Introduction Price discrimination or price differentiation exists when sales of identical goods or services are transacted at different prices

from the same provider. In a theoretical market with perfect information, perfect substitutes, and no transaction costs or prohibition on secondary exchange (or re-selling) to prevent arbitrage, price discrimination can only be a feature of monopolistic and oligopolistic markets, where market power can be exercised. Otherwise, the moment the seller tries to sell the same good at different prices, the buyer at the lower price can arbitrage by selling to the consumer buying at the higher price but with a tiny discount. The effects of price discrimination on social efficiency are unclear; typically such behavior leads to lower prices for some consumers and higher prices for others. Output can be expanded when price discrimination is very efficient, but output can also decline when discrimination is more effective at extracting surplus from highvalued users than expanding sales to low valued users. Even if output remains constant, price discrimination can reduce efficiency by misallocating output among consumers. Price discrimination requires market segmentation and some means to discourage discount customers from becoming resellers and, by extension, competitors. Price discrimination is thus very common in services where resale is not possible; an example is student discounts at museums. Prie discrimination in intellectual property is also enforced by law and by technology. In the market for DVDs, DVD players are designed - by law - with chips to prevent an inexpensive copy of the DVD (for example legally purchased in India) from being used in a higher price market (like the US). Forms of price discrimination There are numerous business practices which fall under the heading of price discrimination. First, consider static situations in which consumers buy all relevant products in a single period. In most markets, rms set the charge for purchase of their products by means of a simple price per unit for each product, where these prices do not depend on who makes the purchase. Such taris (i) are anonymous (they do not depend on the identity of the consumer), (ii) do not involve quantity discounts for a specic product (i.e., there are no intraproduct discounts), (iii) do not involve discounts for buying a range of products (i.e., there are no inter-product discounts) Types of price discrimination 1.First degree price discrimination

In first degree price discrimination, price varies by customer's willingness or ability to pay (cf. Value-based pricing). This arises from the fact that the value of goods is subjective. A customer with low price elasticity is less deterred by a higher price than a customer with high price elasticity of demand. As long as the price elasticity (in absolute value) for a customer is less than one, it is very advantageous to increase the price: the seller gets more money for fewer goods. With an increase of the price elasticity tends to rise above one. One can show that in the optimum the price, as it varies by customer, is inversely proportional to one minus the reciprocal of the price elasticity of that customer at that price.

2. Second degree price discrimination In second degree price discrimination, price varies according to quantity sold. Larger quantities are available at a lower unit price. This is particularly widespread in sales to industrial customers, where bulk buyers enjoy higher discounts. Additionally to second degree price discrimination, sellers are not able to differentiate between different types of consumers. Thus, the suppliers will provide incentives for the consumers to differentiate themselves according to preference. As above, quantity "discounts", or non-linear pricing, is a means by which suppliers use consumer preference to distinguish classes of consumers. This allows the supplier to set different prices to the different groups and capture a larger portion of the total market surplus. 3.Third degree price discrimination In third degree price discrimination, price varies by attributes such as location or by customer segment, or in the most extreme case, by the individual customer's identity; where the attribute in question is used as a proxy for ability/willingness to pay. Additionally to third degree price discrimination, the supplier(s) of a market where this type of discrimination is exhibited are capable of differentiating between consumer classes. Examples of this differentiation are student or senior discounts. For example, a student or a senior consumer will have a different willingness to pay than an average consumer, where the reservation price is presumably lower because of budget constraints. Thus, the supplier sets a lower price for that consumer because the student or senior has a more elastic price elasticity of demand (see the discussion of price elasticity of demand as it applies to revenues from the first degree price discrimination, above). The supplier is once again capable of capturing more market surplus than would be possible without price discrimination. The purpose of price discrimination is generally to capture the market's consumer surplus. An example is a high-speed internet connection shared by two consumers in a single building; if one is willing to pay less than half the cost,

and the other willing to make up the rest but not to pay the entire cost, then price discrimination is necessary for the purchase to take place. It can be proved mathematically that a firm facing a downward sloping demand curve that is convex to the origin will always obtain higher revenues under price discrimination than under a single price strategy. This can also be shown diagrammatically.

In the top diagram, a single price (P) is available to all customers. The amount of revenue is represented by area P, A, Q, O. The consumer surplus is the area above line segment P, A but below the demand curve (D).

With price discrimination, (the bottom diagram), the demand curve is divided into two segments (D1 and D2). A higher price (P1) is charged to the low elasticity segment, and a lower price (P2) is charged to the high elasticity segment. The total revenue from the first segment is equal to the area P1,B, Q1,O. The total revenue from the second segment is equal to the area E, C,Q2,Q1. The sum of these areas will always be greater than the area without discrimination assuming the demand curve resembles a rectangular hyperbola with unitary elasticity. The more prices that are introduced, the greater the sum of the revenue areas, and the more of the consumer surplus is captured by the producer. Profit and Efficiency Maximization under single vs discriminating pricing Single-pricing firm A single-pricing firm sells every unit at a uniform price. Its total revenue (TR) reaches a maximum when the elasticity of demand = |1| before price falls to zero. Because it must lower the uniform price for every unit just to sell just one more unit, MR < P. Discriminating-pricing firm If the price searcher can sell each unit of output according the buyer's willingness to pay (i.e., the reservation price), the total revenue generated will be much larger. This total revenue generated through perfect price discrimination can be called total willingness to pay (TWP)*. TWP reaches its maximum when price charged is equal to zero. Marginal willingness to pay (MWP) is measured by the slope of tangent to TWP. Since each buyer is charged its reservation price, MWP coincides with the demand curve itself. In addition, since the discriminating-pricing firm does not have to lower its price for all units just to sell one more unit, its marginal revenue (MRdp) is equal to MWP. And because MWP is the reservation price paid by each buyer (Pdp), MRdp = Pdp. When the single-pricing firm and the discriminating-pricing firm are faced with the same demand curve, P along the same demand curve for the same output is identical. But the single-pricing price (Psp) applies to all units sold. The pricediscriminating price (Pdp) applies to only the additional unit sold. Maximum-profit output Just like the single-pricing firm, the discriminating-pricing firm produces at an output level where MR = MC to maximize profit. But it is MRdp = MC. Since MRdp = Pdp, so Pdp = MC at the maximum-profit output. Because the single-pricing firm must charge the same price for all buyers, MRsp < Psp. So when MRsp = MC, Psp < MC. Therefore, the maximum-profit output under discriminating pricing is always larger than the maximum-profit output under single pricing. And under discriminating pricing, marginal benefit to the consumer is always equal to marginal cost to the

producer (MB = MC). In other words, maximizing profit will also maximize efficiency under discriminating pricing. Distribution of economic surplus Economic surplus is the difference between what buyers are willing to pay (TWP) and what it costs sellers to produce (TC) under both single pricing and discriminating pricing. Economic surplus is maximized when MB (marginal benefit) = MC (marginal cost). This condition translates into P = MC where P is taken to mean the marginal benefit of the last unit bought. Economic efficiency is maximized when economic surplus is maximized. Under single pricing, economic surplus is divided between consumer surplus (TWP - TR) and economic profit (TR - TC). When the single-pricing maximum-profit output produces positive profit, both consumer surplus and economic profit are positive. Under perfect price discrimination, all economic surplus becomes economic profit to the producer. Consumer surplus is equal to zero. Because every unit is sold at the buyer's reservation price, maximum profit for the discriminating-pricing firm is much higher and output is much larger. In fact, output exceeds the ATCmin level. So the higher output under price discrimination comes at the expense of consumer surplus. But more units can also be bought at different affordable prices by consumers. When profit is zero/negative under single pricing vs discriminating pricing Even when the single-pricing firm is just earning zero profit, the discriminating-pricing firm can still manage to earn positive profit by charging each unit according to the buyer's reservation price. And when the single-pricing firm can no longer afford to stay in business, the discriminating-pricing firm may still be able to produce at a profit by capturing the entire consumer surplus. Conditions for Profit Maximization Revenue (R) = pricequantity = PQ; Marginal Revenue (MR) is "the additional revenue from an additional unit of output". Formally we have MR =dR/dQ, Note that "average revenue", R/Q, is simply price. MR decreases with Q Total Cost=C(Q) depends on output. Total cost is increasing with output. Marginal Cost (MC) is the "additional cost of an additional unit of output" Generally we argue that for the "relevant" range of output, MC is increasing in output , Instances when we might expect it to decrease with output (economies of scale) Profit Maximization: The General Rule =RC

 (Profit = Revenue Cost) Then -maximization occurs at: /Q = 0 R/Q C/Q = MR MC=0

Profit Maximization

Figure 1b
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Solving for Profit-Maximizing Price and Quantity In the figure given the MR and MC depicted the profit maximizing Q and P are 35 and 6.50. We can solve this algebraically MR = MC--> 10- (1/5)Q = 3 or Q =35 and P = 10- (1/10)(35) = 6.5. When to Sell Out No marginal costs associated with selling an extra ticket. Given no marginal costs, profit maximization= revenue maximization. Then why dont promoters set the price to sell out all concerts (or games)? Simple explanation: The price needed to sell out the arena may be below the revenue maximizing price. Necessary conditions for price discrimination OK, so what conditions must a situation meet in order for the firm to pull of price discrimination successfully? Three, it turns out:

(1) You must be able to identify each consumers maximum willing-to-pay price at a reasonable cost. (2) You must be able to charge each consumer this price at a reasonable cost. (Reasonable means that the cost is less than the extra revenue you earn as a result of price discriminating.) (3) Customers must not be able to resell the goods easily. (This explains why new car dealers practice price discrimination shamelessly.) How price discrimination can raise profits and increase production--the case of high fixed costs Product: Round-trip flight from Huntsville to NYC/LaGuardia Assume 2 sets of customers: Suits Grannies 40 willing to pay $900 80 willing to pay $250 TFC for flight MC (constant) of a customer 1. Set price at $900 (Suits only will fly) TR = Psqs = $900 * 40 TVC = MC * qs = $75 * 40 TC = TFC + TVC = profit = TR - TC = = $ 36,000 3,000 38,000 $ (2,000) $ $ 35,000 75

EEK 2. Set price at $250 (both Suits and Grannies will fly) TR = Pq = $250 * 120 = $ 30,000 TVC = MC * q = $75 * 120 9,000 TC = TFC + TVC = 44,000 profit = TR - TC = $ (14,000) EEK again 3. Now--charge Suits $900 and Grannies $250 (i.e., price discrimination) TR = Psqs + Pgqg = $900*40 + $250*80 = $ 56,000 TVC = MC*q = $75*120 = 9,000 TC = TFC + TVC = 44,000 profit = TR - TC = $ 12,000 Profit at last!