Price Discrimination

prico ditcrimination the business practx* of selling the same good at different pneet to different customers

So far, we have been assuming that the monopoly firm charges the same pricc to all customers. Yet in many cases, firms sell the same good to different customers for different prices, even though the costs of producing for the two customers are the same. This practice is called pricc discrimination.

Before discussing the behavior of a price -discrimina ling monopolist, we should note that price discrimination is not possible when a good is sold in a competitive market. In a competitive market, many firms are selling the same good at the market price. No firm is willing to chargc a lower price to any customer because the firm can sell all it wants at the market price. And if any firm tried to charge a higher prk-e to a customer, that customer would buy from another firm. For a firm fo price discriminate, if must have some market power.

A Parable about Pricing

To understand why a monopolist would price discriminate, let's consider an example. Imagine that you are the president of Readalot Publishing Company. Readalot's best-selling author lias just written a new novel. To keep things simple, let's imagine that you pay the author a flat 52 million for the exclusive rights to publish the book. Let's also assume that the cost of printing the book is zero. Readalot's profit, therefore, is the revenue from selling the book minus the $2 million it has paid to tin» author. Given these assumptions, how would you, as Readalot's president, decide the book's price?

Your first step is to estimate the demand for the book. Readalot's marketing department tells you that the hook will attract two types of readers. The book will appeal to the author's 100,000 die-hard fans who are willing to pay as much as $30. In addition, the book will appeal to about 400,000 less enthusiastic readers who will pay up to $5.

If Readalot charges a single price to all customers, what price maximizes profit? There are two natural prices to consider. $30 is the highest price Readalot can charge and still get the 100,000 die-hard fans, and $5 is the highest price it can charge and still get the entire market of 500,000 potential readers. Solving Readalot's problem b a matter of simple arithmetic. At a price of $30, Readalot sells 100,000 copies, lias revenue of $3 million, and make» profit of $1 million. At a pricc of $5, it sells 5(104)00 copies, has revenue of S2.5 million, and makes profit of 3500,000, Thus. Readalot maximizes profit by charging S30 and forgoing the opportunity to sell to the 400,000 less enthusiastic readers.

Notice that Readalot'» decision causes a deadweight loss. There are 4004)00 readers willing to pay S5 for the book, and the marginal cost of providing it to them b zero. Thus, S2 million of total surplus is k>st when Readalot charges the higher price. This deadweight kiss b the inefficiency that arises whenever a monopolist charges a price above marginal cost.

Now suppose that Readak>t's marketing department makes a discovery: These two groups of readers are in separate markets. The die-hard fans live m Australia, and the other readers live in the United States. Moreover, it b hard for readers in one country to buy books in the other.

In response to this discovery, Readalot can change its marketing strategy and increase profits. To the 100,0ft) Australian readers, it can charge $30 for the book. To the 4004)00 American readers, it can charge 15 for the book. In this case, revenue is $3 million in Australia and $2 million in the United States, for a total of $5 million. Profit b then S3 million, which is substantially greater than the $1 million the company could earn charging the same $30 price to all customers. Not surprisingly, Readalot chooses to follow thb strategy of price discrimination.

The story of Readalot Publbhing is hypothetical, but it describes accurately the business practice of many publishing companies. Textbooks, for example, are often sold at a lower price in Europe than in the United Sutes. Even more important b the price differential between hardcover books and paperbacks. When a publisher has a new novel, it initially releases an expensive hardcover edition and later releases a cheaper paperback edition. The difference in price between these two editions far exceeds the difference in printing costs. The publisher's goal b just as in our example. By selling the hardcover to die-hard fans and the paperback to less enthusiastic readers, the publisher price discriminates and raises its profit.

The Moral of thue Story

Like any parable, the story of Readalot Publishing is stylized. Yet also like any parable, it teaches some general lessons. In this case, there are three lessons to be learned about price discrimination.

The first and most obvious lesson b that pricc discrimination b a rational strategy for a profit-maximizing monopolist. That is, by charging different prices to different customers, a monopolist can increase its profit. In essence, a price-discriminating monopolist charges each customer a price closer to his or her willingness to pay, therefore selling more than is possible with a single price.

The second lesson is that price discriminatk-n requires the ability to separate customers according to their willingness to pay. In our example, customers were separated geographically. But sometimes monopolists choose other differences, such as age or income, to distinguish among customers.

A corollary to thb second lesson b that certain market forces can prevent firms from price discriminating. In particular, one such force b arbitrage, the process of buying a good in one market at a low prke and selling it in another market at a higher price to profit from the price difference. In our example, if Australian bookstores could buy the book in the United States and resell it lo Australian readers, the arbitrage would prevent Read.1 lot from price discriminating, because no Australian would buy the book at the higher price.

The third lesson from our parable is the most surprising: Price discrimination can raise economic welfare. Recall that a deadweight loss arises when Readalot charges a single $30 price because the 400.001) less enthusiastic readers do not end up with the book, even though they value it at more than its margin.)I cost of production. By contrast, when Readalot price discriminates, all readers get the l\x>k, and the outcome is efficient Thus, price discrimination can eliminate the inefficiency inherent in monopoly pricing.

Note that in this example the increase in welfare from price discrimination shows up as higher producer surplus rather than higher consumer surplus. Consumers an? no better off for having bought the book: The prk"e they pay exactly equals the value they place on the book, so they receive no consumer surplus. The entire increase in total surplus from price discrimination accrues lo Readalot Publishing in the form of higher profit.

The Analytics of Price Discrimination

Let's consider a bit more formally how price discrimination affects economic welfare. We begin by assuming that the monopolist can price discriminate perfectly. P,-rf,yl prict (¡fcerimination describes a situation in which the monopolist knows exactly the willingness to pay of each customer and can charge each customer a different prke. In this case, the monopolist charges each customer exactly his or her willingness to pay, and the monopolist gets the entire surplus in every transaction.

Figure 9 shows producer and consumer surplus with and without price discrimination. Without price discrimination, the firm charges a single prke above marginal cost, as shown in panel (a). Because some potential customers who value the good at more than marginal cost do not buy it at this high price, the monopoly causes a deadweight loss. Yet when a firm can perfectly price discriminate, as shown in panel (b), each customer who values the good at more than marginal cost buys the good and is charged his or her willingness to pay. All mutually beneficial trades take place, there is no deadweight loss, and the entire surplus derived from the market goes to the monopoly producer in the form of profit.

In reality, of course, price discrimination is not perfect. Customers do not walk into stores with signs displaying their willingness to pay. Instead, firms price discriminate by dividing customers into groups: young versus old, weekday versus weekend shoppers, Americans versus Australians, and so on. Unlike thosie in our parable of Readalot Publishing, customers within each group differ in their willingness to pay for the product, making perfect price discrimination impossible.

How does this imperfect price discrimination affect welfare? The analysis of these pricing schemes is quite complicated, and it lurns out that there is no general answer to this question. Compared to the monopoly outcome with a single price, imperfect price discrimination can raise, lower, or leave unchanged total surplus in a market. The only certain conclusion is thai price discrimination raises the monopoly's profit; otherwise, the firm would choose to cltarge all customers the same price.

Examples of Price Discrimination

Firms in our economy use various business strategies aimed at charging different prices to different customers. Now that we understand the economics of price discrimination, let's consider some examples.

Movie Tickets Many movie theaters charge a lower price for children and senior citizens than for other patrons. This fact is hard to explain in a competitive market. In a competitive market, price equals marginal cost, and the marginal cost of providing a seat for a child or senior citizen is the same as the marginal cost of providing a seat for anyone else. Yet the differential pricing is easily explained if movie theaters have some local monopoly power and if children and senior citizens have a lower willingness to pay for a ticket. In this case, movie theaters raise their profit by price discriminating.

Airlino Prices Seats on airplanes are sold at many different prices. Most airlines charge a lower price for a round-trip ticket between two cities if the traveler stays over a Saturday night. At first, this seems odd. Why should it matter to the airline whether a passenger stays over a Saturday night? The reason is that this rule pro-vides a way to separate business travelers and leisure travelers. A passenger on a business trip has a high willingness to pay and, most likely, does not want to stay over a Saturday night. By contrast, a passenger traveling for personal reasons has

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a lower willingness to pay and is more likely to be willing to stay over a Saturday night. Thus, the airlines can successfully price discriminate by charging a lower price for passengers who stay over a Saturday night.

Discount Coupon» Many companies offer discount coupons to the public in newspapers and magazines. A buyer simply has to clip the coupon to gel $0.50 off his or her next purchase. Why do companies offer these coupons? Why don't they just cut the price of the product by K).50?

The answer is that coupons allow companies to price discriminate. Companies know that not all customers are willing to spend the time to dip coupons. Moreover, the willingness to clip coupons in related to the customer's willingness tu pay for ihe good. A rich and busy executive is unlikely to spend her time clipping discount coupons out of the newspaper, and she is probably willing to pay a higher price for many gi*>ds. A person who is unemployed is more likely lo clip coupons and to have a lower willingness to pay. Thus, by charging a lower price only to those customers who clip coupons, firms can successfully price discriminate.

Financial Aid Many collegesand universitiesgive financial aid to needy students. One can view this policy as a type of price discrimination. Wealthy student» have greater financial resources and, therefore, a higher willingness to pay than needy students, By charging high tuition and selectively offering financial aid, schools in effect charge prices to customers based on the value they place on going to that scfuwil. This behavior i» similar to that of any price-discriminating monopolist.

Quantity Discounts So far in our examples of price discrimination, the monopolist charges different prices to different customers. Sometimes, however, monopolists price discriminate by charging different prices to the same customer for different units that the customer buys. For example, many firms offer lower prices to customers who buy large quantities. A bakery might charge $0.50 for each donut but $5 for a dozen. This is a form of price discrimination because the Customer pays a higher price for the first unit bought than for the twelfth. Quantity discounts are often a successful way of price discriminating because a customer's willingness to pay for an additional unit declines as the customer buys more units.

QUICK QUIZ Giva two «»amples of proa discrimination. • How doas perfocl pria» discrimination affect cotwutwer surplus. producer surplu». »nd total surplu»?

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