Third degree price

discrimination
Welfare Analysis
Third-degree rice discrimination and
welfare
Does third-degree price discrimination reduce
welfare?
not the same as being fair
relates solely to efficiency
so consider impact on total surplus
Example 1 Welfare decreases
Two markets
Market A:
All identical
N
a
=100 consumers
Reservation value p
a
=2
Market B:
Two types.
N
1
=N
2
= 50 of each
Reservation values p
1
=4, p
2
= 2.
Constant mg. cost c=1.







1. No discrimination:
p=4, p=(4-1)*50=150
p=2, p=(2-1)*200 = 200
2. Discrimination:
p
a
=2, p
b
=4, p=100+150
Less consumers are served

Example 2 Welfare increases
Two markets
Market A:
All identical
N
a
=100 consumers
Reservation value p
a
=4
Market B:
Two types.
N
1
=20, N
2
= 80.
Reservation values p
1
=4,
p
2
= 2.
Constant mg. cost c=1.







1. No discrimination:
p=4, p=(4-1)*120=360
p=2, p=(2-1)*200 =200
2. Discrimination:
p
a
=4, p
b
=2, p=300+100
Total output increases
More consumers
served


Price discrimination and welfare
Suppose that there are two markets: weak and strong
D
1

MR
1

D
2

MR
2

MC MC
P
1

P
2

Q
1
Q
2

Price Price
Quantity Quantity
P
U
P
U

The discriminatory
price in the weak
market is P
1

The discriminatory
price in the strong
market is P
2

The uniform
price in both
market is P
U

G
The maximum
gain in surplus
in the weak
market is G
L
The minimum
loss of surplus in
the strong
market is L
Price discrimination and welfare
D
1

MR
1

D
2

MR
2

MC MC
P
1

P
2

Q
1
Q
2

Price Price
Quantity Quantity
P
U
P
U

G L
It follows that W < G L = (P
U
MC)Q
1
+ (P
U
MC)Q
2

= (P
U
MC)(Q
1
+ Q
2
)

Price discrimination
cannot increase
surplus unless it
increases aggregate
output
Price discrimination and welfare
(cont.)
Previous analysis assumes that the same markets
are served with and without price discrimination
This may not be true
uniform price is affected by demand in weak markets
firm may then prefer not to serve such markets without
price discrimination
price discrimination may open up weak markets
In the two market case, if price discrimination opens
one market, welfare always increases:
In the only market that was originally served, price and
quantity dont change (why?)
The previously excluded market is now served
New markets: an example
Demand in North is P
N
= 100 Q
N
; in South is P
S
= 100 - Q
S

$/unit $/unit $/unit
North South Aggregate
Quantity Quantity Quantity
100
100
Marginal cost to supply either market is $20
MC MC MC
Demand
MR
The example: continued
$/unit
Aggregate
Quantity
MC
Demand
MR
Aggregate demand is P = (1 + )50 Q/2
provided that both markets are served
Equate MR and MC to get equilibrium
output Q
A
= (1 + )50 - 20
Q
A

Get equilibrium price from aggregate
demand P = 35 + 25
P
The example: continued
Now consider the impact of a
reduction in
$/unit
Aggregate
Quantity
MC
Demand
MR
Aggregate demand changes
D'
Marginal revenue changes
MR'
It is no longer the case that both
markets are served
The South market is dropped
Price in North is the monopoly
price for that market
P
N

The example again
Previous illustration is too extreme
So there are potentially two equilibria
with uniform pricing
MC cuts MR at two points
Quantity
$/unit
Aggregate
MC
Demand
MR
At Q
1
only North is served at the
monopoly price in North
Q
1

P
N

At Q
2
both markets are served at
the uniform price P
U

Q
2

P
U

Switch from Q
1
to Q
2
:
decreases profit by the red area
increases profit by the blue area
If South demand is low enough or
MC high enough serve only North
Price discrimination and welfare
(cont.)
Quantity
$/unit Aggregate
MC
Demand
MR
Q
1

P
N

In this case only North is served
with uniform pricing
But MC is less than the
reservation price P
R
in South
P
R

So price discrimination will
lead to South being supplied
Price discrimination leaves
surplus unchanged in North
But price discrimination generates
profit and consumer surplus in
South
So price discrimination increases welfare
Price discrimination and welfare again
Suppose only North is served with a uniform price
Also assume that South will be served with price
discrimination
Welfare in North is unaffected
Consumer surplus is created in South: opening of a new
market
Profit is generated in South: otherwise the market is not
opened
As a result price discrimination increases welfare.