ECON 115
Industrial Organization
Industrial Organization
1. Linear (3rd Degree) Price
Discrimination
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First Hour
• QUIZ
Second Hour
• Introduction to Price Discrimination
• Third-degree price discrimination
• Two Rules
• Examples of price discrimination
• One Problem
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• Last week we completed the background
portion of the course: the origins of the
“industrial organization” in antitrust policy
(Week 1), basic micro theory (Week 2) and
finally the time value of money, measuring
market structure and cost (Week 3).
• This week we begin the “meat” of the course,
using economic theory to understand how
firms and industries are organized.
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• Over the next 12 weeks we will investigate:
– Monopolies; capturing the consumer surplus
– Oligopolies; how they interact
– Monopolies; methods of limiting competition
• This week we begin with monopolies
capturing some of the consumer surplus
through price discrimination.
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• Price discrimination is common in the real economy.
• These are examples of price discrimination:
– Prescription drugs are cheaper in Canada than the
United States.
– Textbooks are generally cheaper in Britain than the
United States.
• Effects of price discrimination
– presumably profitable
– may affect efficiency: not necessarily adversely
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• Price discrimination means charging different
prices to different consumers for the same good.
• Recall that a monopolist facing a downward
sloping demand curve and employing non-
discriminatory pricing must reduce its price to all
consumers in order to sell more product.
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• If price discrimination allows a monopolist to
sell more product, it may be seen as increasing
total surplus, thus improving efficiency.
• We will look at how that might happen at the end
of the next lecture.
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• Two issues confront a firm wishing to price discriminate:
1. Identification: can the firm identify demands of
different types of consumer or in separate markets
• easier in some markets than others: e.g tax
consultants, doctors
2. Arbitrage: can the firm prevent consumers charged a
low price from reselling to consumers charged a high
price
• prevent re-importation of prescription drugs to the
United States
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• The firm then must choose the type of price
discrimination
– first-degree or personalized pricing
– second-degree or menu pricing
– third-degree or group pricing
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• There are three types of price discrimination:
Type Name Example
First Degree Personalized
Pricing
Maximum price charged to each
consumer
Second Degree Menu Pricing Quantity discounts
Third Degree Group Pricing Group discounts (“early bird special”
“senior discount” )
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• Third-degree price discrimination: Group pricing.
• Consumers differ by some observable
characteristic(s). A uniform price is charged to
everyone in the group. This is “linear pricing.”
• Different uniform prices are charged to different
groups:
– “children under 12 are free”
– “senior discounts”
– high variety of airline ticket prices
– early-bird specials 13
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• 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.
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• An example of 3rd Degree Price Discrimination:
• Assume the sellers of the last Harry Potter book
face the following demand curves in the United
States and Europe respectively.
• Demand:
– United States: PU = 36 – 4QU
– Europe: PE = 24 – 4QE
• Marginal cost constant in each market
– MC = $4 15
Industrial Organization• We begin with NO PRICE DISCRIMINATION, i.e., the
same price is charged in both markets.
• Use the following procedure to determine price:
1. Determine aggregate demand in the two markets.
2. Determine marginal revenue for that aggregate.
demand
3. Equate marginal revenue with marginal cost to
identify the profit maximizing quantity.
4. Identify the market clearing price from the aggregate
demand.
5. Calculate demands in each market from the individual
market demand curves and the equilibrium price. 16
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17
United States: PU = 36 – 4QU Invert this:
QU = 9 – P/4 for P < $36
Europe: PU = 24 – 4QE Invert this
QE = 6 – P/4 for P < $24
1. Determine aggregate demand:
Q = QU + QE = 9 – P/4 for $36 < P < $24
At these
prices only
the US
market is
active
Q = QU + QE = 15 – P/2 for P < $24
Now both
markets
are active
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RE-Invert the direct demands
P = 36 – 4Q for Q < 3
P = 30 – 2Q for Q > 3
$/unit
Quantity15
36
302. Determine marginal
revenue:
MR = 36 – 8Q for Q < 3
MR = 30 – 4Q for Q > 3DemandMR
3. Set MR = MC:MC
Q = 6.5
P = $17
6.5
17
4. The Market Clearing Price
from the demand curve:
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5. Calculate demands in each market from the individual
market demand curves and the equilibrium price :
QU = 9 – P/4 = 9 – 17/4 = 4.75 million
QE = 6 – P/4 = 6 – 17/4 = 1.75 million
Aggregate profit = (17 – 4)x6.5 = $84.5 million
These are the results WITHOUT PRICE
DISCRIMINATION.
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• The firm can improve on this outcome by
using 3rd degree price discrimination.
• Note that MR is not equal to MC in both
markets:
– MR > MC in Europe
– MR < MC in the US
– Therefore, the firms should transfer some
books from the US to Europe.
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• This requires that different prices be
charged in the two markets.
• Procedure:
1. Evaluate each market separately.
2. Identify equilibrium quantity in each
market by equating MR and MC.
3. Identify the price in each market from
market demand.
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22
1. Evaluate each market separately.
Start with US demand function:
PU = 36 – 4QU
$/unit
Quantity
Demand2. Identify the equilibrium
quantity by equating MR = MC:
MR = 36 – 8QU
36
9
MR
MC = 4
MC4
At MR = MC, QU = 4
3. Identify the price in each
market from market demand:
PU = $20
4
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1. Now use Demand in the Europe
. . . PE = 24 – 4QU
$/unit
Quantity
Demand
to calculate marginal revenue:
MR = 24 – 8QU
24
6
MR
MC42. Equate MR and MC = 4 to
determine quantity:
QE = 2.5
PE = $14
2.5
14
3. Again, identify the price in each
market from market demand:
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• In this case, the firm enjoys a significant
advantage from price discrimination.
• Aggregate sales are 6.5 million books, which
is the same with no price discrimination.
• However, Aggregate profit is (20 – 4)x4 +
(14 – 4)x2.5 = $89 million.
– $4.5 million greater than without price
discrimination
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• With price discrimination the procedure is:
1. Identify marginal revenue in each market.
2. Identify equilibrium MR from the aggregate
MR curve.
3. Equate this MR with MC in each market
to give individual market quantities.
4. Identify equilibrium prices from individual
market demands.
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Industrial Organization• RULE: If demands are linear –
– price discrimination results in the same
aggregate output as no price discrimination.
– price discrimination increases profit because
allocated more profitably across two markets.
• For any demand specifications two rules apply:
– marginal revenue must be equalized in each
market.
– marginal revenue must equal aggregate
marginal cost.26
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• Suppose that there are two markets with the same MC.
• MR in market i is given by MRi = Pi(1 – 1/hi)
– where hi is (absolute value of) elasticity of demand
• From rule 1 (above)
– MR1 = MR2
– so P1(1 – 1/h1) = P2(1 – 1/h2)
– Therefore:
–𝑷𝟏
𝑷𝟐
= (𝟏−
𝟏
𝒉𝟐
)
(𝟏−𝟏
𝒉𝟏
)= 𝒉𝟏𝒉𝟐−𝒉
𝟏
𝒉𝟏𝒉𝟐−𝒉𝟐
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Price is lower in
the market with
the higher
demand elasticity
Industrial Organization• Third Degree Price Discrimination often arises when firms sell
differentiated products:
– hard-back versus paperback books
– first-class versus economy airfare
• Price discrimination exists in these cases when:
– “two varieties of a commodity are sold by the same seller to
two buyers at different net prices, the net price being the
price paid by the buyer corrected for the cost associated with
the product differentiation.” (Phlips, 1983)
• The seller needs an easily observable characteristic that signals
willingness to pay and must be able to prevent arbitrage.
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• NEXT WEEK:
• Exploring 3rd Degree Price Discrimination Further: disaggregating the demand function.
• Nonlinear Price Discrimination (1st
and 2nd Degree Price Discrimination)
• Bonus Lecture on Standard Oil
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• Please make sure you have read Chapters 5 and 6 in the text.
• Start reading Chapter 7 (Sections 7.1 and 7.2)