Price Discrimination Notes

ISyE 6230 Economic Decision Analysis Matt Drake Spring 2005

Preliminaries

Before we begin our discussion of price discrimination and its economic motivations, we must rst (re)introduce a few topics in microeconomics that will prove useful in our subsequent analysis.

1.1

Demand

In order to determine how economic agents should determine prices and quantities of production, we must specify how consumers in a market will react to various prices. The most common method of characterizing consumer behavior is by specifying a demand function that determines the quantity demanded at each price oered by the seller. We can also invert the demand function and characterize the price at which a certain quantity is demanded. For the balance of this essay, we will consider deterministic demand functions which relate exactly what will be sold at a given price. Admittedly demand is generally stochastic, varying randomly from observation to observation, selling period to selling period. While we could introduce a stochastic demand element into the following discussions, deterministic demand allows us to concentrate on the economic insights from the models presented without the complications that accompany random demand. The following1 are several common demand functions utilized in price discrimination analysis. Although these functions are only dependent on the price of the good itself, they can be generalized to include the prices of other goods and other variables as well such as income. 1. Linear demand Q(p) = a bp In the linear demand model, both of the parameters (a and b) are positive. The parameter a can be thought of as the market potential for the good, since this is the amount that would be sold if the price was zero; b is a measure of the consumers price sensitivity. 2. Cobb-Douglas (Constant Elasticity) demand Q(p) = ap In the Cobb-Douglas demand model, parameters a and are positive. Again the parameter a is a market scaling parameter. We will see below that is equal to the price elasticity of demand. Remark 1 We will assume that our demand functions are downward sloping. This means that the quantity demanded decreases as the price of the good increases. A sucient condition for demand to be downward sloping is that the consumers utility functions are quasi-linear. In order to get a sense of how the quantity demanded changes as the price changes, we look at the (own) price elasticity of demand. Denition 1 Price elasticity of demand ( ) is the percentage change in quantity demanded divided by the percentage change in price.
1 The material in this section is common in any microeconomics textbook. The majority of the notation and concepts contained herein is from Tirole (1988).

Since we have assumed downward-sloping demand, the price elasticity of demand will always be negative (because quantity demanded and price are inversely proportional). In order to avoid confusion, we will consider the absolute ratio of the two percentage changes. In terms of the demand function, Q(p), we have = Q(p) p . p Q(p)

Consider a prot-maximizing monopolist that faces demand of Q(p) and production cost C (q ). This monopolist chooses the prot-maximizing price, pm according to pm arg max{pQ(p) C (Q(p))}. Solving (1) yields the following important identity. Theorem 1 (Inverse Elasticity Rule) price pm .
pm C (Q(pm )) pm

(1)

where

is the price elasticity of demand at

The Inverse Elasticity Rule states that the inverse of the elasticity of demand at the monopoly price equals the gross prot margin on the good. Substituting qm Q(pm ) into the Inverse Elasticity identity yields the familiar result that a monopolist produces the quantity where its marginal revenue equals its marginal cost. This results in a price that exceeds the marginal cost of the good, which we shall see below is the socially-optimal price (denoted by ps in Figure 1). To this point we have been concerned with demand in markets for a single good. Single consumers obviously purchase many dierent goods with their money and rms tend to produce more than one type of good. Consequently, we may be interested in analyzing the total demand in a market for multiple goods. In general aggregating demand for multiple goods is a dicult proposition. Consumer demands and production costs are not independent, especially when the goods are complements or substitutes or production of the goods results in economies of scale. There is one case, however, when aggregation of demand is simple. Remark 2 If production costs are separable by good and demands for the goods are independent, aggregate demand is equal to the sum of the individual product demand functions. A similar result holds true if we seek to aggregate demand for the same good over dierent markets (e.g. geographic regions, consumer groups, etc.). If the demands for the good in each market are independent, aggregate demand is equal to the sum of the individual market demand functions for the good. Remark 3 When we aggregate demand for a good over several independent markets, we must be careful to take into account the fact that quantity demanded may be zero in one market at a lower price than in the other market. This is especially true for linear demand functions. We can only add the demand functions over the range of prices where each market is served (i.e. quantity demanded is greater than zero). See Section 4 for an illustrative example of this caveat.

1.2

Consumer Surplus and Social Welfare

Most if not all markets are comprised of consumers possessing unique preferences for goods and services (including money). One way to characterize these preferences is through reservation prices. A consumers reservation price is the maximum amount he is willing to pay to acquire a certain good or service. We can aggregate these reservation prices across all consumers in the market to generate an aggregate demand function for the good. This function characterizes the quantity of the good the rm can expect to sell in the market if she charges any specic price p. By only charging all consumers one xed price for the good, the rm is leaving money on the table. There are a number of consumers in the market who would be willing to pay (possibly much) more for the good, but they will be able to make their purchase at the lower xed price. 2

Figure 1: Consumer surplus under monopoly pricing

Denition 2 Consumer surplus is the market measure of the excess of each consumers willingness to pay for the good over its market price. To formalize the notion of consumer surplus2 , let x(p) denote the quantity of a good demanded if price p is charged. Let p be the maximum price at which a nonnegative quantity of the good is demanded. (Note that p = for some demand functions such as Cobb-Douglas.) Consumer surplus, S (p), is dened to equal
p

S (p) =
p

x(t)dt.

It should be clear that this is the area to the left of the demand curve between p and p . Consumer surplus for a linear demand curve is pictured in Figure 1. Price discrimination is an economic tool that enables rms to capture a portion (or possibly all) of the consumer surplus. As we have seen in supply chain coordination, agents making locally-optimal decisions may not be acting in the best interests of the system as a whole. This is true in a general market structure as well. Firms may produce a quantity that diers from the so-called socially-optimal quantity that would be chosen by a social planner. The social planner chooses a production level to maximize the total market surplus, which is also called the social welfare. Denition 3 Social welfare in the monopolistic market for a single good is the sum of the consumer surplus3 and the rms prot. Social welfare in the context of a general market is analogous to the centralized supply chain prot function. The socially-optimal production level is regarded as a rst-best solution in which the system
Varian (1992) and Tirole (1988) for detailed discussions of consumer surplus. (1988) provides an excellent discussion of the rationale and defense of using the consumer surplus as a welfare measure.
3 Tirole 2 See

maximizes the total welfare. The direct solution to this maximization problem is that the production level should be such that the price charged should be equal to the marginal cost of production. (Recall that price equalling marginal cost was the equilibrium price condition for a purely competitive market.) Any price discrimination mechanism that generates a production level equal to the socially-optimal level will be regarded as ecient with regards to production. Remark 4 It is possible for a mechanism to be ecient in production but allocatively inecient. We will see that rst-degree price discrimination results in ecient production but the rm captures all of the social welfare, leaving no surplus for the consumers. In most consumers minds this may be seen as unfair. The key for us to remember is that the distribution of social welfare is a normative issue just like the split of centralized supply chain prot in a revenue sharing contract. We are concerned here about inducing the maximum social welfare; the distribution of said welfare is an important topic left for another discussion.

Introduction to Price Discrimination

Now that weve set the analytical foundation, we come to the fundamental question of this essay: What exactly is price discrimination and why is it worth studying? While it may seem like this is a simple question to answer, the denition is surprisingly dicult to articulate. If you looked at many books and articles dealing with price discrimination (as I have, indeed!), you would likely nd a dierent denition in all of them.

2.1

Price Discrimination: What It Is

Roughly speaking, price discrimination involves charging dierent consumers dierent prices for the same good; but this denition is too broad and has too many exceptions to be satisfactory. We will dene price discrimination as follows. Denition 4 Price discrimination is the practice of charging dierent (marginal) prices to dierent consumers for the same economic good. These price dierences cannot be explained by the dierence in marginal cost of making the goods available for the various consumers. Carroll and Coates (1999) identify three necessary market conditions for rms that wish to employ price discrimination. 1. The rm must have some market power. Firms that are price takers must charge whatever price the market dictates. In order to charge dierent prices to dierent customers, the rm must have some ability to dierentiate its products from others in the market. This is not to say, however, that the rm must be a monopoly. Any rm that has even the smallest degree of market power faces a downwardsloping demand curve (as opposed to the horizontal demand curve faced by price takers); thus, the consumers will have a surplus in the transactions. Price discrimination can transfer at least some of that surplus to the rm. 2. The rm must be able to control the sale of its products. If a secondary market existed for the good, arbitrage opportunities could arise in which some buyers could purchase the good from the rm at a low price and resell it to others at a price lower than that which the rm would charge those other customers. Services such as oil changes, tax preparation, and landscaping often present price discrimination opportunities because the services are not transferable to other consumers. Varian (1992) argues that preventing resale is generally not a big problem for sellers. Ecient secondary markets that facilitate the sharing of perfect information between buyers and sellers are generally nonexistent, although the proliferation of the Internet and online auctions (such as eBay), in particular, are making resale an increasingly important concern for many industries.

Remark 5 In the mid 1990s the city of Phoenix, Arizona, allowed ticket scalpers to resell tickets to the NBA All-Star Game in a designated area outside of the arena before the game. This centralized trading area operated much like a stock exchange where buyers could acquire perfect information from all of the sellers. Not surprisingly, buyers greatly beneted from this marketplace as tickets were exchanged at much lower prices than days before the event when buyers did not have access to this trading market. See Happel and Jennings (1995) for details about this interesting economic experiment. 3. The consumers should experience heterogeneous utilities from the good; and therefore, they should have dierent price elasticities of demand. If all of the consumers valued the good equally, there would be no rationale for the rm oering dierent prices to dierent consumers. The extent to which the rm has (accurate) information about the dierences in consumer preferences determines the degree of price discrimination that the rm can employ.

2.2

Price Discrimination: What It Is Not

The above denition of price discrimination places important emphasis on cases where prices dier between consumers, yet they are not discriminatory. One classic example4 of dierential but non-discriminatory pricing is delivered prices. When a rm charges delivered prices, she includes the cost of the product plus the freight required to transport the good to the buyers facility. If the seller does not include freight in the cost of the good, she charges a free-on-board (fob) price. It is then the buyers responsibility to arrange for the transportation and to pay the associated cost. Suppose we consider a manufacturer located in Atlanta, GA, who is charging delivered prices for a given commodity. It should be clear that buyers in Aliquippa, PA, and Spartanburg, SC, would pay dierent prices for the commodity since the freight charges dier to the two destinations. This practice is not price discrimination, however, because the buyers each pay the same net price equal to the total purchase cost less freight charges. In fact, charging homogeneous delivered prices to consumers in dierent geographic regions would be a form of price discrimination, since the net prices paid by each consumer would be dierent. A similar argument could be made for two buyers located in the same area who require delivery at dierent times. The manufacturer may charge the one buyer who requests delivery within a week a higher price than the other customer who is more exible in his delivery requirements. In this case the dierential pricing is justied by the heterogeneous temporal requirements of the two buyers. The manufacturer may have to adjust her entire production schedule to meet the rush order; she should be compensated for this added cost. Denition 5 (Debreu (1959)) An economic good is dened not only according to its physical properties but also to the space, time, and state of the world at which it is available for consumption. Debreus emphasis on characterizing the complete economic properties of a good helps us escape the trap of mistaking dierential pricing for price discrimination. The goods purchased by the two geographic buyers above would be considered two distinct economic goods because they are required for consumption in two dierent locations. Price discrimination is no longer a concern because the goods are no longer the same once we consider the spatial and/or temporal properties of consumption.

2.3

History of Price Discrimination

Phlips (1983) suggests that price discrimination came to the forefront of microeconomic analysis through the Taussig-Pigou controversy over the theory of railway rates. Both economists sought to explain the rationale behind the existence of multiple railway rates when transportation seemed, at rst glance, to be a homogenous good.
4 This

section is derived (mostly) from Phlips (1983).

In 1891 Taussig maintained that the multiple prices could be explained by joint production costs. Since the transportation of all passengers resulted from a joint production process with a corresponding joint production cost, this cost must be allocated among the dierent classes of traveler according to their demand price. This is (grizzly) analogous to a shepherd choosing to slaughter the quantity of sheep at the point where the sum of the prices of wool, lamb, and mutton are equal to the marginal cost of slaughtering. These separate products derived from sheep result from a joint production process (slaughtering) that generates one common marginal cost. In Taussigs opinion, the transportation services provided to dierent passengers were distinct services resulting from a joint production process. Contrariwise, Pigou argued in 1912 that the transportation services were not distinct goods and that rail costs were not predominantly joint. He believed that the railroads had the ability to discriminate between buyers. In The Economics of Welfare (1920), Pigou claimed that under perfectly competitive conditions, transportation for freight and passengers would have a common equilibrium price. Consequently, the observed dierences in bulk freight rates or the presence of dierent passenger classes must be due, instead, to railroads attempts to capture excess consumer surplus through price discrimination. Pigous assertions are correct if we are considering a single economic good called transportation. We must be careful to identify price discrimination when the goods have some clearly distinguishable characteristics such as quality, reliability, or time of travel. (Recall our discussion of economic goods in Section 2.2.) In the case of transportation, however, we should refrain from proclaiming that these dierent goods are the result of a joint production process and are sold in dierent markets5 as Taussig argued.

2.4

Types of Price Discrimination

Pigou (1920) identied three dierent types of price discrimination based on the information required for implementation. His method of classication is the widely-accepted standard almost a century later. 1. First-degree price discrimination occurs when the seller charges each individual consumer his reservation price; thus, she obtains the maximum possible revenue from each consumer. For this reason, rst-degree price discrimination is often called perfect price discrimination. In this case the seller must possess information on each consumers maximum willingness to pay; obviously, this is a nontrivial proposition that is impossible to satisfy in practice. Practical markets which come the closest to perfect price discrimination are the markets for unique art pieces and online auctions. 2. Second-degree price discrimination involves the seller charging dierent marginal prices depending on the quantity of goods purchased. The schedule of prices oered to each consumer is the same, however. Classic examples of second-degree price discrimination are quantity discounts (including block taris) and two-part taris. The seller does not need to exogenously divide the consumers into classes. The schedule of prices is designed so that each consumer reveals his type by self-selecting a quantity to purchase with corresponding marginal price. We shall see that the self-selection aspects of these schedules of prices is analogous to the incentive-compatibility constraints of the principal-agent framework. 3. Third-degree price discrimination requires that the seller divide the customers into exogenous groups according to specic characteristics and then oer a constant marginal price to each customer class. These characteristics should separate consumers with dierent price sensitivities (demand elasticities). There are countless examples of this form of price discrimination including student discounts, matinee prices, and hardcover vs. paperback books.

2.5

But Isnt It Wrong to Discriminate?

Like most practices in this world, price discrimination is not intrinsically good or bad. We must evaluate each situation individually, relative to the status quo in the market. In general, discriminatory pricing that
5 Models of joint production are relevant when the resulting products are consumed under dierent circumstances such as in the wool and lamb mentioned above.

Figure 2: Example of rst-degree price discrimination using a two-part tari (Tirole 1988)

leads to a welfare loss is undesirable. In these cases the rm is capturing consumer surplus at the expense of the market as a whole. It is possible, though, that price discrimination may lead to a welfare gain over an ordinary monopoly even though it may not yield the socially-optimal amount. Price discrimination in these sorts of cases is desirable because is comes closer to the social optimum than a single-price monopoly does. (See Section 4 for examples of both of these cases.)

First-Degree Price Discrimination

We will now provide an example of rst-degree price discrimination by a monopolist using two-part taris6 discussed in Tirole (1988). Consider a market for a single good consisting of n consumers with identical downward sloping demand functions, q = Q(p)/n. The monopoly rm knows the associated aggregate demand function, q = Q(p). A simple linear monopoly price, pm , yields a prot of m = pm Q(pm ) C (Q(pm )), where C (q ) is the (increasing and convex) cost of producing q units. Suppose the monopolist instead chose to oer the competitive price, pc , where price is equal to the marginal cost of production (see Figure 2). The net consumer surplus would be
qc

Sc =
0

[P (q ) pc ]dq,

where P (q ) Q1 (p) is the inverse demand function. The monopolist can charge each consumer a xed premium for the privilege to purchase at the competitive price pc . This xed premium, A, may be as high
6 In Section 2.4 we claimed that two-part taris were a form of second-degree price discrimination. So what gives? Why are we using it as an example of rst-degree price discrimination? The following example requires that the monopolist has information about each consumers demand curve, which she would likely never have in practice. Since two-part taris are almost always oered to heterogeneous consumers with private information about their demands, these taris require each consumer to self-select his best quantity according to a single price schedule. Therefore, in practice, two-part taris are forms of second-degree price discrimination.

as Sc /n without inducing the consumer to purchase zero units. In summary, the monopolist can charge the two-part tari, c pc q + S if q > 0 n T (q ) = 0 if q = 0, and earn a perfectly-discriminatory total prot of disc = Sc + pc qc C (qc ). This is exactly the optimal social welfare with the consumer surplus equal to zero after paying the xed portion of the two-part tari. Since the monopolist receives all of the maximal system prot, disc > m . The monopolist obtains a higher prot under the two-part tari than under the single monopoly price. Since the socially-optimal quantity is produced, the two-part tari contract is ecient. First-degree price discrimination could be seen as a welfare improvement over a single monopoly price; although, consumers will likely be displeased because their surplus has been reduced. We can generalize this result to the situation where consumers have individual demand curves. The monopolist should charge the competitive price, pc , equal to the marginal cost and require an individualized xed payment equal to the consumer is net surplus at price pc .

Third-Degree Price Discrimination

To illustrate third-degree7 price discrimination, we present an example from Carroll and Coates (1999). Recall that third-degree price discrimination requires the rm to exogenously divide consumers into several classes with dierent price sensitivities. Suppose a monopolist is selling a single product in a market that can be segmented into customers of type 1 and type 2. Suppose further that the rm faces a constant marginal cost of $20. The demand from type 1 customers is given by Q1 (p1 ) = 100 4p1 , and the type 2 buyers have the demand Q2 (p2 ) = 25 0.5p2 . As a benchmark for maximum social welfare, we shall rst consider a perfectly competitive rm. The aggregate demand in the market is given by Q(p) = Q1 (p1 ) + Q2 (p2 ). We cannot simply add the two demand functions together, though, because the type 1 demand will be negative for certain prices that generate positive demand from type 2 customers. Consequently, aggregate market demand is given by 125 4.5p if p 25 25 0.5p if 25 < p 50 (2) Q(p) = 0 if p > 50. Theorem 2 When we aggregate independent customer class demand curves to construct a market demand curve, the market demand curve will always have at least one kink if the individual class demand curves are linear in price with dierent slopes. As the price increases, one of the classes will cease being served before the other(s). The inverted demand curve can be written by 0 27.778 0.222q P (q ) = 50 2q

if q > 125 if 12.5 q 125 if q < 12.5.

(3)

To handle the kink in the demand, we rst assume that the competitive equilibrium occurs in the area of demand where both markets are served (P (q ) = 27.778 0.222q ) because the marginal cost is in the range where this price is valid and the competitive rm will produce the quantity where price equals marginal cost. Setting P (q ) equal to the marginal cost of $20, we nd that qc = 35, which is in the range of quantities where this portion of demand is valid. Type 1 consumers purchase 20 units, receiving a surplus of $50; type 2
7 It may seem peculiar that we are considering the types of price discrimination out of order, but hopefully it will be clear that it is more straightforward to present third-degree price discrimination before second-degree price discrimination.

consumer buy 15 units and receive a surplus of $225. The total consumer surplus under perfect competition is equal to $275. This is also the social welfare under pure competition because the rm makes zero prot. Now we will compute the price charged by a single-price monopolist. The monopolist faces the same market demand and inverse demand curves as in (2) and (3), respectively. We have already seen that a singleprice monopolist produces the quantity where marginal revenue equals marginal cost. Again we begin by assuming that the equilibrium lies in the portion of the inverse demand curve where P (q ) = 27.778 0.222q . We shall see if the computed equilibrium is valid under our assumption. The expression for marginal revenue is given by P (q )q ; thus, M R = 27.778 0.444q . Equating this with marginal cost of $20, we derive a monopolistic quantity of qm = 17.5 with a corresponding price of pm = 23.89. This price lies in the range in which the assumed portion of the demand curve is valid, so we have found the monopolists optimal price. Type 1 customers buy 4.444 units, receiving a surplus of $2.47; type 2 customer purchase 13.056 units and receive a surplus of $170.45. The net consumer surplus in this case is $172.92. The monopolist receives a prot of ($23.89 $20)17.5 = $68.08. The sum of monopolist prot and consumer surplus results in social welfare of $241, which is less than the social welfare under pure competition. We conclude this example by examining the behavior of a discriminating monopolist who charges a dierent price for each consumer type. The inverse demand function for type 1 customers is P1 (q1 ) = 25 0.25q1 with a corresponding marginal revenue of M R1 = 25 0.5q1 . Equating this marginal revenue pd with the marginal cost of $20, we can solve for q1 = 10. The resulting price charged for type 1 consumers pd is p1 = 22.50, and type 1 customers keep a surplus of $12.50. The inverse demand function for type 2 consumers is P2 (q2 ) = 50 2q2 , generating a marginal revenue pd of M R2 = 50 4q2 . The quantity that equates marginal revenue with marginal cost is q2 = 7.5, and the corresponding price for type 2 customers is ppd = 35. The type 2 consumer surplus is $56.25, making the 2 net consumer surplus for both markets $68.75. The monopolists prot function is given by pd = ($22.5 $20)10 + ($35 $20)7.5 = $137.50. Note that the monopolists prot under third-degree price discrimination is greater than the non-discriminating monopolists prot. The net social welfare under price discrimination is $206.25. This means that social welfare is less under third-degree price discrimination than it is under single-price monopoly market conditions as well as under perfect competition. This is the case in general when output does not increase under third-degree price discrimination. (Indeed, the output in our case was 17.5, which was the optimal output under a single-price monopoly.) Theorem 3 (Varian (1992)) A necessary (but not sucient) condition for welfare to increase is that total output increase. Third-degree price discrimination may not necessarily result in a welfare loss when compared with an ordinary monopoly. Varian goes on to show that welfare may, in fact, increase under third-degree price discrimination if the ability to discriminate induces the monopolist to serve a new market. If the single-price monopolist would choose not to serve a small market, price discrimination results in the same quantity produced for the large market and a positive quantity for the small market, resulting in a welfare gain. Remark 6 (Tirole (1988)) When customers can be separated into distinct types, the monopolists (thirddegree) price discrimination problem is a special case of a multiproduct monopolists pricing problem where the demands are independent and the production costs are possibly dependent. The Inverse Elasticity Rule (presented in Theorem 1) characterizes the goods relative prot margins. The monopolists prot maximization hypothesis implies that the rm should charge higher prices in markets that have less elastic demand. This provides a rationale for oering student and senior citizen discounts and for setting prices for medical or legal services based on income.

Second-Degree Price Discrimination

Monopolists are not always able to separate their customers a priori as is required under third-degree price discrimination. Firms can still capture excess consumer surplus by designing price oerings that induce consumers to classify themselves into groups according to the decisions that they make. The following example of a nonlinear outlay schedule comes from Phlips (1983). Suppose the monopolist sells a single commodity to a market consisting of n customer types, but the monopolist cannot exogenously classify each consumer she sees before oering him a price for the good. She desires, therefore, to oer every customer the same menu of quantities at dierent marginal prices dependent on the quantity purchased. Let Ri (q ) denote the maximum amount a customer of type i is willing to pay to purchase q units of the good, and let qi denote the number of units purchased by customers of type i. The outlay Yi is the point on the nonlinear price schedule that corresponds to the price charged for goods qi . In order for consumer i to prefer the bundle designed for him (qi , Yi ) as opposed to the other oerings {(qj , Yj ) : j = i}, the dierence in the required outlay for quantity i and quantity j must be less than or equal to the dierence between the maximum amount the consumer was willing to pay for the quantities. Formally, we have Ri (qi ) Ri (qj ) Yi Yj i, j = i. (4) The monopolist wants to maximize her prot by setting the quantities and outlays for the price schedule. She can capture the greatest consumer surplus if she can induce the richest customersthe ones with the highest reservation outlaysto purchase the largest quantities. This observation holds if higher incomes correspond to higher reservation outlays for the same quantity and value of an additional unit increases with income. It then follows that Ri (q ) < Ri+1 (q ) for all q and Ri (q ) < Ri+1 (q ) for all q . The system of inequalities in (4) prevents customers with higher reservation outlays to purchase too little. The monopolist wants to charge the maximum outlay possible, so she will make the adjacent inequalities binding, which yields Yi = Ri (qi ) Ri (qi1 ) + Yi1 . The prot-maximizing schedule can be computed iteratively starting with q0 = 0 and Ri (q0 ) = 0 for all i and according to Y1 Y2 . . . Yi . . . Yn = = R1 (q1 ) R2 (q2 ) R2 (q1 ) + Y1

Ri (qi ) Ri (qi1 ) + Yi1

Rn (qn ) Rn (qn1 ) + Yn1 .

Solving the above system recursively yields

i

Yi =
j =1

[Rj (qj ) Rj (qj 1 )].

To determine the quantities qi that the monopolist should sell in order to maximize prots and/or social welfare, we need to consider the number of consumers of each type in the market, Ni . This analysis is relatively complicated, so we will suce to make a few observations about the conclusions. Interested readers should consult Phlips (1983) for complete details. Remark 7 When social welfare is being maximized, quantities should be set so that all income groups purchase quantities priced at their marginal costs. A prot-maximizing monopolist chooses the quantity that sets the price equal to the marginal cost for only the highest-value consumers. The prices for all other customer types will be set above marginal cost.

10

Commodity Bundling

We just saw in Section 5 that a monopoly can obtain extra consumer surplus by oering a menu of pricequantity bundles of a single product. This section considers a rm producing multiple goods and shows how she can bundle the goods together to obtain excess surplus. In general there are three possible ways that a rm can bundle multiple products. 1. The rm could sell each product separately; this process is called pure commodities. 2. The rm could only oer bundles of the products; we will refer to this practices as pure bundling. 3. The rm could sell the products separately as well as bundled together in a process called mixed bundling. Remark 8 While it may seem like mixed bundling is always at least as protable as the other two forms, there are cases in which pure commodities and pure bundling are better than mixed bundling. This depends on the demand characteristics of the consumers, in particular their relative valuations of the individual goods. We will now present an example of commodity bundling provided in Phlips (1983). Note that this is an example of third-degree price discrimination because the consumers are exogenously divided into groups. Suppose a rm produces two products, creatively called product 1 and product 2, and sells them to four dierent customers, denoted A, B, C, and D. Each consumer has a reservation price Rb = 100 for the bundle of the two goods. Their individual reservation prices for the two goods are given as follows:
A R1 B R1 C R1 D R1

= 10 = 45 = 60 = 90

A = 90 R2 B R2 = 55 C = 40 R2 D R2 = 10.

Note that their reservation prices for the bundle are the sum of the reservation prices for the individual goods. Suppose that the marginal costs of production for the goods are C1 = 20 and C2 = 30. Prots are maximized under ordinary monopoly pricing (pure commodities) at prices p1 = 60 and p2 = 90, which are higher than the marginal costs. Consumer D receives a surplus of 30 from good 1, while customers A and B are priced out of the market. Consumers B, C, and D are also excluded from the market for good 2. This situation is ripe for price discrimination because the monopoly solution chooses not to serve some customers in the market for each good. Recall from Section 4 that price discrimination increases social welfare when it open up new markets for the good which would not be served under single-price monopolies. If the rm decides to oer pure bundles, she will choose a price pb = 100, the bundle reservation price for each consumer. Each of the four consumers will purchase one bundle, and the rms prot will be 100 4 [(20 + 30)4] = 200. This is closer to perfect price discrimination because each customer can purchase the product and the rm keeps all of the surplus. The dierence, though, is that A and D can purchase goods 1 and 2, respectively, even though their reservation prices are less than the marginal cost of producing these goods. This possibility would not exist under perfect price discrimination. Under a mixed bundling strategy, the rm can oer good 1 to customer D at price p1 = 90, and she can sell good 2 to customer A at p2 = 90. Customers B and C can purchase the bundle at price pb = 100. Total rm prot under mixed bundling becomes (90 20) + (90 30) + [(100 50)2] = 230. The rm captures all of the surplus, and each customer can make a purchase. Theorem 4 (Phlips 1983) Mixed bundling is the most protable strategy when some consumers have reservation prices less than the marginal cost for a particular product. The variance of the reservation prices among the consumer classes is an important consideration when designing a multiproduct strategy. In our example, customers B and C had similar, high reservation prices 11

for the two goods. Mixed bundling is generally more protable than pure commodities or pure bundling when the consumers with high reservation prices value the products similarly. The rm can use the bundle to capture surplus from the consumers who value the goods the most, and she can use separate prices to target those customers who only value one product highly. Denition 6 Tie-in sales are a form of pure bundling where the seller bundles complementary products together to extract excess surplus from the consumers. Tie-in sales are especially common in the purchase of durable goods. Consumers generally make these purchases infrequently; thus, the sellers may only see demand from a particular consumer once every ve or ten years. In order to dierentiate customers who value the use of that durable good heterogeneously, she can require the additional purchase of a particular (unique) replaceable component in order to ensure that heavy users pay a higher eective price than light users. Let me give you an example from my life. I have a high-quality Cuisinart coee pot that grinds the whole beans automatically and then dispenses them into the lter for brewing. (I highly recommend this product for you coee lovers out there! I can wake up to freshly ground and brewed coee every morning.) The machine also comes with a charcoal water lter that must be replaced after about 60 pots of coee. Cuisinart is the only company that makes a lter to t my particular coee maker. In fact, a several of other brands (Braun, Krups, etc.) manufacture similar products each with a dierent charcoal lter that you can purchase only from them. These manufacturers have tied the sale of a durable good (the coee maker) with a replaceable component (the lter), causing a heavy user (like me!) to pay a higher eective price for the use of the pot since I must replace the lter more often than someone who only makes one pot a week. The coee lter example of a tie-in sale is eective because all of the producers in the market engage in similar practices. Tie-ins may be problematic if a rms competitors do not have equivalent requirements. Recall the case of the Sony Betamax video player from the late 1970s. All reports and studies indicated that Sonys product was vastly superior to Panasonics VHS system. Surprisingly, though, the product was extinct by the mid 1980s. What happened? Sony retained the exclusive rights to produce the machines and contract with movie studios to supply movie titles, while Panasonic licensed the technology to other electronics manufacturers and allowed all studios to openly provide titles. The result was a library of movies that dwarfed that available for the Betamax system and many more VHS players at dierent levels of quality available at electronics stores for customers to choose from. This exibility more than made up for the lack of quality compared to Sonys product in the customers mind, so the superior technology bombed. Remark 9 The moral of the Sony Betamax example is that when considering a tie-in sale format, the rm must ensure that customers are willing to comply with the arrangement. If the consumer can obtain a similar product from another manufacturer without the limitation of the tie-in, they will likely make that choice.

References
[1] K. Carroll and D. Coates (1999). Teaching price discrimination: Some clarication. Southern Economic Journal, 66(2), 466-480. [2] G. Debreu. Theory of Value. Wiley, New York, 1959. [3] S. Happel and M. Jennings (1995). Herd them together and scalp them. The Wall Street Journal, February 23, page A-14, column 4. [4] L. Phlips. The Economics of Price Discrimination. Cambridge University Press, New York, 1983. [5] A. Pigou. The Economics of Welfare. Macmillan, London, 1920. [6] J. Tirole. The Theory of Industrial Organization. MIT Press, Cambridge, MA, 1988. [7] H. Varian. Microeconomic Analysis. Third Edition. W.W. Norton & Company, New York, 1992.

12