4. Second degree PD

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From the course by National Research University Higher School of Economics

Industrial Organization: Strategy and Competition in Business

3 ratings

National Research University Higher School of Economics

Industrial Organization: Strategy and Competition in Business

3 ratings

Industrial Organization is the area of economics that studies the markets as institutions, the state of competition and strategic interaction among firms, the industrial policy and the business decisions firms make within the market framework. The course looks at the markets from three different perspectives: the economic theory, the applied business perspective and the institutional and legal perspective. The focus of the course is split equally between the economic theory and business perspective but there is a significant legal component incorporated in various topics. The course includes economic modeling, game theory, numerous real life examples and several case studies. We explore interesting topics of market organization such as negotiations, antitrust, networks, platforms, electronic markets, intellectual property, business strategies, predation, entry deterrence and many others. The basic objective of the course is to enable the student to understand the structure of markets and the nature of strategic competition. Knowledge in this course will be valuable for the students in acquiring managing and governance skills, enriching their understanding of the institutional framework of business, and improve their analytical ability in negotiations. Prerequisites: The course requires understanding of basic economic modeling, knowledge of intermediate microeconomics (especially production/cost theory), knowledge of basic concepts and methodologies of game theory, intermediate econometrics and basic calculus.

From the lesson

Price discrimination

The topic for this lecture is pricing. In general in economics, we are used in a paradigm in which firms set only one price for each of their products. Sometimes this is indeed the case but, often, we observe that firms charge different prices to different consumers or different occasions or different purchased quantities. In reality, when a firm has some market power and the consumers are each not willing to pay the same for every unit, the firm can price-discriminate to increase its profits. We will analyze the three degrees of price discrimination, tying, bundling and several other methods of advanced pricing. We will also present a brilliant pricing case study with Polaroid.

2. First degree PD12:04

3. Third degree PD6:27

4. Second degree PD10:42

Meet the Instructors

Kosmas Marinakis
Assistant Professor
ICEF and Faculty of Economics Sciences, HSE

The second degree price discrimination is the most interesting one.

Sometimes the seller knows that there are

different kinds of consumer but cannot tell them apart.

So, cannot separate the consumers into groups.

This would be very difficult because we do not know

which consumers to pick for one group and which to pick for the other group.

However, it is possible if you are smart enough

to discriminate to charge different prices by setting up

creating self-selection mechanisms and mechanisms that

will make consumers so that themselves they will choose the right group.

How does this happen?

You create different versions or different bundles or different sets of products so that

consumers by themselves will join the appropriate group

where they belong to voluntarily by themselves.

This is the critical difference between

the second degree price discrimination and the third degree price discrimination.

In the third degree you separate the consumers,

in the second degree consumers self select which group they will join.

Now, the natural question that you can ask is why should I join?

Why should I ever want to join the expensive group?

Wait a second and you will see why you might cover reasons to indeed join

the expensive group and why actually

you already have done that several times in your life.

So, the mechanisms have to be what we call in game theory separating,

meaning that every consumer should want to join

the group that is intended is designed is created for these specific consumers.

If they are not separating in other words they are pooling,

this means that all consumers will want to join one group,

so creating groups would be not working so nicely for you because

it means that you didn't create them

correctly or you didn't have sufficient reasons to create them.

So, mechanisms must be separating,

every consumer should join the group that is intended specifically for them.

Assume we have only two consumer types.

The enthusiasts, as I love to call them, and the usuals.

So, they will have some people that they like

the product more they are enthusiastic about

the product and some consumers that they just like the product as usual,

not that much, they will still buy it if it's in

the right price but they are not that crazy about this product.

Now, enthusiasts have a different demand than usual,

this is what separates the two groups.

So, if this is our graph about demands,

this would be the demand for usuals and this will

be the demand for enthusiasts, enthusiasts,

they like the product more and therefore their demand

is higher than the demand of the usual consumers.

Again, here we have an informational problem,

that the firm cannot tell if a consumer is E or U,

if he's an enthusiast or if he's a usual.

If it was up to you and they would just charge you different prices

by just asking you and you go into the store and they tell you,

''So, what are you?''

And I would say if I say that I'm enthusiastic which I am,

I'll have to pay a higher price, I'm a usual.

Okay, so you have reasons to not reveal your true type,

the firm will have to do something to take this information out of you voluntarily.

Let's see how this can work.

And we're going to use the two part tariff that we used before.

So, this means that consumers will pay

a participation fee plus a price for a unit that they will be charged.

First of all, notice and it's very crucial

it's a little tricky here so be very very careful now,

that if you have a single two part tariff but two different consumers,

it will be impossible to get the entire consumer surplus.

You cannot capture the entire consumer surplus anymore.

Now, you're going to capture just more than in monopoly but not all of it in any way.

So, we have two choices.

If we charge A to be equal to the surplus of the enthusiasts,

enthusiasts have a high consumer surplus which

means that the entry fee will be expensive.

If you do that, enthusiasts will join,

but usuals will not be able to join this market.

They will not be able or willing to pay S_E as a participation fee.

Your other option is to charge a participation fee and entry fee

equal to the consumer surplus of the usuals.

This means that everyone will be able to buy,

this will be cheap for enthusiasts,

enthusiasts will enter and they will also have

a surplus because they were willing to pay more,

but also now, your usuals will be able to join.

These are the only two alternatives that you have.

If you charge any A between these two S_E and S_U,

then this is an irrational choice because you're just losing profit.

There's no reason for you because they are no different consumers,

consumers are no different,

like gradually different, consumers are of just two different types.

You either charge the high surplus or the low surplus,

any surplus in between is just waste of money for you.

So, if the demands of the two different groups,

the enthusiasts and the usuals are far apart,

they're separated a lot,

this means that the surpluses that these two groups will have,

they will be much much different also.

In this case, you may need to proceed by not serving the market of usuals at all.

And this is because in order to price in the usuals,

you will have to drop your participation fee very

low and you will lose a lot of money from the enthusiasts.

So, if you don't want to do that and probably if are sufficiently far apart,

the two demands, you will want to just serve one group,

do not price discriminate at all.

The other group will see the expensive price and will just not join by itself.

In this case, you will set the price equal to the perfectly competitive price equal to

the marginal cost because you are already

capturing the entire surplus of your enthusiasts.

Now, if the consumer types are very similar and

the demand curves of the two groups are close together,

then in this case, you might say wait a second they're not that different so

maybe with just going a little bit

lower and charging a higher unit price

but going a little bit lower with my participation fee,

I will be able to price in everybody.

So, we'll have more customers if

my cost structure and everything is allowing for that then to

have the capacity why not for going for for more customers.

So, this would be a profit maximizing solution.

So, if the consumer types are similar,

then we may want to charge a little higher price than marginal cost,

and then A will be equal to the surplus of the usuals,

so everybody can be priced in.

Natural question again, how is this price discrimination?

Why is it price discrimination?

Why? They do not have different prices.

You end up charging

one single two part tariff same participation or

entry fee for everybody and same unit price for everybody.

How is this price discrimination?

You do not have different prices per group.

The entry fee is cheaper for if you want to serve both kinds.

So, you will go with S_U which is smaller than S_E.

And you'll price little more than marginal cost if you decide to serve both of them.

So, enthusiasts will end up paying more,

and the reason is that they will buy higher quantities as usually.

So, they effectively will pay

a lower average price because the participation fee will be split among more units,

but in the end,

their total expenditure for the product will be

higher because the price is higher than the marginal cost.

On the other hand,

usual consumers buy less therefore

effectively they pay a higher average price because the participation fee will be

divided among less units and then overall they will end

up to have lower expenditures so they will be able to afford to buy some of the product.

Stay with us because now,

we have a very interesting case about

the Polaroid instant cameras and how they change the world of photography,

not because of the invention but because of the genius pricing method that they applied.

Just stay with us.

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