Firms, Prices & Markets Timothy Van Zandt

© August 2012

Chapter 11
Implicit Price Discrimination (Screening)
SOLUTIONS TO EXERCISES

See text for background information for Exercises 11.1–11.4. Note constant MC = € 300.

Exercise 11.1. (Uniform pricing) Suppose you decide to offer only unrestricted tickets. There are only two
prices you might charge (depending on the values of B and L). What are they? For each of the two prices, (i)
describe who purchases the tickets and (ii) write your profit as a function of B and L.

Solution: Either €1000, in which case only business travelers purchase tickets, or €600,
in which case all travelers purchase tickets. My profit when charging the high price is
B × 700; my profit when charging the low price is (B + L) × 300.

Exercise 11.2. (Benchmark: Explicit price discrimination) Suppose your airline can perfectly price dis-
criminate.

a. What products do you offer (unrestricted, restricted, both, or neither), and what price(s) do you charge each
market segment?

Solution: I should charge each customer his valuation for the product he values the most
(since my cost of the two products is the same). Hence, I offer only unrestricted tickets. I
charge business travelers €1000 and leisure travelers €600.

b. What is your total profit as a function of B and L?

Solution: My per-unit profit is €700 for each business traveler and €300 for each leisure
traveler, so my total profit is (B × 700) + (L × 300).

Exercise 11.3. (Screening) Suppose you offer both restricted and unrestricted tickets, with the intention that
the business travelers buy the unrestricted ticket and the leisure travelers buy the restricted ticket. Note that the
business travelers are willing to pay more than the leisure travelers for both types of tickets. The important fact
is that the extra amount the business travelers are willing to pay for the unrestricted ticket is more than the extra
amount the leisure travelers are willing to pay.

a. What would happen if you attempted to extract all the surplus by setting the price of the unrestricted ticket
equal to the business travelers’ valuation (€1000) and the price of the restricted ticket equal to the leisure travelers’
valuation (€500)?

Solution: The business travelers prefer to buy the restricted ticket. This ticket costs
€500 and is worth €600; hence the business traveler’s surplus is €100. In contrast, buying
the unrestricted tickets gives the business traveler zero surplus.

b. The binding parts of the participation and self-selection constraints are:

1. you must not set the price of restricted tickets so high that the leisure travelers prefer not to travel at all;
2. you must not set the price of unrestricted tickets so high that the business travelers prefer to buy restricted
tickets.

Identify these constraints by name.

Firms, Prices & Markets • Solutions for Chapter 11 (Implicit Price Discrimination (Screening)) 2

Solution: (1) is the participation constraint of leisure travelers; (2) is the self-selection
constraint of the business travelers.

c. Calculate your optimal prices.

Solution: I set the price of the restricted ticket to the leisure traveler’s valuation of €500.
I set the price of the unrestricted ticket to the highest amount such that the business travelers
are still willing to purchase these tickets, i.e., to €400 more than the price of the restricted
ticket, or €900.

d. Calculate the profit (given the optimal prices) as a function of B and L.

Solution: (B × 600) + (L × 200).

Exercise 11.4. (Comparison) You have thus narrowed your options down to three potentially good ones:

A. sell only unrestricted tickets at a high price to business travelers only;

B. sell only unrestricted tickets at a lower price to all travelers;
C. sell unrestricted tickets to business travelers and restricted tickets to leisure travelers at the prices you obtained
in Exercise 11.3.

The optimal prices you obtained for options A, B, and C do not depend on the numbers of business and leisure
travelers. However, the ranking of the options does. The purpose of this exercise is to see this relationship.

a. Suppose there are 50 business travelers and 50 leisure travelers. Calculate your profit for each of the three
options and find which option has the highest profit.

Solution: Option C is best:

Option Profit
A 50 × 700 = 35,000
B 100 × 300 = 30,000
C (50 × 600) + (50 × 200) = 40,000

b. Suppose there are 99 business travelers and 1 leisure traveler. How do the profits of the three options compare?

Solution: Option A is best:

Option Profit
A 99 × 700 = 69,300
B 100 × 300 = 30,000
C (99 × 600) + (1 × 200) = 59,600
Firms, Prices & Markets • Solutions for Chapter 11 (Implicit Price Discrimination (Screening)) 3

c. Suppose there are 99 leisure travelers and 1 business traveler. How do the profits of the three options compare?

Solution: Option B is best:

Option Profit
A 1 × 700 = 700
B 100 × 300 = 30,000
C (1 × 600) + (99 × 200) = 20,400

d. Fix the total number of customers at 100, so that B is the percentage that are business travelers and L is the
percentage that are leisure travelers. On a single graph, plot the profit as a function of B (for B between 0 and
100) for each of the three options. (For each option, profit as a function of B is a line and hence is easy to draw
by hand.) For each option, identify the region on the graph (i.e., the range of values of B) for which that option
yields the highest profit.

Solution:
Option Profit as a function of B Shown in graph as
A 700B dotted line
B 100 × 300 = 30, 000 solid line
C B × 600 + (100 − B) × 200 = 20, 000 + 400B dashed line
See Figure S1.
Figure S1
Profit A
(1000s)
60 C

50

40

30 B

20

10
% Bus. travelers (B )

10 20 30 40 50 60 70 80 90

B best C best A best

Firms, Prices & Markets • Solutions for Chapter 11 (Implicit Price Discrimination (Screening)) 4

Exercise 11.5. You are in charge of sales for a symphony that has a mini-season of two concerts, one featuring
music by Wagner and the other featuring new music by John Harbison. Some in the potential audience like old
music much more than contemporary, others like both equally, and others like contemporary much more than old
music. You must decide how to price the individual tickets and the series in order to maximize profit.
We make some simplifying assumptions: The symphony has a very large concert hall relative to its popularity
and hence capacity constraints are not an issue; all seats are equally desirable; and the marginal cost of each
concertgoer is zero. Hence, the symphony’s goal is to maximize revenue.
Assume the market is highly segmented, with only three types of customers. There is one customer of each
type (which is equivalent to assuming there are equal numbers of each type). The valuations of these customers
for each of the two concerts are as shown in Table E11.1

Table E11.1
Valuation
Type of
customer Wagner Harbison

A 50 5
B 40 40
C 5 50

A customer may go to one or both of the concerts. A customer’s valuation of a bundle equals the sum of his
valuations of the concerts in the bundle.

a. (Benchmark: Explicit price discrimination) Suppose, hypothetically, that you can perfectly price discrimi-
nate. How much should you charge each type of customer for each concert? What is the total revenue?

Solution: I charge each customer his valuation for each concert. For example, type A
pays €50 for Wagner and €5 for Harbison. Each customer buys a ticket for each concert.
Total revenue equals the sum of the valuations: €190.

b. (No bundling) Return to the real situation in which you cannot perfectly price discriminate. Suppose you
sell only individual tickets. What price should you charge for each concert? Who buys tickets? What is the total
revenue?

Solution: €40 for each concert. Types A and B buy Wagner tickets, Types B and C buy
Harbison tickets. Total revenue is 4 × €40 = €160.

c. (Pure bundling) Suppose you offer only the series and do not sell individual tickets. What price should you
charge? Who buys? What is your total revenue?

Solution: €55 for the series. Each customer buys the subscription. Total revenue is
€165.

d. (Mixed bundling) Suppose you sell individual tickets and also the series. What prices should you charge?
What does each type of customer buy? What is the total revenue?

Solution: €50 for individual tickets and €80 for the series. Type A buys a Wagner ticket,
type C buys a Harbison ticket, and type B buys the series. Total revenue is €180.
Firms, Prices & Markets • Solutions for Chapter 11 (Implicit Price Discrimination (Screening)) 5

Exercise 11.6. (Perfect price discrimination) Suppose that you produce an indivisible good at a constant
marginal cost of $14. You have 12 customers, each of whom buys at most one unit of the good. They have the
following valuations:
$10, $12, $15, $16, $17, $19, $22, $22, $25, $26, $27, $30.

a. If you cannot price discriminate, what price should you charge? What is your total profit? (A spreadsheet
may be useful.)

Solution: For each price P (equal to one of the valuations), we calculate:

1. demand Q = the number of customers whose reservation values are at least P ;

2. revenue R = P × Q;
3. cost C = 14 × Q;
4. profit Π = R − C.
Price Demand Revenue Cost Profit
A1 10 12 120 168 (48)
A2 12 11 132 154 (22)
A3 15 10 150 140 10
A4 16 9 144 126 18
A5 17 8 136 112 24
A6 19 7 133 98 35
A7 22 6 132 84 48
A8 25 4 100 56 44
A9 26 3 78 42 36
A10 27 2 54 28 26
A11 30 1 30 14 16
A12 31 0 0 0 0

Price of 22 yields highest profit of $48, with sales equal to 6.

b. Take as the status quo your decision in the previous part. The purpose of this part is to demonstrate that the
outcome is not economically efficient. Show that there is a customer who is currently not buying the product and
to whom you could sell the good at a price that would make both you and that customer better off (if you could
identify the customer and if the transaction would not disturb your current sales to other customers).

Solution: There are four customers whose reservation values are above 14 but below
22. These customers do not purchase because their reservations values are below 22. If
we could, for example, arrange to sell the good to one of these customers at a price that is
midway between 14 and his reservation price, then the customer would be better off and
we would make a higher profit.

c. Now suppose that you can perfectly price discriminate (charge each customer a different price). Which cus-
tomers do you sell to, how much do you charge, and what is your total profit?

Solution: We sell to each customer whose reservation value is at least 14, and we charge
each such customer their reservation value. Thus, we sell to 10 customers and receive as
revenue
15 + 16 + 17 + 19 + 22 + 22 + 25 + 26 + 27 + 30 = 219.

Our cost is 14 × 10 = 140, and hence our profit is 219 − 140 = 79.
Firms, Prices & Markets • Solutions for Chapter 11 (Implicit Price Discrimination (Screening)) 6

Exercise 11.7. (Perfect price discrimination) Consider a market in which each customer purchases at most
one unit of an indivisible good. Consider a shift from a monopolist who cannot price discriminate to the same
monopolist with perfect price discrimination. Which customers are better off, worse off, or indifferent?

Solution: With perfect price discrimination, all customers get zero surplus. Without
price discrimination:

• customers who do not purchase get zero surplus and hence are neither better nor worse
off than with price discrimination;
• there are some customers who purchase at their reservation price, and these customers
are also neither better nor worse off;
• however, most of those customers who purchase do so at a price that is below their
reservation value—hence obtaining positive consumer surplus—and these customers
are better off without price discrimination.

Exercise 11.8. (Perfect price discrimination) Zahra, a profit-maximizing entrepreneur, sells an indivisible
product of which each customer buys at most one unit. She produces the good at a constant marginal cost of $5.
Zahra’s market contains many customers, whose diverse valuations she knows.However, she is initially prohibited
by law from price discrimination. She chooses to charge $10, which results in sales to 10,000 customers. She
calculates that these customers obtain a total of $50,000 in consumer surplus. Suppose now that the prohibition
is lifted and so Zahra can engage in perfect price discrimination. Based on this limited information, what can you
say about (a) how many customers she will sell to, (b) what range of prices she will charge, and (c) by how much
her profit will go up? Be as specific as possible and explain your answers. (Note: Do not assume linear demand,
since that would not be in the “limited information” spirit of this question and since the data are not consistent
with linear demand.)

Solution: Zahra will continue to sell to her current 10,000 customers, but she will charge
each one his valuation, thereby appropriating all the customer surplus. If this were the end
of the story, her profit would increase by the $50,000 surplus that is transferred to her from
the customers.
However, Zahra will also sell to customers whose valuations are between her marginal
cost of $5 and $10, charging each one his valuation. She will obtain additional profit from
these customers. Hence, (a) Zahra will sell to more than 10,000 customers, (b) she will
charge prices ranging from $5 up, and (c) her profit will increase by more than $50,000.

Commentary It is tempting to assume that the aggregate demand curve is linear and thereby
derive exact quantities sales and profit under perfect price discrimination. However, the ques-
tion clearly states that you are to answer it “based on this limited information”, which does
not include the shape of the demand curve. Furthermore, demand cannot be linear given the
data: With constant marginal cost of $5 and a profit-maximizing linear price of $10, the choke
price if demand were linear would be $15. But then the average consumer surplus would be
$2.5, for total consumer surplus of $25,000.
Firms, Prices & Markets • Solutions for Chapter 11 (Implicit Price Discrimination (Screening)) 7

Exercise 11.9. (Screening via differentiated products) The purpose of a numerical example like that of
Exercises 11.1–11.4 is to obtain intuition about real-world pricing problems by working through a simple example
that you can “touch and feel”. Imagine that six months after reading this book you find yourself with a real-world
pricing problem that is similar—in that you consider offering multiple quality levels and there are two broad
market segments—although without the stark simplicity of our example. Write a brief (e.g., three-paragraph)
summary of the intuition you have obtained from the numerical example. You should think of this summary as a
brief memo or presentation whose purpose is to analyze the problem for your colleagues.

Solution: One possible good answer:

We face a problem of trying to extract revenue from two groups of customers that are
quite different. We have high-end customers who are willing to pay a lot for our product
and we have low-end customers who are willing to pay less for our product. If we could
identify whether a customer is high-end or low-end each time we made a sale, we could
just charge different prices for the two groups of customers. Unfortunately, although we
are aware that there are two groups of customers out there, we cannot tell which customers
are in each group and hence we must charge each customer the same price.
One option is to charge a low price that would be acceptable to most customers; this
would give us a low margin but high volume. Another option is to charge a high price that
would attract mainly our high-end customers; this would give us a high margin but lower
volume. Which of these two options is better depends on the size of the low-end and high-
end markets. For example, if the low-end market is small compared to the high-end market,
then the loss in volume when we charge the high price is relatively small and so a higher
price is better than a low price.
There is also a third option: Our market studies indicate that the low-end are not willing
to pay a high premium for product quality. The high-end customers are the opposite. Sup-
pose we sell a low-quality version of our product, priced to attract the low-end customers.
This price need not be much lower than the price that would attract the low-end customers
to the full-quality product. We could then charge a high premium for the full-quality prod-
uct and still attract most of the high-end customers to this product. As long as there are
enough low-end customers relative to high-end customers, the third option is better than
only offering the full-quality product at a high price and losing sales from the low-end cus-
tomers. As long as there are enough high-end customers relative to low-end customers, the
third option is better than only offering the full-quality product at a low price and foregoing
the higher margins from the high-end customers.
Firms, Prices & Markets • Solutions for Chapter 11 (Implicit Price Discrimination (Screening)) 8

Exercise 11.10. (Bundling) You are a movie distributor with two movies to offer: an arts film called Sorrow
and Loneliness and an action film called Death Machine. You distribute to three theaters: “Supermall Megaplex”,
“Downtown Deluxe”, and “Ethereal Visions”. You know that the amounts each theater would pay for these movies
are as shown in Table E11.2.

Table E11.2
Valuation

Theater Sorrow Death

Supermall $60 $100

Downtown $90 $60
Ethereal $120 $10

(The amount a theater is willing to pay for one of these movies does not depend on whether or not it chooses
to buy the other movie.) Your marginal cost is zero and so your objective is to maximize revenue. In each of the
following problems, you cannot explicitly segment your market.

a. Suppose that you do not bundle. What is the optimal price of Sorrow and what is the optimal price of Death?
What is your total revenue?

Solution: Sorrow: Optimal price is either $60 or $90, both of which give revenue of
$180.
Death: Optimal price is $60, for revenue of $120.
Total revenue: $300.

b. Now suppose that you offer the two movies only as a bundle (pure bundling). What is the optimal price for
the bundle? What is your revenue?

Solution: Willingness-to-pay for bundle:

Theater WTP
Supermall $160
Downtown $150
Ethereal $130
Optimal bundle price is $130. which gives revenue of $390.

c. Suppose you can engage in mixed bundling. What is your optimal pricing strategy? What does each theater
buy? What is your revenue?

Solution: Offer bundle for $150 and Sorrow alone for $120. Do not sell Death by itself.
Supermall and Downtown theaters buy the bundle; Ethereal buys Sorrow.
Total revenue is $150 + $150 + $120 = $420.
Firms, Prices & Markets • Solutions for Chapter 11 (Implicit Price Discrimination (Screening)) 9

Exercise 11.11. (Bundling) You are a monopolist selling two different types of concert tickets, for rock
music and world music. You have zero marginal cost and hence your objective is to maximize revenue. You face
three groups of potential customers, with an equal number of customers in each group. Table E11.3 summarizes
the valuation of each group for each concert.

Table E11.3
Valuation

Type Rock World

A 5 60
B 35 65
C 40 70

a. (Pure bundling): What is the optimal price for the bundle of both tickets? What is your profit?

Solution: The valuations for the bundle are as follows:

Valuation

Type Rock World Bundle

A 5 60 65
B 35 65 100
C 40 70 110

For simplicity, suppose that there is one customer of each type. Otherwise, revenue and
profits are as given, but multiplied by the number of customers of each type.
You might charge 65 and sell 3 tickets, for profit (revenue) of $195, or charge $100 and
sell two tickets for profit of $200, or charge $110 and sell one ticket, for profit of $110. The
best option is to charge $100.

b. (Mixed bundling) Find one mixed bundle pricing strategy that gives you higher profit than your answer for
pure bundling.

Solution: You should be able to guess by looking at the data that you might want to sell
the bundle to these two customers who have a high valuation for it (B and C), and then sell
a “World” ticket to the type A customer. Charge the highest price to A that satisfies his
participation constraint, i.e., $60. Now we need to adjust the price of the bundle to satisfy
the self-selection constraints of types B and C. The problem is that these two customers
could choose the World ticket instead of the bundle. Their surplus if buying the world
ticket is $5 and $10, respectively. We have to lower the price of the bundle so that they get
at least that much surplus by buying the bundle. Thus, we have to lower the price of the
bundle to $95. The overall revenue (profit) is then $250.