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Managerial Economics, 8e
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Chapter 9
Managerial Use of Price Discrimination
Chapter Review
Managers practice price discrimination either when they sell physically identical products at different prices or when similar products are sold at prices with different ratios to marginal cost. The strategy works best in markets with various classes of buyers who are differentiated by different price elasticities of demand; where segments can be identified and segregated with relatively low costs (lower than the added expected revenue); and where markets can be sealed so goods cannot be transferred easily from one class to another. Once managers choose a discriminating strategy, they maximize profit by allocating outputs across markets so the marginal revenues are equal to each other and to the total marginal cost. This is called third-degree price discrimination. Managers use second-degree price discrimination when they can price increments of output at different rates, usually charging higher rates for initial increments of output, then lower rates as consumption increases. First-degree price discrimination entails pricing goods at the reservation price of each consumer. This practice captures the entire consumer surplus and converts it to producer surplus or variable-cost profit. It is the strategy of first choice because of this. However, it is difficult to estimate each consumer's reservation price, and this scheme is more costly to implement than the other degrees of price discrimination.
Two-part tariffs are a strategy to enable managers to use first-degree price discrimination. This pricing strategy has managers charge the consumer an "entry" fee for the right to pay a "use" fee to actually purchase the product. In the simplest case, where all demanders are the same, the optimal use fee is the marginal cost of the product and the entry fee is the consumer surplus available when that use fee is charged. If consumers have different demand curves, managers may exclude weaker demanders from the market and follow the preceding rule with the stronger demanders. On the other hand managers could include all demanders by pricing the use fee at or above its marginal cost and choosing an entry fee equal to the resulting consumer surplus of the weak demander. Managers, who practice price discrimination on the entry fee, while charging all consumers the marginal cost as a use fee, realize the maximum profit.
Consumer preferences tend to show temporal variation (by day, week, or season). To account for these variations in temporal behavioral, managers many times charge high prices during the peaks and lower prices during the troughs (as opposed to a single price across the whole temporal cycle). The rule for managers to optimize price is to set the relevant marginal revenue equal to marginal cost.