MBA201a: Price Discrimination*
*
Note for pricing projects: This is the beginning of the “advanced pricing” material.
Basic price discrimination
Definition: A firm is price discriminating if it is selling goods at
prices that differ by more than the firm’s marginal costs of
producing the goods.
– One important example is selling the same good for different
prices.
– Cost-based price differences are not considered price
discrimination (e.g. price differences based on transportation
costs).
Professor Wolfram
MBA201a - Fall 2009
Page 1
When can a firm price discriminate?
A firm’s ability to price discriminate is hampered if:
– Consumers can arbitrage price differences, for instance by
reselling the good to other consumers.
– It faces competition from other firms providing perfect or
near-perfect substitutes.
– It faces legal restrictions (more on this later).
Professor Wolfram
MBA201a - Fall 2009
Page 2
One type of price discrimination
P
MC
D
Q
- Each consumer is charged
his or her willingness to
pay.
- Often done through negotiation.
- Called “perfect” or “first-degree” price
discrimination.
Professor Wolfram
MBA201a - Fall 2009
Page 3
The effects of perfect price discrimination
P
MC
D
MR
Professor Wolfram
MBA201a - Fall 2009
Q
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The effects of perfect price discrimination
P
Profits at monopoly price*
MC
D
MR
Q
*Assuming no fixed costs
Professor Wolfram
MBA201a - Fall 2009
Page 5
The effects of perfect price discrimination
P
Profits from perfect price discrimination
MC
D
MR
Professor Wolfram
MBA201a - Fall 2009
Q
Page 6
Effects of price discrimination in general
– The seller gains: revenue and profits go up.
– The low-price buyer often gains, since under monopoly
pricing he would have been priced out of the market.
– The high-price buyer often loses, since he is charged a
higher price.
– On net, it is not clear whether this is good or bad for society
as a whole. It depends!
Professor Wolfram
MBA201a - Fall 2009
Page 7
Types of price discrimination
1. First-degree PD: charge every consumer his or her
willingness to pay.
2. Third-degree PD: sort customers into several groups
based on observable, exogenous characteristics.
3. Second-degree PD: present all customers with a menu of
prices and allow the customers to self-select.
Professor Wolfram
MBA201a - Fall 2009
Page 8
Discrimination among groups: 3rd degree PD
– Firm must be able to identify the different segments (e.g.
require student id for student discount, driver’s license for
senior-citizen discount).
– Rule: different elasticities  different prices
• Recall the “elasticity rule” from our discussion of
monopoly prices.
• Here it means that the firm should set higher prices in
less elastic market segments.
Professor Wolfram
MBA201a - Fall 2009
Page 9
Markups on European cars
Model
Belgium France
Germany
Italy
UK
Fiat Uno
7.6
8.7
9.8
21.7
8.7
Fiat Tipo
8.4
9.2
9.0
20.8
9.1
Ford
Escort
8.5
9.5
8.9
8.9
11.5
13.0
9.2
9.5
9.0
Renault 19 8.9
Professor Wolfram
MBA201a - Fall 2009
Page 10
Second-degree price discrimination
Basic idea: Present consumers with a menu of (price, quality) pairs
and let them sort themselves into groups.
– A consumer’s willingness to pay for quality should be
correlated with his or her willingness to pay a high price for
the underlying good.
– Examples:
• Retail: Old Navy, Gap and Banana Republic jeans.
• Airlines: first class and coach seats.
Professor Wolfram
MBA201a - Fall 2009
Page 11