Q1. Is price discrimination socially desirable?

Discuss

When we were young, did we ever order from the children's menu in a restaurant? When a
family with small children goes to a restaurant, they are often given a children's menu in addition
to the regular menu. If they order two similar items, one from each menu, they will find that the
item ordered from the children's menu will be a bit smaller, but its price will be much smaller. In
fact, it would often be worthwhile for the entire family to order from the children's menu, but
they cannot. Restaurants usually only allow children to order from it.

Why do restaurants use children's menus? Economists doubt that restaurant owners have a
special love for children; they suspect that the owners find offering children's menus to be
profitable. It can be profitable if adults who come to restaurants with children are, on the
average, more sensitive to prices on menus than adults who come to restaurants without children.
Children often do not appreciate restaurant food and service, and often waste a large part of their
food. Parents know this and do not want to pay a lot for their child's meal. If restaurants treat
children like adults, the restaurants may lose customers as families switch to fast-food
restaurants. If this explanation is correct, then restaurants price discriminate.

A seller price discriminates when it charges different prices to different buyers. The ideal form of
price discrimination, from the seller's point of view, is to charge each buyer the maximum that
the buyer is willing to pay. The case, wherein the marginal revenue curve becomes identical with
the demand curve. The seller will sell the economically efficient amount, it would capture the
entire consumers' surplus, and it would substantially increase profits.

Price discrimination exists when sales of identical goods or services are transacted at
different prices from the same provider. In a theoretical market with perfect information, no
transaction costs or prohibition on secondary exchange (or re-selling) to prevent arbitrage, price
discrimination can only be a feature of monopoly and oligopoly markets, where market power
can be exercised. Otherwise, the moment the seller tries to sell the same good at different prices,
the buyer at the lower price can arbitrage by selling to the consumer buying at the higher price
but with a tiny discount. However, market frictions in oligopolies such as the airlines and even in
fully competitive retail or industrial markets allow for a limited degree of differential pricing to
different consumers. Price discrimination also occurs when it costs more to supply one customer
than it does another, and yet the supplier charges both the same price.

The effects of price discrimination on social efficiency are unclear; typically such behavior leads
to lower prices for some consumers and higher prices for others. Output can be expanded when
price discrimination is very efficient, but output can also decline when discrimination is more
effective at extracting surplus from high-valued users than expanding sales to low valued users.
Even if output remains constant, price discrimination can reduce efficiency by misallocating
output among consumers.
Price discrimination requires market segmentation and some means to discourage discount
customers from becoming resellers and, by extension, competitors. This usually entails using one
or more means of preventing any resale, keeping the different price groups separate, making
price comparisons difficult, or restricting pricing information. The boundaries set up by the
marketer to keep segments separate are referred to as a rate fence. Price discrimination is thus
very common in services, where resale is not possible; an example is student discounts at
museums.

Price discrimination can also be seen where the requirement that goods be identical is relaxed.
For example, so-called "premium products" (including relatively simple products, such as
cappuccino compared to regular coffee) have a price differential that is not explained by the cost
of production. Some economists have argued that this is a form of price discrimination exercised
by providing a means for consumers to reveal their willingness to pay.

Since price discrimination is potentially profitable, businesses have found many ways to do it.
Theaters often charge younger customers less than adults. Doctors sometimes charge the rich or
insured patient more for services than they charge the poor or uninsured. Grocery stores have a
lower price for people who bother to check the newspaper and clip coupons. Some companies,
such as firms selling alcoholic beverages, produce similar products but try to promote one as a
prestige brand with a much higher price. Electric utilities usually charge lower rates to people
who use a lot of electricity (and thus probably have electric stoves and water heaters) than they
do to those who use only a little electricity (and who probably have gas stoves and water
heaters). Banks offer special interest rates on Certificates of Deposit (CDs) that will not be
obtained when one lets a CD roll over. People who are more sensitive to interest rates will take
the time and effort to personally renew each maturing CD.

To the extent that businesses find ways to price discriminate, they eliminate the triangle of
welfare loss and approach the economically efficient amount of production. Thus, the mere
existence of monopoly does not prove there is economic inefficiency.

“Perfect price discrimination would be socially desirable, but rarely practical.” “Third
Degree price discrimination is common practice, but socially undesirable.”
Perfect price discrimination is when every consumer is charged precisely what she values the
good, i.e. she is indifferent between buying the good and not. If it is possible and does not
Incur substantial transaction costs, every firm with some degree of monopoly power – i.e.
Downward-sloping demand curve – will want to exercise it since it would allow the firm to
turn the consumer surplus into producer surplus.
It is easy to see the benefits of perfect price discrimination on monopolistic markets. Innovations
would be implemented throughout the market instantly without the need to sell basic
versions of software, processors and digital cameras with intentionally lower quality. Markets
would be just as efficient as in perfect competition, producing where marginal cost equals
price.
The determinants of price discrimination are thus availability and cost of information and
transaction costs. The first determinant is often more important but we see examples also of
the other, e.g. in the difference between retailing in developed and developing countries.
Third world street vendors find it worthwhile to negotiate with the customer to find out how
much she values the good. In the industrialized world, wages are higher and in most cases it is
not profitable to use time to try to find out the consumer’s preferences. The costs of obtaining
this information is of course raised by the fact that the consumer has every incentive to pretend
she wants the product less than she actually does, e.g. by starting to leave the store.
Third degree price discrimination, also called direct segmentation, is when groups of consumers
are charged different prices. It is so common that it is seen as natural by the public that
children, students, conscripts and pensioners pay less for many services. Many non-profit
organizations,
e.g. government transport monopolies and organizations charging membership
fees, also use third degree price discrimination, implying that there are other reasons behind
the practice than pure economic.
As Tim Harford notes1, direct segmentation is always an improvement if it opens new markets
without influencing the old markets. His example is drugs sold at discount in developing
countries. He also gives examples of where third degree price discrimination is unambiguously
inefficient – where a train seat is worth more to a worker than to a student, but the student
gets the seat because of indirect segmentation.
Nothing conclusive can therefore be said, although we would expect indirect segmentation to
be less frequent when markets are working better and monopoly power limited. In most cases,
we would not expect third degree price discrimination to be present in well functioning markets.
Perfect price discrimination is desirable with the important reservation that the consumer surplus
is turned into producer surplus. A normative evaluation of this redistribution is not within
the field of economics. We can also conclude that it is almost impossible to practice in reality
because of the consumer incentives and high costs involved.

Q2. In the absence of information, individual rationality leads to group sub-optimality.

Discuss.

In case of industries which follow oligopoly structure, there is a wide application of a theory
known as ‘Game Theory’. It is a theory of rational behavior in interactive decision-making
problems. The outcome depends not only on the choices made by one player, but also on what
other players choose to do at the same time. The game consists of specified interactive playing
field, a specification of all possible courses of action, and a schedule of the payoffs to each of the
players under all possible outcomes. Players plan their own courses of action in order to
maximize their expected payoff, under the knowledge that the other players are trying to do the
same. A player’s strategy is a complete specification of the action to be taken in response to
outcomes that are discovered as the game proceeds. One player’s payoff from choosing a
strategy depends on what the other players do, but players cannot make binding agreements with
each other.

Given all the players’ strategies, there will be a set of possible outcomes to the game. These
determine the payoffs for each of the players. A specific outcome is called equilibrium. There is
circularity to the problem that has to be solved, as in order to select his or her best strategy, a
player must know what other players will do, but they in turn are in the same position.

The best solution of the game, which would be called co-operative solution, is for everybody
to reveal their true strategy. But incase where the strategy of other player is not known
there is a possibility that the optimal solution is not arrived at. Thus, each choosing a
strategy of avoiding a worst possible outcome leads to a solution, but one that is not best that
could be achieved for all concerned.

When game theory is applied to oligopoly, the players are firms, their game is played in the
market, their strategies are their price/output decisions, and the payoffs are their profits.

Example:

The oligopolist’s dilemma: to

co-operate or compete
A’s output
(payoff matrix)
One-half Two-thirds
monopoly output monopoly output
monopoly output
One-half
B’s output

20, 20 15, 22
Two-third

22, 15 17, 17

In the above figure, the basic dilemma of oligopolists is shown for the case of a two-firm
oligopoly. Each firm can produce an output equal to either one-half of the monopoly output (the
passive strategy) or two-thirds of the monopoly output (the aggressive strategy). Passive strategy
amounts to tactic co-operation while the aggressive strategy is clearly non-cooperative.

A’s production is indicated across the top, and its profits (measured in millions of Rs.) are shown
in red within each square. B’s production is indicated down the left side, and its profits are
shown in green within each square. For example, the top right square tells us that if B produces
one-half, while A produces two-thirds, of the output that monopolists would produce, A’s profits
will be Rs. 22 million, while B’s will be Rs. 15 million.

If A and B co-operate, each produces one-half the monopoly output and earns profits of Rs. 20
million, as shown in the upper left box. In this ‘co-operative solution’, either firm can raise its
profits by producing two-thirds of the monopoly output, provided the other firm does not do the
same.

Strategic behavior:

Suppose that firm A reasons as follows: if B produces one-half of the monopoly output and if A
do the same, it receives a profit of 20, but if it produce two-thirds of the monopoly output, it
receives 22.

If B produces two-thirds of the monopoly output, A produces one-half of the monopoly output, it
receives a profit of 15, whereas if it produces two-thirds, it receive 17. Clearly, A’s best strategy
is to produce two-third of the monopoly output in either case. B will reason in the same way. As
a result they end up by jointly producing one-and-a-third times the monopoly output, where each
earns a profit of 17.

In this type of game, the non-cooperative equilibrium makes both players worse off than if
they were able co-operate. Here the individual maximization does not always lead to an
optimum allocation of resources.

Thus, the game theory shows that in the absence of information, individual rationality leads to
group sub-optimality.

ICFAI UNIVERSITY, DEHRADUN

 STUDENT NAME Amrita Sharma

IUD NO 0901203084

IBS NO 09BS0003084

SECTION SECTION C

COURSE CODE: SLEC-501

COURSE NAME: MANAGERIAL ECONOMICS

FACULTY NAME: ASHISH DASH

DATE: 14-SEP-2009

No Assignment-1 Marks

Q1. Is price discrimination socially desirable? Discuss

7.5

Q2.S In the absence of information, individual rationality leads to

group sub-optimality. Discuss.

7.5

STUDENT SIGNATURE FACULTY SIGNATURE