Chapter 12 Pricing and advertising1

 Conditions for Price Discrimination

 Perfect Price Discrimination (First-degree discrimination, e.g., charge prices by
consumers’ willingness to pay)
 Group Price Discrimination (Third-degree discrimination, for example, lower prices for
students, CAA members)
 Nonlinear Price Discrimination (Second-degree Price Discrimination, for example, buy
one get one free)
 Advertising

12.1 Definitions and Conditions for Price Discrimination

● Price discrimination Practice of charging different prices to different consumers for similar goods or
services, to earn a higher profit.

In practice, a firm can engage in price discrimination by charging consumers different prices for the
same good based on

 individual characteristics (lower prices for students)

 belonging to an identifiable sub-group of consumers (CAA rates, government rates for hotels)
 the quantity purchased (buy two get one free)

It is not price discrimination if the different prices simply reflect differences in costs.
Example: selling magazines at a newsstand for a higher price than via direct mailing. The price
of a mattress at COSTCO warehouse is lower than that through the Costco website because of
the cost of shipment.

As shown in the chart, if a firm can charge only one price for all its customers, that price will
be P*, and the quantity produced will be Q*.

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The notes should be only used for the students in Dr. Haozhen Zhang’s class of Econ2020.

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Two reasons why a firm earns a higher profit from price discrimination than uniform pricing:
1. Under region A of the demand curve (p>monopoly price): Ideally, the firm would like
to charge a higher price to consumers willing to pay more than the uniform price P*,
thereby capturing some of the consumer surpluses under region A of the demand
curve.
2. Under region B of the demand curve (MC<p<monopoly price): Price-discriminating
firms sell to some people who are not willing to pay as much as the uniform price but
willing to pay a price greater than the MC. In that way, the firm could also capture
some of the surplus under region B of the demand curve.

Therefore, the firm uses price discrimination to increase its profits by capturing consumer
surplus from consumers.

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Conditions for Price Discrimination

Necessary conditions for successful price discrimination:

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 1. A firm must have market power. Otherwise, it cannot charge a price above the
competitive price. Examples: monopolist, oligopolist, monopolistically competitive,
cartel.
2. There must be variation in consumers’ reservation price; the maximum amount
someone is willing to pay.
3. A firm must be able to identify the maximum amount someone is willing to pay, e.g.,
know which consumers are willing to pay relatively more.
4. A firm must be able to prevent or limit resale from customers who are charged a
relatively low price to those who are charged a relatively high price. A firm’s inability
to prevent resale is often the biggest obstacle to successful price discrimination.
Resale is difficult or impossible for services, and when transaction costs are high.
Examples: haircuts, plumbing services, an admission that requires showing an ID
Not all differential pricing is price discrimination.

It is not price discrimination if the different prices simply reflect differences in costs.
Example: selling magazines at a newsstand for a higher price than via direct mailing

12.2 Perfect Price Discrimination (First-degree price discrimination)

 Under perfect price discrimination, the firm charges each consumer a price that is
exactly equal to the maximum he/she is willing to pay.

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  Firm profit is increased by the amount of consumer surplus that would exist in a
competitive market; all CS is transferred to the firm.
 Each consumer gets zero consumer surplus.

Graphic analysis
As shown in the chart, for example, the monopolist charges $6 for the first unit, $5 for the
second and $4 for the third until MR=MC in this case. Its MR1=6, MR2=5, and MR3=4.

Demand curve is also the MR curve. Thus, the firm will produce MC(Q*)=MR(Q*)=D(Q*)

Copyright Person Canada

Is the outcome efficient?

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Producing where Demand = MC, all consumer surpluses are transformed into firm profit.

 The perfect price discrimination result of producing where demand equals MC means that
the competitive quantity of output gets produced.

 This outcome is efficient:

o it maximizes total welfare
o no deadweight loss is generated

 But the outcome is harmful to consumers because all surpluses are producer surplus!

3. Group Price Discrimination (Third-degree Price Discrimination)

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A firm divides potential customers into two or more groups (based on some easily observable
characteristics) and set a different price for each group.
Example: senior or student discounts

The firm chooses quantities sold to each group, Q1, and Q2, such that

FOCs:

Note that dQ/dQ1= dQ/dQ2=1

The first-order conditions imply that marginal revenue from each group should be the same
and equal to marginal cost:

 Recall that in Chapter 11, marginal revenue is a function of elasticity:

 The following is from the note of chapter 11,

Write the expression for marginal revenue: R=p(Q)*Q
We can rewrite MR function so that it is stated in terms of elasticity:

This makes the relationship between MR, p, and elasticity of demand quite clear.

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  Therefore, in this price discrimination case,

where m is MC

Thus, the higher price will be charged in the less elastic market segment.
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For example, if pB > p A, >1/ ε B. Since elasticities are negative,
εA ||
1
εA
1
< ¿ ∨¿ and then
εB
|ε A|> ¿ ε B ∨¿

4. Nonlinear Price Discrimination (Second-degree Price

Discrimination)
Price varies only with the quantity purchased, but each customer faces the same nonlinear
pricing schedule.

Not all quantity discounts are price discrimination; some reflect reductions in firm costs
associated with large-quantity sales.

Many utilities use block-pricing schedules, by which they charge one price for the first few units
of usage (block) and then a different price for subsequent blocks.

Example: increasing-block pricing associated with electricity; per KWH charge increases the
more you use

Example: Consider a firm that uses declining-block prices to maximize profit.

$70 is charged for 1 ≤ Q ≤ 20; $50 is charged for Q > 20
Thus, a consumer who buys 30 units pays $70 • 20 = $1400 for the first block and $50 • 10 =
$500 for the second block, for a total of $1900.

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5. Advertising
 Monopoly firms don’t just decide on price and quantity; they also make important
decisions about how much to advertise their products.
 Advertising may positively influence consumers’ preferences and thereby increase
demand for the product.
 Although higher demand increases gross profit, if the cost of advertising is substantial, net
profit may or may not rise.

Deciding Whether to Advertise

Advertise if cost is less than additional gross profit, area B.

How Much to Advertise

An important question for firms: If a monopoly raises advertising expenditures by $1, how
much does its gross profit rise?
Additional advertising pays when gross profit rises by more than $1, following an additional
dollar spent on advertising.
Thus, the profit-maximizing amount of advertising equates the marginal benefit and marginal
cost of advertising.

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Mathematically:

where R is revenue and is a function of output and advertising cost

That is, the firm maximizes profits by choosing Q and A

The profit-maximizing FOCs:

The monopoly advertises until the marginal benefit from the last dollar of advertising equals
$1, the marginal cost of advertising.

An example in the textbook (Third edition), please note that there is a mistake in the second
equation of FOCs (why?)

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Another example in the text book (Fourth Edition):

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