Price Discrimination

Question 1

What is a predatory price?

Answer 1

This is a aggressive approach that uses pricing to reduce competition in the market - similar to limit pricing, but very different

Question 2

How do firms engage in predatory pricing?

Answer 2

first lowering its price below AC (making a loss) - drives rivals out of business (or defers entry) - then raises prices when exit has occurred (threat of entry reduced) - takes advantage of new market power it has acquired (changes level of competition)

Question 3

What are the two stages involved in deploying predatory pricing?

Answer 3

1. P < AC (short run loss - gain market power and position)
2. P > AC (long run abnormal profit)
   involves inter-temporal substitution of profits.

Question 4

What are the necessary conditions of predatory pricing?

Answer 4

High degree of strategic interdependence.
Deep pockets.

Question 5

What does high degree of strategic interdependence involve?

Answer 5

Predatory pricing involves the use of low price strategy to target a rival, but customers must be willing to swap in favour of those lower prices, products must be close substitutes.
Price increases after rivals are forced out.
For example, Bus, airline routes, supermarkets (loss leaders, product sold at lower costs to drive out rivals), trade dumping (low cost in certain markets)

Question 6

What does deep pockets involve?

Answer 6

Initial low prices being charged in market will result in firm making losses in the short run.
Firm therefore needs the financial resources (bank loan) to cover these losses in the SR and to feel they can more than make them back with enhanced profits in the LR.
Firm needs to be better positioned then rival to make sure the rival leaves the market.

Question 7

What is predatory pricing from a societal welfare perspective?

Answer 7

consumers benefit from low prices in short run but lose out in the long run as price is rasied, potential for creation of a deadweight loss, if firms remaining gain more market power

Question 8

Is predatory pricing legal?

Answer 8

it is generally illegal in many markets, govs generally want more competition not less, but hard to prove given there are many reasons to offer low prices.

Question 9

What is price discrimination?

Answer 9

the practice of selling the exact same good to different customers for different prices. It is a form of non uniform pricing.
Discretion over prices only occur in imperfectly competitive and monopoly markets - firms must have some powers over buyer to allow them to vary their prices.
Not all price differences are due to price discrimination.

Question 10

How is price discrimination beneficial to consumers?

Answer 10

Gain access to lower prices, increased product availability and market expansion may not be able to afford a product at a uniform price but can access it due to tailored pricing strategies.
Depends on type of price discrimination and market conditions. Beneficial when it expands market access and improves efficiency by selling more units - removes deadweight loss and captures more consumer surplus.

Question 11

How is price discrimination beneficial to producers?

Answer 11

gain economies of scale, increased revenue and profits by charging different prices to different consumers and gains a competitive advantage.

Question 12

What are examples of price discrimination?

Answer 12

Discounts on trains, buses, cinemas, theatres for students, OAPs and unemployed.
Discount coupons on products that reward repeat consumption with lower reward repeat consumption with lower prices e.g. money off next purchases (Tesco clubcard)
Significant international prices differentiation in many consumer goods (tax currency value differences, VAT, included in UK, but not USA).
Intertemporal price variation in newly introduced products - tv sets, books, computers etc.
Higher prices in restaurants, theatres and clubs on Fridays and Saturdays nights (peak load pricing)

Question 13

What are the necessary conditions to implement non-uniform pricing?

Answer 13

1. Market power - must feel free to charge high prices without losing many customers to rivals.
2. Consumer willingness to pay - income levels, interest levels, groups don’t mind co-existing, those paying don’t mind if others are paying less.
3. Firms must know or infer valuation of good in order to charge right price to each customer.
4. Preventing arbitrary - right people paying right price for their goods, cant be potential for customers in a low price market to sell onto a customer in a high priced market.
   Mechanism can be used to arbitrage by tying a good to a particular customer e.g. student rail cards having expiry dates on them.

Question 14

What is first degree ‘perfect’ price discrimination?

Answer 14

Selling at a different price to each customer. Each firm tries to judge maximum buyer is willing to pay (no consumer surplus) and charges them that price.
Such behaviour is seldom (rare) found in real world - maybe in market haggling situation and certain types of auctions.
Firms successfully extracts all consumer surplus as a product sold at max price.

Question 15

What is the effect of first degree price discrimination under uniform pricing and perfect price discrimination?

Answer 15

effect on total revenue of selling a extra unit is composed of 2 effects.
1. increase due to addition of another unit to sales at a positive price.
2. decreased due to receiving a slightly lower price on all other unit.
The second of these effects is eliminated, hence MR = D

Question 16

What is second degree price discrimination (quantity discrimination)?

Answer 16

Selling at different prices depending upon how much of the good customer buys. Firms sell different amounts of the good to the same person at different prices.
Typically involves a quantity discount whereby small levels of consumption are charged t relatively high rates and increasingly high levels are charged at lower rates.
Practice is widespread, variety of measures to prevent arbitrage e.g. warning on products part of a multipack that says not to be sold separately.
Consumers are free to choose whichever option they wish, but the lower points are conditional on some aspect of the sale such as quantity or exact version of the product purchased.

Question 17

What is third degree price discrimination (multi-market PD)?

Answer 17

Firms identify groups of consumers with different sensitivity to the variation in the price of a good e.g. student/senior citizens vs regular adults admission to cinema or peak vs off-peak train tickets.

Question 18

What prices to firms charge for third degree price discrimination?

Answer 18

Firms charge a optimal price to each of these groups, the firm discriminates between groups but not between individuals within groups.
Need to ensure discrimination isn’t being done on protected characteristics which make it illegal e.g. on race.
There are mechanisms to stop members of price sensitive groups re-selling the good to members of the price insensitive groups i.e. student card

Question 19

What is the demand curve like for third degree price discrimination?

Answer 19

Demand curve is kinked at the height where quantity demanded in the elastic segment becomes positive.
The demand curve kinks in the opposite direction to the kink in the kinked demand curve model

Question 20

Where are most customers served under?

Answer 20

most are under 1st and 2nd degree price discrimination. With perfect price discrimination, the competitive output is produced. Total welfare is greater under 1st and 2nd degree then under uniform pricing (higher production volume means less deadweight loss as charging at maximum price)

Question 21

When is firms welfare higher?

Answer 21

firms welfare is higher as firms make greater abnormal profit, consumer welfare is lower under price discrimination.
Firms extract consumer surplus as profit.
Different customers pay different prices under price discrimination - equity issues can be unfair.

Question 22

What are two-part tariffs?

Answer 22

Form of price discrimination where price of a good/service is composed of two parts.
1. Lump sum fee 2. a per unit charge

Question 23

When does overall price change in two-part tarrifs?

Answer 23

overall price changes depending on how much is consumed. A pricing strategy that is very common in the real world - gas, electric, telephone, charges, credit cards etc.
Similar to 3rd degree pricing because firms work out what optimise abnormal profit’s and charges that to all consumers.

Question 24

What are the outcomes for individuals in two-part tariffs?

Answer 24

for a individual the outcome can be identical to perfect price discrimination. This is also true if a market is created by perfect homogenous culture.

Question 25

What happens in real markets?

Answer 25

in real markets consumers are generally not homogenous so firms need to work out the optimum price to charge. Where different fees are not possible the firms works out what options abnormal profits and charges that to all consumers.

Question 26

What is limit pricing?

Answer 26

involves preventing new suppliers from entering the market by lowering product prices, boosting production levels and creating new circumstances that make it unprofitable for new providers to enter the market. Incumbents set a price that is low enough to discourage new firms from entering the market, but high enough to still be profitable, thus making barriers to entry.

Question 27

What is cost based/mark-up pricing?

Answer 27

producers derive a price by simply adding a certain percentage (mark up) for profit on top of average costs. The size of the profit markup will depend on the firms aims whether its aiming for high or even maximum profits or merely a target based on previous profit.

Question 28

How do you choose a level of output for cost based pricing

Answer 28

Average costs vary with output, if firms estimate that it will be working to full capacity, its average costs is likely to be quite different from that if it only works at 80 or 60% capacity. Typically base markup on SRAC.

Question 29

What is AVC like in the SR cost based pricing?

Answer 29

is a saucer shape, it falls as a result of diminishing marginal returns, flat range of AVC curve reflects the reserve capacity held by the business - this is the spare capacity the business can draw upon if needed e.g. product may be subjective to seasonal variation. Firms normal range of output is on the horizontal section of the AVC curve, this is the output within which the plant has been designed to operate and the business expects to be producing. AVC carry on falling as more is produced and so will ATC, AVC then remains constant with minimum AVC being reached, a point beyond the flat section of AVC curve. In practice many firms do not regard AFC in this way. Instead they focus on AVC and just add an element for overheads (AFC)

Question 30

How do you choose the mark up?

Answer 30

Most significant consideration is likely to be the implication of price for the level of market demand. If a firm could estimate its demand curve, it could then set its output and mark up levels to avoid a shortage or surplus. If a firm couldn't estimate its demand curve, them it could adjust its mark-up and output over time by a process of trial and error, according to its success in meeting profit and sales aims.

Question 31

What's a problem when choosing mark-up?

Answer 31

A problem is that prices have to be set in advance of the firm knowing just how much it needs to produce, firms usually base their assumptions about next years sales on this years figures add a certain % to allow for growth in demand and then finally adjust this up or down if they decide to change mark up. Multi-product firms have different mark-ups for their different products depending on their various market conditions - these firms will distribute their overhead costs unequally, most profitable will be least elastic demand and make the greatest contribution to overhead - if prices are constant but costs change, firms must be necessarily charge the size of the mark up.