 and marginal costs are constant at MC = 1. First, let s look at the equilibrium if the monopolist cannot price discriminate. Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 39 / 50
First, we have to aggregate the demand curve. (Remember to turn them back into demand curves before adding them together. I skipped this.) For prices above 6, only country 2 will be in the market. We end up with the aggregate inverse demand curve of p = 9 q if p > 6 p = 7 1 3 q if p 6 These have corresponding marginal revenue curves of MR = 9 2q if p > 6 MR = 7 2 3 q if p 6 Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 40 / 50
9 p D 6 1 S 18 Q Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 41 / 50
9 p D 6 1 MR S 18 Q Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 42 / 50
We can nd the equilibrium price by setting marginal revenue equal to marginal cost. From the gure, it appears that this will happen at p 6, so I will use that equation. 7 MR = MC 2 3 q = 1 2 3 q = 6 q = 9 Plugging this back in to the demand curve yields p = 7 1 3 q = 4 Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 43 / 50
9 p D 6 4 1 MR 9 S 18 Q Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 44 / 50
What would happen if the rm could e ectively price discriminate by group? Fortunately, this is much easier. For each individual country, we optimize as if it were a monopoly. For country 1, we have MR = MC 9 2q = 1 2q = 8 q 1 = 4 and country 1 demands only 4 units. To get the price we plug it back into its demand function p 1 = 9 q 1 = 8 Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 45 / 50
For country 2, we have MR = MC 6 q = 1 q 2 = 5 and country 2 demands 5 units. Once again, to get the price, we plug it back into its demand function p 2 = 6 1 2 q 2 = 3.5 and as we can see, country 2 is charged a much lower price than country 1. Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 46 / 50
Let s look at pro ts. For uniform pricing, the rm receives TR = p q = 4(9) = 36 TC = q = 9 π = 36 9 = 27 And for third degree price discrimination, the rm receives TR = p 1 q 1 + p 2 q 2 = 8(4) + 3.5(5) = 49.5 TC = q 1 + q 2 = 9 π = 49.5 9 = 40.5 and the monopolist s pro ts from price discriminating are much higher! Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 47 / 50
Some intuition. Country 1 had much more elastic demand than country 2. (Its demand curve is atter.) Giving each country a di erent price allowed for a much larger quantity of country 1, and less of a reduction of quantity from country 2 due to their higher price. This resulted in much higher pro ts for the monopolist. Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 48 / 50
Summary Price discrimination increases pro ts for the monopolist. Depending on how groups can be identi ed, the monopolist will try to charge as many di erent prices as possible to di erent groups. Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 49 / 50
Preview for Monday Second degree price discrimination. What does Costco have in common with the local bar? Advertising. Eric Dunaway (WSU) EconS 305 - Lecture 26 October 29, 2015 50 / 50