Price Discrimination And Competition

Price discrimination, according to Hal R. Varian (2014, p480), is a more efficiently way of setting prices by selling goods or services to different consumers with different prices. As a monopoly behavior, it has been discussed by economists with lots of experiments. This paper will firstly illustrate how firms gain from price discrimination followed by the evaluation of the effectiveness of three practices of price discrimination: coupons, bundling, and discounts with some empirical evidence. And then discuss the competitive price discrimination outside the monopoly market and the welfare effect of it.

There are three degrees of price discrimination.

And generally speaking, firms gain from price discrimination since this can reduce consumer surplus. As the graph shows below, taking the first-degree price discrimination as an example, suppose that the original price without discrimination is at P0, the the area A is the consumer surplus (the difference between the willingness to pay of consumers and their actual payment) and area B is the producer surplus.

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If first-degree price discrimination is applied, producer surplus will now be represented by the sum of the area A and B. Similar result can be found for other degree price discrimination as well though consumer surplrs may not be eliminate entirely. There are many particular devices of price discrimination and three of them will be evaluated below.

Coupons, which allow holders to purchase products or goods for free or with lower price, can be identified as an example of the third-degree price discrimination. From the perspective of consumers, according to Narasimhan (1984), there is a trade-off between savings and opportunity costs, for example, time spent on organizing the coupons, of using coupons.

Thus, an assumption that people with higher price sensitivity are more likely to use coupons. In other words, firms can discriminate between customers with higher or lower price elasticity. To maximize their overall profits, as Varian (2014, p488) mentioned, the marginal cost must equal to the marginal revenue in markets of both groups. Therefore, for a firm that price discriminates, a lower price should be set for the group of consumers with higher price elasticity than consumers with lower price elasticity.

However, the analysis about demand elasticity above is only based on the opportunity cost of using coupons. Actually, there are many other factors that may influence the demand elasticity and reasons of using coupons, for example, the taste difference.

Nevo and Wolfram (2002) have tested the relationship between coupons and shelf prices of cereal, using the data of 23350 observations of 25 brands in 51 to 65 cities over 16 quarters from 1989 to 1992. The result represents a negative relationship between coupons and shelf prices, and suggest that usage of coupons is driven by three factors, including strategies interaction between manufactures, incentives of decision maker of coupons as well as the effects on repeat purchase by using coupons.

Another way of price discrimination for monopolist is bundling, a kind of second-degree price discrimination, offering related products in packages for sale together (Hal R. Varian, 2014, p492). A common example is the meal deals in most restaurants and there is a more typical case, Microsoft, who bundled its operating system (Windows) with the Microsoft Media Player. Varian (2014) mentioned several reasons for firms to use this strategy.

[image: ]One of the main reasons is that, in terms of consumer behavior, bundling may increase the net revenue and thus more profit. Taking the meal deals as an example, assume the willingness to pay for two consumers are like the table shows below. Since the price of goods depends on the consumers with lowest willingness to pay, without bundling, the maximum total revenue of selling both goods to these two customers can be 500p (selling sandwich at 150p and soft drink with price 100p). While if the seller bundles sandwich with soft drink, total willingness to pay for consumer 1 will be 270p and that for consumer 2 will be 300p, so that the seller can sell the two goods in a bundle at a price of 270p, leading to a significantly higher net revenue at 540p. Apart from higher revenue, other reasons like saving the costs, such as storing fees, or complementarities may also lead to the choice of bundling.

However, the bundling strategies is a kind of abuse of market dominance when a firm which is enjoying benefits of monopoly in one market transfers its market power to another market (Hinloopen, Muller and Normann, 2014). They designed a model with one firm in monopoly market competing with another firm in duopoly market, using quantity of demand at 54 and a constant marginal cost at 4, repeated over 15 periods. And the result shows that bundling have little effect on the multi-product firms but reduces the profits for the single-product firm significantly.

Furthermore, the effect of bundling is depended. For example, Timothy and Vineet (2013) have tested the data for video games, and the result shows a significant loss of revenue by at least 35% for pure bundling compared with mix bundling.

There are many different types of discounts, for example, bulk discounts, the discounts apply on multiple purchase across the same products or different products, which works quite similar to bundling. Another type of discounts is provided for certain group of people. One of the most common examples is the student discounts. This is also a kind of third-degree price discrimination, distinguishing consumers by the price elasticity as well simple through their occupations. Obviously, in most cases, students are likely to be more price elastic and have lower willingness to pay compared to workers, so that providing student discounts can attract more students to consume the goods. The total revenue will then increase due to the larger amount of goods consumed by student.

Yet the discounts as a device of price discrimination may not always be effective. A study of advance purchase discounts and clearance sales has been taken by Moller and Watanabe (2010). They proposed a two period models where the demand is uncertain in the first period – the advance purchase period, and the uncertainty is resolved in the second period – the consumption period, with a monopolistic seller. Taking this study as an example, the price changed over time due to the uncertainty of consumers’ demand. The result of their model shows that advance purchase discounts, as a form of price discrimination, may be inefficiency in markets where ‘temporal capacity limits are difficult to implement, marginal costs of capacity are low but sufficiently increasing, prices can be committed to in advance, resale is feasible and rationing is random rather than efficient’ (Moller and Watanabe, 2010).

Currently, there are increasing interests in the competition that may be taken by the price discrimination in non-monopoly market and the welfare changes of firms due to the increase in competition. Generally speaking, the price discrimination can lead to more competition outside the monopoly cases and is likely to be harmful to the profits of the firms but beneficial to some consumers.

In reality, monopoly seems to be impossible, and a market is more likely to be imperfect competition. Thus, the price discrimination may be affected by the interaction of the rivals of a firm in the market. If one of the firms in a market price discriminate through, for example, providing discounts as I mentioned in section 2, then it will definitely attract some of the consumers who shop only on price in the market regarding any other factors. So that to compete with the firm, their rivals have to cut their price as well, and consequently, this will lead to the price war in the market. So that the price discrimination of one firm in a market can result in an escalation in the competitions. And if firms can gain from this price discrimination, more potential competitors may enter the market. Furthermore, this price war may also lead to an improvement in the efficiency of production as the firms may need to reduce the costs during the production in order to offset the reduction of price that may occur during the price discrimination though this may also lead to a decrease in quality of goods and consumers may suffer.

However, Matthias and Johannes (2019) have also argued that the competition cased by price discrimination may be inefficiency in terms of capacity constraints. They mentioned that for spatial price discrimination, more distant firms with higher costs may serve the intermediate customers even though there are free capacity for lower costs firms.

Under the competitions caused by price discrimination, in most cases, all the firms will be suffered. Taking the retail market as an example, two types of consumers can be found with different preference of quality. Suppose that there are only two firms with constant marginal costs in this market, one produce goods with higher quality and the other lower quality, consumption choices of ‘cheap consumers’ will then only depend on price and that of the other group will vary in the preference for the quality of goods. Then, if price discrimination is applied, firm producing goods with lower quality will be monopolist to market with ‘cheap consumer’, according to Kenneth S. Corts (1998), prices will be lower than the equilibrium price and leading to an all-out competition for firms but higher consumer welfare. Moreover, profits gained by firms may decrease as well compare to the uniform-price equilibrium.

The result above is under the assumption of best-response asymmetry, in other words, firms take advantage in different markets, but similar result can come out even in more general cases. However, if the firms are best-response symmetry, ranking the same group of customers as their strong market, as Kenneth S. Corts (1998) mentioned, price discrimination will lead to a rise in equilibrium price in strong market but a reduction in weak market. So that certain group of consumers will be benefited and the other will be worse off. And the profit to firms will be ambiguous as the revenue of the firm may depend on the quantity they sell or in other words, depend on the price elastic of their consumers.

As a result, monopolists can always benefit from price discrimination as section 2 shows, while firms that are not in the monopoly market may worse off due to the price discrimination.

Although the price discrimination can intensify competition at the beginning, firms may try to avoid the price discrimination when they are worse off. One of the effective solutions may be commitment of not to discriminate, for example, the EDLP policy mentioned by Kenneth S. Corts (1998), and this may soften the competition between firms again.

Price discrimination seems to be a common way for monopoly markets to raise profits through different devices including coupons, bundling and discounts, but they are not always effective. And in a competitive market, such as oligopoly market, firms may try to avoid price discrimination since in most cases, it will lead to lower profits but higher consumer welfare for certain group of consumers. In conclusion, monopolists are always better off from the price discrimination but firms in imperfect competitive market may prefer uniform-equilibrium price since it may be more profitable than price discrimination.