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Chapter 9

EC260 Chapter Notes - Chapter 9: Marginal Cost, Price Discrimination, Marginal Revenue

Course Code
Olivia Ozlem Mesta

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Chapter 9: Price Discrimination
The Motivation for Price Discrimination
-Price discrimination is a pricing strategy in which customers are charged different prices for
the same good or service
-The motivation behind price discrimination is to capture consumer surplus
-In a perfectly competitive market, managers have no power over price so they cannot practice
price discrimination
-Consumer surplus = area V
-Apart from the consumer whose reservation price is PM, all other consumers in area V value
the good at prices higher than the reservation price, but only have to pay PM
-These consumers represent one source of potential profit that the single price monopolist is
not capturing
-Another source of potential profit exists from area X + Z (deadweight loss)
-These consumers are not willing to pay PM but have reservation prices that lie above the MC
of the firm
-The single price monopolist earns variable cost profit of area W + Y
-Total revenue is equal to area W + Y + U
-Area U represents the variable cost of the firm
-The single price monopolist cannot increase his/her profits by charging a price different from
the monopoly price because a higher price increases X + Z and a lower price increases V
-In order to capture these areas, the monopolist would have to charge different prices for
different consumers

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Types of Price Discrimination
First Degree Price Discrimination
-Also known as “perfect price discrimination”
-All customers are charged a price equal to their reservation price
-Lets the monopolist capture 100% of the consumer surplus and the dead-weight loss
-The perfectly price discriminating monopolist produces the same output as a perfectly
competitive firm
-The two market structures have the same total social welfare
-The big difference is the distribution of the consumer and producer surplus
-Producer surplus = W + Y + V + X + Z and consumer surplus = 0
Second Degree Price Discrimination
-Commonly used with public utilities like gas, water and electricity
-Different prices are charged for different quantities of a good
-Allows the company to increase revenue and profit
-Some consumer surplus remains un-captured
Third Degree Price Discrimination
-Most common form of price discrimination
-Three conditions must hold:
1. demand is heterogeneous (i.e., not all consumers are identical)
2. managers have the ability to segment the market
3. the market segments are sealed from each other (i.e., a market segment with a lower price
cannot resell to a market segment with a higher price)

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-Since it’s too expensive to discover the preferences of each individual allowing for FDPD,
managers can determine the preferences of groups of individuals with similar traits
-Student discounts are an example of TDPD: limited income makes students more responsive
to price differences; their price elasticity of demand is more elastic; they can be readily
identified by their student IDs
-When segmenting a market, managers need to decide how much output to allocate to each
class and what price to charge each class
-Profit will be maximized if output is allocated such that the marginal revenues from each class
are equated
-When this is true the ratio of prices from one class to another equal:
-n1 and n2 are the price elasticities of demand for the first and second classes
-The expression is derived from: MR = P(1 + 1/n)
-Each class will have a similar expression with its own prices
-So if MR1 and MR2 are equal, then it’s easy to derive the expression above by equating the
marginal revenues
-If the two price elasticities were equal, it would not make sense to charge two different prices
because the expression implies that if |n1| = |n2| then P1 = P2
-In addition to looking at demand in each class, managers should consider costs
-Profits will be maximized when the MC of producing the entire output is equal to the common
value of the MR in each class
-π = TR1 + TR2 - TC
-Its profit is maximized when the following two conditions are met:
-The managers must choose output such that MR1 = MR2 = MC
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