Industrial Organization I

1
Industrial Organization I

• Pricing Strategies with Market Power (Part I)

2
Recap

• Markets are imperfect
• IO studies sources of market imperfection as well
  as consequences
• Market imperfections give firms market power

3
Equilibrium in Imperfect Competition
Price
MC
Producer surplus
P
Demand
Marginal Revenue (MR)
Q
QPC
QIC

• Last class
• In imperfect competition, is there ever a case
  when producer surplus is greater if QPC is
  produced instead of QIC?

4
Equilibrium in Imperfect Competition
Price
Producer surplus
MC
P
Demand
Marginal Revenue (MR)
Q
QIC
QPC

• Answer No.
• Profit maximizing rule MRMC at QPC MCgtMR so
  it is not optimal

5
Price Discrimination Introduction

• So far
• 1 price for all consumers
• 1 price for all units purchased
• Larger profits if
• Different consumers pay different prices (e.g.
  income, age, location, preferences)
• Price per unit varies with quantity consumed

6
Assumptions

• Keys
• No arbitrage possibilities
• Goods high taxes or transportation costs,
  perishable products
• Services (Restaurants, transportation,
  entertainment), e.g. 65 and over discounts,
  student id.
• Market power (lets assume monopoly for now)

7
Assumptions

• Price discrimination is legal
• Firm has information on demand preferences
• Ideally identify the type of consumer
• Example age or income

8
Reasons for Price Discrimination

• Consumers are heterogeneous willingness to pay
  varies (price sensitivity)
• Consumer receives a surplus with uniform pricing
• Firms with market power can do better

9
Classification
10
Complete Discrimination

• Each consumer pays a different price
• More price sensitive consumers pay a lower price
• Less price sensitive consumers pay a higher
  price
• Firm requires information about willingness to
  pay
• Example high prices with bargaining
• Used cars salesmen

11
Complete Discrimination

• Example 2 potential used car buyers (unit demand)

Buyer 1
Buyer 2
10,000
Uniform Price 9,000 Profit 9,000
8,000
Consumer Surplus
Q
Q
1
1
12
Complete Discrimination (case 1)

• Unit demand

Buyer 2
Buyer 1


Price 1 10,000
10,000
Price 2 8,000
8,000
Q
Q
1
1

• Complete Discrimination Profit 10,000 (buyer
  1) 8,000 (buyer 2) 18,000
• Consumer surplus 0

13
Complete Discrimination (case 1)

Aggregate Demand
Individual Demand
P
?CS PS

MC
Vi
Q
1
Q
Q

• Aggregate demand looks like multi-unit
• Firm sets PiVi (it charges a personalized
  price)

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Complete Discrimination (case 2)

• Multiple-unit demand

800
Uniform Price
500
Q
5
15
Complete Discrimination (case 2)

• Multiple-unit demand
• How to achieve perfect price discrimination?
• Option 1 take it or leave it price-quantity
  package
• Option 2 two-part tariff (non-linear pricing)

16
Take it or leave it offer

• Option 1 take or leave it price-quantity package
  (r,q)
• Consumer utility
• Firms profit maximizing problem

17
Take it or leave it offer

• Constraint is binding because monopolist
  wants/can extract all surplus
• Take it or leave it offer becomes

18
Take it or leave it offer

• Important points
• Pareto efficient level of output (q) marginal
  willingness to pay equals marginal cost
• Firm achieves maximum profits and consumer is
  indifferent between buying or not
• Output is the same as in perfect competition

19
Complete Discrimination (case 2)

• Option 2 two-part tariff
• Inverse demand
• Equlibrium price and quantity
• Lump-sum payment

20
Complete Discrimination (case 2)

• Option 2 two-part tariff
• This non-linear pricing schedule takes the form

21
Direct Discrimination

• Different groups of consumers pay different
  prices
• More price sensitive consumers pay a lower price
• Less price sensitive consumers pay a higher
  price
• Firm requires information about groups and can
  identify them easily/legally.
• Examples Haircuts, students, 65,
  coach/business, dry cleaning, Ladies Night

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Direct Discrimination
p
p1
p2
D1 D2
MC
p2
D2
p1
D1
q1
q1
q2
q2
Q
MR
Q
MR1
MR2

• Maximization rule MR1 MR2 MC (q1 q2).
• Intuition If MR1gtMR2, q1 can increase q2
  decrease until MR1MR2
• More sensitive segment (elastic) pays a lower
  price (group 1)
• Less sensitive segment (inelastic) pays a higher
  price (group 2)
• ? is higher than with uniform pricing

23
Direct Discrimination

• Mathematically
• Monopolist solves
• Focs are
• After some manipulation

24
Direct Discrimination Inter-related Demands
pD
Day
DD (pNpu)
pD
pD
c
DD (pNpD)
qD
qD
qD
MRD (pDpu)
MRD (pNpN)

• Day vs. night pricing (phone, electricity)
• Lower night price increases night demand and
  decreases optimal day price (wrt to independent
  demand level)

25
Direct Discrimination Inter-related Demands
pN
Night
DN (pDpD)
pN
pN
DN (pDpu)
qN
qN
qN
MRN (pDpu)
MRN (pDpD)

• Higher day price increases night demand and
  optimal night price (wrt to independent demand
  level)

26
Direct Discrimination Inter-related Demands

• Mathematically

27
Direct Discrimination Inter-related Demands

• Lets assume a symmetric demand system
  (substitution effects are identical)

gt0 (lets assume 1 is a larger mkt)
gt0
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Direct Discrimination Inter-related Demands

• If elasticity 2 gt elasticity 1 then p1gtp2
• If smaller mkt has more elastic dd, it must have
  a lower p
• Price discrimination also applies in more general
  case of related demands (there are several cases,
  however)
• Other related demands
• Durable goods markets (higher price today makes
  some people wait for tomorrow)
• Monday night movie discounts

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Direct Discrimination Welfare
p
p1
p2
D1 D2
MC
p2
D2
p1
D1
q1
q1
q2
q2
Q
MR
Q
MR1
MR2

• In some cases, price discrimination provides
  goods and services to groups that would not have
  access under uniform pricing
• Prescription drugs developed vs. developing
  countries

31
Direct Discrimination Welfare

• Firm is better off (in the worst case the firm is
  as well off)
• Consumers in low elasticity markets are worse off
• Consumers in high elasticity markets are better
  off
• Total welfare usually increases
• A necessary condition is that total output
  increases
• Intuition different prices are not Pareto
  optimal for consumers (resale can be performed).
  If quantity sold is the same under price
  discrimination, welfare has to be lower