4 & 5. Price discrimination Flashcards
What is Price discrimination?
Price discrimination is the capacity of firms to price consumers differently considering what they want to purchase.
The increasing use of Internet as a market place has led to think that we would enter to an area of perfectly competitive market. The two main reasons lie in the demand side, where we can observe information enhancements, and in the supply side, with information improvements.
.
Why should firm price discriminate?
We are saying firms have market power, downward sloping demand curve like a monopoly.
.
There are five central assumptions in a perfectly competitive environment:
1. Atomicity;
2. Product homogeneity;
3. Perfect information: every agent (firms, consumers) knows the price charged by every firm
within the market;
4. Technological symmetry: every firm has access to the available production technologies;
5. No entry and exit barriers.
Perfect price discrimination – 1st grade
It consists in pricing each consumer with a different price for each unit sold, price that exactly matches his/her willingness to pay (under the hypothesis that each consumer buys only 1 unit).
This way, the firm is able to recover both losses: the profit surplus is maximized, the social welfare the same (so this is an efficient solution). The problem is that there is not the osues surplus: there are no differences between price and willingness to pay. Since all the pie goes to the firm, this type of discrimination is considered a sort of utopia, a highly theoretical possibility but hard to be developed in reality. This is because a firm is unable to know in advance the willingness to pay of each consumer. Secondly, even if this becomes possible, it is impossible to prevent bad behaviors of consumers (for instance, they can buy at a low price and then resell the good at a higher one).
Internet has made this discrimination less utopist, because through the web it is easier to know the willingness to pay.
.
Look at graph.
.
Discussion:
Optimal pricing solution. Inefficient in terms of social welfare in the viewpoint of monopolies too. Because choosing uniform pricing is leaving money on the table. In particular it loose the consumer surplus A but also the deadweight loss B

Why is it leaving money in the table bcz there are ppl who will pay more than what they actually paid (A)

Will pay more than marginal cost for the good
A way to sell to those customers for a profit..
Price discrimination will try to recoup the quantities A and B. We will analyse 3 ways,
!st price discrimination: perfect from pop of social welfare and

Profit is not just the level before but this whole area. A consumer surplus, B wipe out deadweight loss, producer surplus is at the max level and equal to social welfare. Issue is ethics because Consumer surplus = 0.

This is a theoretical concept. (Like the pizza example, 1st slice, 2nd slice) Considered impossible, was difficult to avoid resale phenomenon. Ppl lower on the demand curve may sell for a higher price to the ppl higher in the demand curve.
Perfect price discrimination (I°)
(Pigou, 1920):
One consumer - One price for each unit sold
Each customer is charged a different price – exactly matching his/her willingness to pay for each unit
.
Max Producer Surplus.
Max Social Welfare.
Equity problems: no Consumer’s Surplus.
Problems:
Which is the wtp of each consumer is difficult to know
Difficult to avoid arbitrage (absence of resale).
.
Example: Consumer profiling (or price steering) via devices already exists(search made by myself through Booking.com via smartphone (left) and desktop (right))
Extra: From “shopping-then-shipping” to “shipping-then-shopping”?
Most shoppers have noticed Amazon’s recommendation engine while they shop. At present, Amazon’s AI does a reasonable job suggesting items for customers to buy, particularly considering the millions of items on offer. However, the company’s predictions are far from perfect. […] Now, imagine that Amazon’s AI collects more information about us: In addition to our searching and purchasing behavior, it also collects other data it finds online, including social media, as well as offline, such as our shopping behavior at Whole Foods. It knows not only what we buy, but also what time we shop, which location we shop at, how we pay and more. What if the AI uses that data to improve its predictions? What happens to Amazon’s strategy as its data scientists, engineers and machine learning experts work tirelessly to dial up the accuracy on the prediction machine?
At some point, the AI’s prediction accuracy crosses a threshold, such that it becomes in Amazon’s interest to change its entire business model. The predictions become sufficiently accurate that it becomes more profitable for Amazon to ship you the goods that it predicts you’ll want rather than wait for you to order them.[…..]
By Ajay Agrawal, Joshua Gans and Avi Goldfarb – Harvard Business Review, Oct 4, 2017.
3° Price discrimination
“Group” Pricing: different prices for different groups of consumers, same price within the same group.
Selection by (exogeneous) indicators:
Age
Occupation
Geography
(Internet) Device
Examples: geographical market segmentation (books in India and UK); special discounts (senior, student, etc); mode of buying.
.
Extra: It consists in setting different prices for different groups of customers (group pricing). Within the same group, prices are homogeneous.
Sometimes it is convenient to subdivide the market considering some exogenous indicators:
3 degree price discrimination: The trick is to apply the elasticity rule to each market segment:
The trick is to apply the elasticity rule to each market segment:
.
- In sub-market i: max πi = TR(qi) – TC(qi) o pi(qi) · qi – TC(qi)
.
First order condition formula: pi+qidpi/dqi=MC
pi[1+(qi/pi)(dpi/dqi)]=MC
pi[1-(1/|ei|]=MC
(pi-MC)/pi=1/|ei|
.
- In sub-market j repeat the same and obtain: (pj-MC)/pj=1/|ej|
.
Of course absence of resale possibilities is needed also in this case
.
Implications:
Rule: different elasticities = different prices.
Specifically, higher prices in less elastic markets
Exercise on 3° price discrimination
Exercise on 3° price discrimination
No fixed costs, marginal costs constant and equal to 2

Total demand curve represented by uptown market
.
LEt’s suppose firm has total cost function = 2q
Analyse 2 scenarios,
1st w price discrimination (can subsegment markets), 2nd no price discrimination
2° Price discrimination
Self-selection by consumers
seller cannot directly identify consumer type, but can still induce consumers to distinguish themselves. This selection may be based on the willingness of consumers to consume:
different quantities (so price paid by consumers depends on the quantity of the good consumed: non linear-pricing, bundling)
Different versions of the same product (Versioning): (often) case of VERTICAL DIFFERENTIATION (rather than HORIZONTAL)
.
Extra:
It is characterized by self-selection by consumers: seller cannot directly identify consumer type, but can still induce consumers to distinguish themselves. This selection may be based on the willingness of consumers to consume:
- Different quantities (so price paid by consumers depends on the quantity of the good consumed: non-linear pricing);
- Different versions of the same product (Versioning).
A typical non-linear pricing technique is the two-part tariff:
- With identical consumers (same demand curve), the firm may obtain the maximum surplus possible (same as perfect discrimination)
- With heterogeneous consumers, the firm will opt for multiple two-part tariffs. If there are 2 typologies of consumers with CS2(p) > CS1(p), we will have: A1 < A2 e p1 > p2
Versioning
The aim is to sell more than one version of the same product at different prices targeting different segments of consumers.
.
This applies also when the low quality version has the same cost of production of the high quality one (or even higher):
o Software: basic version obtained by degrading the premium through the disablement (bearing some costs) of some functions;
.
o Information services about share prices: the delayed version is produced with some additional costs with respect to the immediate version.
Companies leave that consumers choose the version they prefer (self-selection).
.
The art of Profitable versioning:
In order to make a profitable versioning, there is a key constraint (incentive): you cannot make the inexpensive version too attractive to those willing to pay more. Therefore, companies need to lower the price of the premium version and lower the quality of the basic one.
.
Key constraint (incentive): you can’t make the inexpensive version too attractive to those willing to pay more.
Need to: Lower price of the premium version
Lower quality of the basic version
.
.
One additional constraint (participation) refers to the fact that the cheap version must be sufficiently cheap that low types are willing to purchase.
.
Additional constraint (participation): basic version (of decent quality) must be relatively inexpensive that those with relatively low (but still sufficient) willingness to pay wish to purchase (to “be in the market”).
.
.
The second additional constraint (good design): it is impossible for consumers to transform the basic into the premium version. they need to be really different versions: don’t upset “high-wtp” customers.
.
Versioning (and PD) and Social Welfare
What about consumer welfare? Is versioning good or bad for consumers?
It is difficult to say a priori. The answer crucially depends on whether versioning is able to enlarge the customer base or not:
- If the number of customers increase, the consumer’s surplus may not be inferior with versioning;
- If the number of consumers does not increase, then versioning enables the producer to gain more at the expense of consumers. In this case, versioning leads to a lower consumers’ surplus.
.
(Discussion in class)
sales are increasing with versioning) or if more products are sold. Social welfare is low.
.
.
Versioning on Quantity
Second degree price discrimination (“sort of” versioning on quantity)
.
TWO-PART TARIFF:
- Tariff entails a fixed entry fee (f) and a per-unit price (p) (Abbonamento)
- Total average unit price depends on quantity
- Customers self-select depending on their preferences
- Simplifying, it is like having 2 main dichotomous options: a) consume few units (and spend less in absolute terms) but paying a high average price; b) consume more units (and spend more in absolute terms) but paying a lower average price.
.
Beware of the participation constraint:
Excursus: To better meet the participation constraint the seller may also propose different combinations (f,p), i.e. a (relatively) low f and high p for “low” demanders (those who consume few units), and a (relatively) high f and low p for “high” demanders (see the graphical representation in the next slide)
.
.
VERSIONING(functionalities/ product features) How many versions?
No general rule
There are not general rules to decide how many versions a company should implement.
More versions lead to:
- More possibilities to capture all the value from consumers;
- More personalization costs (which presumably are convex in the number of versions);
- Risk of cluttering effect for potential consumers.
.
To alleviate cluttering (especially when the number of versions increases) many firms think is important to describe functionalities in a very detailed way for each version.
.
Shapiro and varian said that “if you cannot decided how many versions to have, choose 3.”
3 can be better than 2 for the phenomenon of extremeness aversion: that is the risk that 2 versions (heavy and light) are felt by potential consumers as too big or too small, with the risk that a high percentage will opt for the light version, thus generating less revenues for the company.
.
Adding another category (super gold premium) and making the previous premium version as the medium one can produce some advantages.
.
If switching from 2 to 3 is not possible for some reasons, note that a firm might always artificially increase the number of versions and sell the preferred version exploiting the cognitive inclination of consumers.
Simonson e Tversky experiment (1992, JMR): Extremeness Aversion (and cluttering); Decoy effect
Microwave oven. Two possible set of choices for two identical groups of people (n = 60):
- 1° group:
1) basic (Emerson): 110 $ 57% of consumers
2) premium (Panasonic): 180$ 43% of consumers
- 2° group:
basic (same): 110 $ 27%
premium (same): 180$ 60%
High-premium (Panasonic): 200$ 13%
.
Annotation1: note that with the “extremeness aversion” (and cluttering) argument we are now diverging from the rational “homo oeconomicus” implied by the neoclassical theory who always knows exactly and with no doubt what she/he wants
.
Intro to behavioural economics: Thinking fast and slow; Misbehaving
.
.
Annotation2: if switching from 2 to 3 is not possible for whatever reason, note that a firm might always artificially increase the number of versions and sell the preferred version exploiting the cognitive biases of consumers
Dan Ariely and the Decoy effect(in Predictably Irrational, 2010)
