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Lecture 6: 3rd Degree
Price Discrimination
AEM 4160: Strategic Pricing
Prof. Jura Liaukonyte
Lecture Plan


HW2
Second degree price discrimination


Cellphone example
Third degree price discrimination


Market segmenting
Examples
Benefits of Raising the Per-Minute Charge
Using Menus to Increase Profit


Even better by offering a menu of two-part tariffs, each
designed to attract a specific type of consumer
Intuition:

Extract more surplus from high-demand consumers by making
the low-demand plan less attractive to high-demand customers
Third-Degree Price Discrimination



Consumers differ by some observable characteristic(s)
A uniform price is charged to all consumers in a
particular group – linear price
Different uniform prices are charged to different groups


Subscriptions to professional journals [library/student]
Entry prices by age
Third-Degree Price Discrimination

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
Third Degree Price Discrimination: Example


Harry Potter volume sold in the United States and Europe
Demand:



United States: PU = 36 – 4QU
Europe: PE = 24 – 4QE
Marginal cost constant in each market

MC = $4
The Example: No Price Discrimination


Suppose that the same price is charged in both markets
What do we need to find out?
The Example: No Price Discrimination



Suppose that the same price is charged in both markets
What do we need to find out?
Use the following procedure:





Calculate aggregate demand in the two markets
Identify marginal revenue for that aggregate demand
Equate marginal revenue with marginal cost to identify the
profit maximizing quantity
Identify the market clearing price from the aggregate demand
Calculate demands in the individual markets from the individual
market demand curves and the equilibrium price
The Example
United States: PU = 36 – 4QU
QU = 9 – P/4 for P < $36
Europe: PU = 24 – 4QE
QE = 6 – P/4 for P < $24
Invert this:
Invert
At these prices
only the US
market is active
Aggregate these demands
Q = QU + QE = 9 – P/4 for $24 < P < $36
Q = QU + QE = 15 – P/2 for P < $24
Now both
markets are
active
The Example
Invert the direct demands
P = 36 – 4Q for Q < 3
36
P = 30 – 2Q for Q > 3
Marginal revenue is
MR = 36 – 8Q for Q < 3
17
MR = 30 – 4Q for Q > 3
Set MR = MC
Q = 6.5
$/unit
Demand
MR
MC
6.5
Price from the demand curve P = $17
Quantity
15
The Example

Substitute price into the individual market demand curves:

QE = 6 – P/4 = 6 – 17/4 = 1.75 million
Aggregate profit = (17 – 4)x6.5 = $84.5 million


QU = 9 – P/4 = 9 – 17/4 = 4.75 million
The Example: Price Discrimination


The firm can improve on this outcome
Check that MR is not equal to MC in both markets




MR > MC in Europe
MR < MC in the US
This requires that different prices be charged in the two
markets
Procedure:



take each market separately
identify equilibrium quantity in each market by equating MR and MC
identify the price in each market from market demand
The Example
$/unit
Demand in the US:
PU = 36 – 4QU
Marginal revenue:
36
20
MR = 36 – 8QU
MC = 4
4
Equate MR and MC
QU = 4
Price from the demand curve
Deman
d
MR
MC
4
PU = $20
9
Quantity
The Example:
$/unit
Demand in the Europe:
PE = 24 – 4QE
Marginal revenue:
24
14
MR = 24 – 8QE
MC = 4
4
Equate MR and MC
QE = 2.5
Price from the demand curve
Deman
d
MR
MC
2.5
PE = $14
6
Quantity
The Example

Aggregate sales are 6.5 million books


the same as without price discrimination
Aggregate profit is (20 – 4)x4 + (14 – 4)x2.5 = $89
million

$4.5 million greater than without price discrimination
Some Additional Comments

Suppose that demands are linear



price discrimination results in the same aggregate output as no price
discrimination
price discrimination increases profit
For any demand specifications two rules apply


marginal revenue must be equalized in each market
marginal revenue must equal aggregate marginal cost
Price Discrimination and Elasticity


Suppose that there are two markets with the same MC
MR in market i is given by MRi = Pi(1 – 1/ηi)


Where ηi is (absolute value of) elasticity of demand
From rule 1 (above)


MR1 = MR2
So = P1(1 – 1/η1) = P2(1 – 1/η2) which gives
P1 1  1  2  1 2  1


.
P2 1  1 1  1 2   2
Price is lower in the
market with the
higher demand
elasticity
Takeaways

Firms would prefer to use perfect (aka first-degree) price discrimination, but
this may be impossible.

Third-degree PD is one way to approximate perfect PD, but requires that
firms can separately identify members different groups.

Second-degree PD induces customers to sort themselves into groups.

Recall the no arbitrage constraint—consumers can’t resell to others.

Price discrimination and other advanced pricing strategies are powerful tools;
you now have the economic models to understand them.
BUNDLING AND
TYING
Introduction

Firms often bundle the goods that they offer




Bundled package is usually offered at a discount
Bundling may increase market power



GE merger with Honeywell
Tie-in sales ties the sale of one product to the purchase of
another
Tying may be contractual or technological




Microsoft bundles Windows and Explorer
Office bundles Word, Excel, PowerPoint, Access
IBM computer card machines and computer cards
Kodak tie service to sales of large-scale photocopiers
Tie computer printers and printer cartridges
Why? To make money!
More Examples of Bundling



Telecommunications
 Firms bundle local, long-distance, and mobile telephone
services,
Banks
 Bundle checking, credit, and investment services
Hospitals bundle an array of medical services
Incentives to Bundle



Bundling may arise in many contexts to sort consumers in
a manner similar to second-degree price discrimination.
When consumers have heterogeneous tastes for several
products, a firm may bundle to reduce that heterogeneity,
earning greater profit than would be possible with
component (unbundled) prices.
Bundling—like price discrimination—allows firms to
design product lines to extract maximum consumer
surplus.
Bundling Advantages




Simplifies consumer choice (as in telecommunications and
financial services)
Reduces costs from consolidated production of
complementary products
Reduces consumer search costs and product or
marketing costs
Bundling to extend market power and/or deter entry

as witnessed by antitrust challenges to Microsoft’s bundling of
software applications (e.g. its Internet browser, media player)
with its dominant Windows operating system
Cable TV




Crawford’s (2001) empirical study of bundling decisions
of cable providers
bundle several networks into a basic bundle service, cable
provider increases its profit on average above unbundled
sales by 14%
13% less CS than from unbundled sales
bundling together similar networks is less profitable than
bundling dissimilar ones
Example: Cable and Satellite TV
Industry
Third Degree Price Discrimination

Raw Data Analysis

Collected the price of Comcast Xfinity’s basic cable in 11
cities



Chose Comcast because it has the largest market share
Plotted prices relative to geography
Ran regressions against the number of competitors in the
market
30
Geographic Price Discrimination
25
Price of Basic Cable ($)
20
15
Price of Basic Cable
10
5
0
Price vs. Number of Competitors in the Marketplace
30
Price
25
Log. (Price)
20
Price of Basic Cable ($)
Linear (Price)
y = -1.5295x + 27.735
R² = 0.5554
15
R² = 0.6439
10
5
0
0
1
2
3
4
5
6
Number of Competitors
7
8
9
10
Computer Software Suites


Microsoft and others bundle dissimilar programs—word
processors and spreadsheets—into a suite
Gandal (2003):




survey of home PC users: 43% use both programs;50% used
only one; 7% used neither
survey business PC users: 63% used both, 37% used only one
A lot of users use only one (but not both) pieces of software
consumers with a high value for spreadsheets had a low value
for word processors and vice versa: negative correlation in
demand
Tie-In Sales


Generally considered to be an ‘extension of monopoly’
by courts. In other words, courts believed it was an
attempt to use one monopoly to create a second.
Frequently, tying good is sold very cheaply, while tied
good is very expensive. Famous cases: IBM and computer
cards, Xerox and toner, Canning machines and tin plate.
Printers and Ink Cartridges




High-intensity usage consumers => high willingness-topay
Low-intensity usage consumers => print small volumes
=> a low willingness-to-pay
Strategy: lower the price of the initial, one-time purchase
printer and raise the price of the aftermarket, repeat
purchase ink cartridge
Ink cartridge becomes the mechanism by which
consumers' intensity of usage is metered:


Inducing high-intensity users to pay a higher overall price
Low-intensity users a lower overall price
Examples cont’d

This basic idea holds for a variety of other aftermarket
situations:



Razors and razor blades
Video game consoles and video games
Etc.
Anti-Trust and Bundling

The Microsoft case is central




Accusation that used power in operating system (OS) to gain
control of browser market by bundling browser into the OS
Need to show
 Monopoly power in OS
 OS and browser are separate products that do not need to be
bundled
 Abuse of power to maintain or extend monopoly position
Microsoft argued that technology required integration
Further argued that it was not “acting badly”
 Consumers would benefit from lower price because of the
complementarity between OS and browser
And now…

This view gained more force and support in Europe
 Bundling of Media Player into Windows
 Competition Directorate found against Microsoft

No on appeal
Antitrust and tying arrangements


Tying arrangements have been the subject of extensive
litigation
Current policy

Tie-in violates antitrust laws if



There exists distinct products: tying product and tied one
Firm tying the products has sufficient monopoly power in the tying
market to force purchase of the tied good
Tying arrangement forecloses or has the potential to foreclose a
substantial volume of trade