Chapter 12

Pricing
Key issues
1. why and how firms price discriminate
2. perfect price discrimination
3. quantity discrimination
4. multimarket price discrimination
5. two-part tariffs
6. tie-in sales
Nonuniform pricing
prices vary across customers or units
noncompetitive firms use nonuniform
pricing to increase profits
Single-price firm
nondiscriminating firm faces a trade-off
between charging
maximum price to consumers who really want
good
low enough price that less enthusiastic
customers still buy
as a result, single-price firm usually sets an
intermediate price
Price-discriminating firm
avoids this trade-off
earns a higher profit by charging
higher price to those willing to pay more than
the uniform price: captures their consumer
surplus
lower price to those not willing to pay as much
as the uniform price: extra sales
Extreme examples of tradeoff
maximum customers will pay for a movie:
college students, $10
senior citizens, $5
theater holds all potential customers, so MC
= 0
no cost to showing the movie,
so t = revenue
Example 12.1a

Pricing
Profit from 10
College Students
Profit from
20 Seniors
Total
Profit
Uniform, $5 $50 $100 $150
Uniform, $10 $100 $0 $100
Price
discriminate
$100 $100 $200
Example 12.1b

Pricing
Profit from 10
College Students
Profit from
5 Seniors
Total
Profit
Uniform, $5 $50 $25 $75
Uniform, $10 $100 $0 $100
Price
discriminate
$100 $25 $125

Broadway theaters
increase their profits 5% by price
discriminating rather than by setting
uniform prices
Geographic price discrimination
admission to Disneyland is $38 for out-of-
state adults and $28 for southern
Californians

tuition at New Yorks Fordham University
is $4,000 less for commuting first-year
students than for others
Successful price discrimination
requires that firm have market power
consumers have different demand
elasticities, and firm can identify how
consumers differ
firm must be able to prevent or limit
resales to higher-price-paying customers
by others
Preventing resales
resales are difficult or impossible when
transaction costs are high
resales are impossible for most services
Prevent resales by raising
transaction costs
price-discriminating firms raise transaction
costs to make resales difficult
applications:
U.C. Berkeley requires anyone with a student
ticket to show a student picture ID
Nikon warranties cover only cameras sold in
this country
Prevent resales by vertically
integrating
VI: participate in more than one successive
stage of the production and distribution
chain for a good or service
VI into the low-price purchasers
Prevent resales by government
intervention
governments require that milk producers charge
higher price for fresh use than for processing
(cheese, ice cream) and forbid resales
governments set tariffs limiting resales by making
it expensive to import goods from lower-price
countries
governments used trade laws to prevent sales of
certain brand-name perfumes except by their
manufacturers
Flight of the Thunderbirds
2002 production run of 25,000 new Thunderbirds included
only 2,000 for Canada
potential buyers are besieging Ford dealers in Canada
many hope to make a quick profit by reselling these cars in the
United States
reselling is relatively easy and shipping costs are relatively low
why a T-Bird south?
Ford is price discriminating between U.S. and Canadian customers
at the end of 2001, Canadians were paying $56,550 Cdn.
(Thunderbird with the optional hardtop), while U.S. customers
were spending up to $73,000 Cdn.
Thunderbirds (cont.)
Canadian dealers try not to sell to buyers who will export
the cars
dealers have signed an agreement with Ford that explicitly
prohibits moving vehicles to the United States
dealers try to prevent resales because otherwise Ford may cut off
their Thunderbirds or remove their dealership license
one dealer said, Its got to the point that if we havent sold
you a car in the past, or we dont otherwise know you,
were not selling you one.
nonetheless, many Thunderbirds were exported: eBay
listed dozen of these cars on a typical day
3 types of price discrimination
perfect price discrimination (first-degree): sell
each unit for the most each customer is willing to
pay
quantity discrimination (second-degree): charges
a different price for larger quantities than for
smaller ones
multimarket price discrimination (third-degree):
charge groups of customers different prices
Perfect-price-discriminating
monopoly
has market power
can prevent resales
knows how much each customer is willing
to pay for each unit purchase (all knowing)
All-knowing monopoly
sells each unit at its reservation price
maximum price consumers will pay (captures
all possible consumer surplus)
height of demand curve
MR is the same as its price (AR)

Figure 12.1 Perfect Price Discrimination
p , $ per unit
6
5
4
3
2
1
Q , Units per day
6 5 4 3 2 1 0
MC
e
Demand, Marginal revenue
MR
1
= $6 MR
2
= $5 MR
3
= $4
Perfect price discrimination
properties
perfect price discrimination is efficient
competition and a perfectly discriminating
monopoly
sell the same quantity
maximize total welfare: W = CS + PS
have no deadweight loss
consumers worse off (CS = 0) than with
competition
s c
d
p , $ per unit
E
D
C
B
A
Q , Units per day Q Q = Q
MC
s
Demand, MR
MR
s
p
c
= MC
c
e
c
e
s
p
s
p
1
MC
1
MC
d
Amazon
in 2000, Amazon revealed that it used dynamic
pricing: gauges shoppers desire and means,
charges accordingly
example
a man ordered DVD of Julie Taymors Titus at
$24.49
checks back next week and finds price is $26.24
removes cookie: price fell to $22.74
after newspaper articles, Amazon announced it
had dropped this policy
Botox revisited
how much more would Allergan earn from
Botox if it could perfectly price
discriminate?
Application Botox Revisited
p ,
$ per
vial
1.30 2.61 2.75
A

$187.5
million
C $187.5 million
B $375 million
Demand
Q , Million daily doses of Botox
75.0
7.5
0
e
s
e
MC
MR
143.0
c
Solved problem
How does welfare change if firm in Table
12.1 goes from charging a single price to
perfectly price discriminating?
Table 12.1a

Pricing
Profit from 10
College Students
Profit from
20 Seniors
Total
Profit
Uniform, $5 $50 $100 $150
Uniform, $10 $100 $0 $100
Price
discriminate
$100 $100 $200
Answer: Panel a
welfare is same with single price or price
discrimination because output unchanged
single price: if theater sets a single price of $5
it sells 30 tickets and t = $150
20 seniors pay their reservation price so CS = 0
10 college students (reservation prices of $10) have CS
= $50
welfare = $200 = profit ($150) + consumer surplus
($50)
If firm perfectly price
discriminates
it charges all customers their reservation
price so theres no consumer surplus
seniors pay $5 and college students, $10
firm's profit rises to $200
welfare
W = $200 = profit ($200) + CS ($0)
is same under both pricing systems where
output stays the same
Table 12.1b

Pricing
Profit from 10
College Students
Profit from
5 Seniors
Total
Profit
Uniform, $5 $50 $25 $75
Uniform, $10 $100 $0 $100
Price
discriminate
$100 $25 $125

Answer: Panel b
welfare is greater with perfect price discrimination
where output increases
if theater sets single price of $10
only college students attend and have CS = 0
t = $100
W = $100
if it perfectly price discriminates:
CS = 0
t =$125
W = $125
Quantity discrimination
firm does not know which customers have highest
reservation prices
firm might know most customers are willing to
pay more for first unit (demand slopes down)
firm varies price each customer pays with number
of units customer buys
price varies only with quantity: all customers pay the
same price for a given quantity
note: not all quantity discounts are a form of price
discrimination
Utility block pricing
public utility (electricity, water, gas)
charges
one price for the first few units (a block) of
usage
different price for subsequent blocks
both declining-block and increasing-block
pricing are common
p
1
, $ per unit
30
50
70
90
Q , Units per day
20 40 90 0
m
(a) Quantity Discrimination
Demand
A =
$200
C =
$200
B =
$1,200
D =
$200
p
2
, $ per unit
30
60
90
Q , Units per day
30 90 0
m
(b) Single-Price Monopoly
Demand
F = $900
G
=
$450
MR
E = $450
Figure 12.3 Quantity Discrimination
Multimarket price discrimination
firm knows only which groups of customers
are likely to have higher reservation prices
than others
firm divides potential customers into two or
more groups
firms set a different price for each group
Theater
senior citizens pay a lower price than
younger adults at movie theaters
by admitting people as soon as they
demonstrate their age and buy tickets,
theater prevents resales
International price
discrimination: Cars
even including shipping and customs,
European price for BMW 750IL

price is 13.6% more from an American firm
than imported from Europe
International price
discrimination: Software
Australia's Prices Surveillance Agency
criticized American software industry for
charging Australians 49% more than
Americans,
then, Agency called for an end to import
restrictions so that Australian retailers could
import software directly
Price discriminating: 2 groups
marginal cost = m
monopoly charges Group i members p
i
for
Q
i
units
profit from Group i is

i
= p
i
Q
i
mQ
i
To maximize total profit
monopoly sets its quantities so that
marginal revenue for each group i, MR
i
,
equals common marginal cost, m:
MR
1
= m = MR
2
.

example: Sonys Aibo robot dog
p
J
, $ per unit
Q
J
, Units per year
DWL
J
D
J
CS
J
t
J
MR
J
p
J
= 2,000
500
3,500
0
M C
Q
J
= 3,000 7,000
(a) Japan
Figure 12.4 Multimarket Pricing of Aibo
p
US
, $ per unit
Q
US
, Units per year
DWL
US
D
US
CS
US
t
US
MR
US
p
US
= 2,500
500
4,500
0
M C
Q
US
= 2,000 4,500
(b) United States
Profit-maximizing condition
MR
i
= p
i
(1 + 1/
i
), so

MR
1
=p
1
(1 + 1/
1
) = m = p
2
(1 + 1/
2
) =
MR
2



2
1
2
1
1
1
.
1
1
p
p
c
c
| |
+
|
\ .
=
| |
+
|
\ .
Solved problem
monopoly sells in two markets
constant elasticity of demand is
c
1
= -2 in first market
c
2
= -4 in second market
MC = $1
resales are impossible
what prices should monopoly charge?
Answer


p
1
= 1/(1 ) = 2
p
2
= 1/(1 ) = 4/3

p
1
/p
2
= 2/(4/3) = 1.5
1
1 1
i
i
p MC
c
| |
+ = =
|
\ .
1
1/ 1
i
i
p
c
| |
= +
|
\ .
Coca-Cola Version 1
a two-liter bottle of Coke costs 50% more in
the U.K. than in EU nations (SF Chronicle, May
17, 2000: D2)
if Cokes marginal cost is the same for all
European nations, how does the demand in
the U.K. differ from that in the EU?
Answer
p
UK
/p
EU
= 1.5
an example that is consistent with this ratio
is c
UK
= - 2 and c
EU
= -4
generally:


or 1.5c
EU
- c
UK
= 0.5 c
UK
c
EU

1 1
1 / 1 1.5
EU UK
c c
| | | |
+ + =
| |
\ . \ .
Generics and brand-name loyalty
Why do prices of some brand-name
pharmaceutical drugs rise when equivalent,
generic brands enter the market?
Entry of generics
generics enter when patent for profitable drug
expires
generics: 40% of U.S. pharmaceutical sales by volume
name-brand drugs with sales of about $20 billion went
off patent by 1997
most states allow/require pharmacist to switch
prescription from more expensive brand-name
product to generic unless doctor or patient object
Price effects
18 major orally-administered drug products
that faced generic competition 1983-1987
on average for each drug, 17 generic brands
entered and captured 35% of total sales in first
year
price effects
brand-name drug prices rose an average of 7%
but average market price fell over 10%
because generic price was only 46% of brand-name
price
Explanation
customers with different demand elasticities
some are price sensitive: willingly switch to less
expensive generic drugs
others are unwilling to change brands
AARP survey found that people 65 and older are 15%
less likely than people 45 to 64 to request generic
versions of a drug from their doctor or pharmacist
introduction of generics makes demand facing
brand-name drug less elastic
Identifying an individuals group
identify using observable characteristics of
consumers price elasticities
identify consumers based on their actions:
consumers self-select into a group
Why firms use self-identification
each price discrimination method requires
that, to receive a discount, consumers incur
some cost, such as their time
otherwise, all consumers would get a
discount
by spending extra time to obtain a discount,
price-sensitive consumers differentiate
themselves from others
Getting consumers to identify
themselves: Coupons
self-selection: people who spend their time
clipping coupons buy goods at lower prices
than those who value their time more
coupon-using consumers paid $24 billion
less than other consumers in the first half of
1990s
Airline tickets and hotel rooms
self-selection (business vs. vacation
travelers): cheap fares require advanced
purchase and staying over a Saturday night
Sheraton and other hotel chains offer
discounts for rooms booked 14 days in
advance for the same reason
Reverse Auctions
priceline.com uses a name-your-own-price
or reverse-auction to identify price sensitive
customers
a customer enters a relatively low price bid
for a good or service, such as airline tickets
merchants decide whether to accept that bid
or not
Why priceline works
to keep their less price-sensitive customers from using this
method, airlines force successful Priceline bidders to be
flexible:
to fly at off hours
to make one or more connection
to accept any type of aircraft
when bidding on groceries, a customer must list two or
more brands you like.
as Jay Walker, Pricelines founder said, The
manufacturers would rather not give you a discount, of
course, but if you prove that youre willing to switch
brands, theyre willing to pay to keep you.
Welfare effects of multimarket
price discrimination
multimarket price discrimination results in
inefficient production and consumption
welfare under multimarket price
discrimination is lower than under
competition or perfect price discrimination
welfare may be lower or higher with
multimarket price discrimination than with
a single-price monopoly
Gray markets
producers of recordings, books, sunglasses,
and shampoo, price discriminate by selling
these goods for higher prices in U.S. than in
foreign markets
if the price differential is great enough,
some goods are reimported into U.S. and
sold in a $130 billion-a-year "gray market"
by discounters (Costco, Target, Wal-Mart)
Gray markets (cont.)
1995 federal court decision:
copyright owners has exclusive right to control
marketing
can prevent reimportation
1998 Supreme Court decision reversed:
discount retailers had the legal right to sell copyrighted
U.S. goods in U.S.
once sold, "lawfully made" copies can be resold
without the permission of copyright holder
reduces firms ability to price discriminate
Other forms of nonlinear pricing
two-part tariffs
tie-in sales

both are second-degree price discrimination
schemes where the average price per unit
varies with the number of units consumers
buy
Two-part tariff
firm charges a consumer
lump-sum fee (first tariff) for right to buy any
units
constant price (second tariff) on each unit
purchased
because of lump-sum fee, consumers pay
more, the fewer units they buy
Two-part tariff examples
telephone service: monthly connection fee,
price per minute of use
car rental firms: charge per-day, price per
mile
Personal seat license
Carolina Panthers introduced the PSL in 1993, and
at least 11 NFL teams used a PSL by 2002
over $700 million has been raised by the PSL
portion of this two-part tariff
Raiders football season tickets: personal seat
license at $250-$4,000 (right to buy season tickets
for next 11 years), tickets $40-$60 each
Two-part tariff with identical
consumers
monopoly that knows its customers' demand
curve can set a two-part tariff that has same
properties as perfect-price-discriminating
equilibrium
Two-part tariff with nonidentical
consumers
suppose two customers - Consumer 1 and
Consumer 2 - with demand curves, D
1
and
D
2
consider two cases, monopoly
knows customers demand curves and can
charge them different prices
cannot distinguish between types of customers
or cannot charge consumers different prices
Can distinguish/discriminate
monopoly knows customers demand curves; can
charge them different prices
monopoly charges each customer p = MC = m =
$10/unit
thus, makes no profit per unit but sells number of
units that maximizes potential CS
monopoly sets lump-sum fees = potential CS
A
1
+ B
1
+ C
1
= $2,450 to Consumer 1
A
2
+ B
2
+ C
2
= $4,050 to Consumer 2
monopoly's total profit= $6,500
Figure Two-Part Tariff with Identical Consumers
p , $ per unit
q
1
, Units per day
60 70 80
D
1
80
20
10
0
m
B
1

= $600
C
1
= $50
A
1
= $1,800
Cannot distinguish/discriminate
monopoly cannot distinguish between types of
customers or cannot charge them different prices
monopoly has to charge each consumer the same
lump-sum fee and same p
due to legal restrictions, telephone company
charges all residential customers same monthly fee
and same fee per call, even though company
knows that consumers' demands vary
p , $ per unit
q
1
, Units per day
60 70 80
D
1

80
20
10
0
m
(a) Consumer 1
B
1

= $600
C
1
= $50
A
1
= $1,800
Figure 12.5 Two-Part Tariff
p , $ per unit
q
2
, Units per day
90 100 80
D
2

20
10
0
m
(b) Consumer 2
B
2
= $800
C
2
= $50
A
2
= $3,200
100
Monopoly doesnt capture all CS
monopoly charges lump-sum fee equal to
potential CS
1
or CS
2

because CS
2
> CS
1
both customers buy if lump-
sum fee = CS
1
Consumer 2 buys if monopoly charges lump-
sum fee = CS
2

in Figure 12.5, monopoly maximizes its
profit by setting lower lump-sum fee and
charging p = $20 > MC
Why is price > marginal cost?
by raising its price, monopoly earns more
per unit from both types of customers but
lowers its customers potential CS
if monopoly can capture each customer's
potential CS by charging different lump-
sum fees, it sets p = MC
Tie-in sales
customers can buy one product only if they
purchase another product as well
most tie-in sales increase efficiency by
lowering transaction costs
2 forms of tie-in sales
requirements tie-in sale: customers who buy
one product from a firm must purchase all
units of another product from that firm
(copiers/toner or service)
bundling (or a package tie-in sale): two
goods are combined so that customers
cannot buy either good separately
(shoes/shoelaces)
Requirement tie-in sales
firm cannot tell which customers are going
to use its product most (highest willing to
pay)
firms uses requirement tie-in sale to identify
heavy users
IBM requirement tie
1930s: IBM produced card punch machines,
sorters, and tabulating machines that
computed using punched cards
IBM leased (rather than sold) punch
machines; lease would terminate if
customer used non-IBM card
by leasing, IBM avoided resale problems
and forced customers to buy cards from it
Bundling
bundling allows firms that can't directly
price discriminate to charge customers
different prices
profitability of bundling depends on
customers tastes and ability to prevent
resales
Selling Raiders' season tickets
suppose stadium can hold all potential
customers, so MC = 0 for selling one more
ticket
should Raiders bundle tickets for preseason
(exhibition) and regular-season games, or
sell separately?
Table 12.3 Bundling of Tickets to Football Games

When bundling increases profit
bundling likely to increase profit if consumers'
demands are
negatively correlated:
consumers who value one good much more than other
customers value other good less
here, bundling pays only if customers willing to
pay relatively more for regular-season tickets are
not willing to pay as much as others for preseason
tickets and vice versa
Supreme Court on tie-in sales
Kodak was prohibited by the Supreme
Court from using certain tie-in sales in 1992
Kodak sells photocopiers and Kodak parts
and service to its customers
Kodak refused to supply some parts to
independent repair firms - effectively
forcing customers to buy those parts and
associated service from Kodak
Charge and response
company was charged with illegally tying sale of
its photocopiers with its parts and service
Kodak argued that
case should be dismissed because both sides agreed
Kodak faced substantial competition in initial sale of
photocopiers
customers would not buy from Kodak if they knew that
they would be overcharged on repair parts and service
because Kodak didn't have market power in copier
market, it couldn't price discriminate or extend its
market power to another market
Supreme Court rejects Kodak
consumers may be uninformed (cant forecast
repair cost)
even if Kodak lacks market power in
photocopiers, its a monopoly supplier of its
unique repair parts
factual investigation needed to determine if
consumers are ignorant and have to be protected
(Court did not explain consumer benefit if Kodak
forced to sell repair parts to independent repair
shops at prices set by Kodak)
1. Why and how firms price
discriminate
to successfully price discriminate a firm needs
market power
to know which customers will pay more for each unit of
output
to prevent resales
firm earns a higher profit from price
discrimination than uniform pricing because it
captures some or all of the CS of customers who are
willing to pay more than uniform price
sells to some people who wont buy at uniform price
2. Perfect price discrimination
to perfectly price discriminate, firm must know
maximum amount each customer is willing to pay
for each unit of output.
perfectly price discriminating firm captures all
potential consumer surplus
sells efficient (competitive) level of output
compared to competition
welfare is same
consumers are worse off
firms are better off
3. Quantity discrimination
some firms charge customers different
prices depending on how many units they
purchase
doing so raises their profits
4. Multimarket price
discrimination
firm does not have enough information to
perfectly price discriminate but knows relative
elasticities of demand of groups of customers
firm charges each group a price in proportion to its
elasticity of demand
welfare under multimarket price discrimination is
< under competition/perfect price discrimination
> or < under single-price monopoly
5. Two-part tariffs
by charging consumers a fee for the right to
buy and a price per unit, firms may earn
higher profits than from charging only for
each unit sold
if a firm knows demand curves of its
customers, it can use two-part tariffs
(instead of perfectly price discriminating) to
capture all consumer surplus
6. Tie-in sales
firm may increase its profit by using a tie-in sale:
customers can buy one product only if they also
purchase another one
requirement tie-in sale: customers who buy one
good must make all of their purchases of another
good or service from that firm
bundling (package tie-in sale): firm sells only a
bundle of two goods together
prices differ across customers under both types of
tie-in sales
Docking Their Pay
2002 dispute between
the International Longshore and Warehouse Union
(ILWU)
shipping companies, represented by the Pacific
Maritime Association
led to the closure of 29 west coast ports for 12
days and significant damage to U.S. and foreign
economies
these docks handle about $300 billion worth of
goods per year
Lockout
shippers locked out 10,500 union workers
lockout: an action by the employers that
causes a work stoppage similar to what
would happen if the union called a strike
Damages
by one estimate, the shutdown inflicted up to $2
billion a day in damages of the U.S. economy
revenues fell 80% at West Coast Trucking
one of Hawaiis largest moving companies declared
bankruptcy as a consequence
Singapores Neptune Orient Lines said that the
shutdown cost it $1 million a day
Had the shutdown lasted longer, vast amounts of
food and other perishables waiting to be shipped
would have spoiled.
Why
these events were triggered by the
expiration of a union contract
dispute had more to do with employment
issues than wages
Background
number of dock workers has shrunk over
the years as firms have used automation to
become more efficient
10,500 registered union workers averaged at
least $80,000 (some estimates set the figure
at $100,000) a year with benefits and other
perks worth about $42,000 under the
previous contract
Offer
Pacific Maritime Association negotiators
had offered
$1 billion worth of new pension benefits
lifetime benefits of $50,000 a year
higher salaries of $114,500 a year for longshore
workers and $137,500 for marine clerks
health care plan with no deductibles
Union Concerns
use of new technologies
potential loss of 400 longshore positions
wanted guarantees that new clerical
positions would be filled by their union
members
Take-it-or-leave it
Traditionally, longshore unions offered employers
a take-it-or-leave-it choice:
union specified both a wage and a minimum
number of hours of work that the employers had to
provide
1975 U.S. Department of Labor study found 2/3 of
transportation union contracts (excluding railroads
and airplanes) had wage-employment compared to
only 11% of union contracts in all industries
Task
Compare equilibrium where a union
specifies both wages and hours of work to
the perfect price discrimination equilibrium
w
w*
H* H H, Hours per year
w, wage per hour
B
C
Demand
Supply
A