Lecture 16 - April 26: Perfectly competitive markets
Ability of firm to price discriminate depends on what he knows about his consumers
First-degree • Monopolist knows exact willingness-to-pay of all consumers
• Can prevent arbitrage
Second-degree
• Monopolist has no observable signals.
• By selecting a product that is best for them, consumers reveal their type
Third-degree • Monopolist can discriminate based on observable characteristic
First degree
• Perfect price discrimination
• Each unit of product sold to consumer who values it most @ maximum price consumer is willing to pay
• Firm will appropriate entire consumer surplus
• Efficient quantity is achieved = no deadweight loss
• Infeasible is it
Pharmaceutical incentives (drugs vs vaccines)
• Investment in medicine continues to be one of biggest challenges in regulation
• Incentives for research, development, infrastructure are important o Vaccines & drugs involve huge fixed costs + low variable costs
o Academic research is useful for early stages of drug development but not for clinical trials and deployment
o Positive externalities in production
• On the other hand, patents can have large distortionary effects property rights
• Lobbying is rampant
• High investments in direct to consumer and doctor advertisement
• Skewed incentives for pharmaceutical research
• Development of drugs for developing countries is particularly skewed o Property rights aren’t always maintained across borders o Poverty implies low margins
• Incentives have led to extremely low expenditures in R&D on diseases specific to developing countries
• Between 1995-1997 there were 1223 patents for new drugs
• 13 of these were for tropical diseases.
Only 4 of these 13 were a result of explicit research
In developing countries, vaccines have proven to be far more effective than drugs in eradicating disease
• 75% of children are given a standard set of cheap, off-patent vaccines
• Vaccines are easier to administer – doctors don’t need to administer them However, vaccines are under-provided
• Global marketplace for drugs exceeds $300 billion, whereas worldwide vaccine sales were only about $5 billion
• Why? There are lots of answers, but a striking one emerges when thinking about first-degree price discrimination
Example 1 Homogeneous population
• Suppose population = 1000 people.
• Each has 50% chance of catching the flu
• If 1 person catches the flu, they would be willing to pay $100 to take a drug to eliminate symptoms
• A pharmaceutical company can make a drug or vaccine
• Each involve same variable cost of $0 per dose constant MC = 0 Which should firm choose?
Profit from drug:
• 50% of 1000 = 500 people will get sick on average = Each will pay $100
• Revenue =500 × $100 = $50 000 Profit from vaccine:
• Each person would pay up to $50 for vaccine
• At this price all 1000 people will pay for $50 vaccine
• Revenue = 1000 people × $50 = $50 000
In this example, future economic profit is same. So, company can choose whichever has lowest expected R&D cost
Example 2 Heterogeneous population
• Suppose population = 1000 people
• Different people have different chance of getting the flu
• 100 people have a 10% chance
• 100 people have a 20% chance
• ...
• 100 people have a 100% chance
Firm does not know who is whom, thus can only set a uniform price Should firm produce a vaccine or a drug?
Profit from drug
• (10% × 100 people) + (20% × 100 people) + . . . (100% × 100 people) = 550 people will get sick
• Each will pay $100
• Revenue = 550 people × $100 = $55 000 Profit from vaccine charge uniform price
• For any price only people with flu probability p with price below 100p will buy
• Best price = $50
• Revenue = $30,000
• In case of the drug, everyone who gets sick is the same.
o This is just like first-degree price discrimination
• In the case of the vaccine, everyone is different and the firm is unable to tell the difference
• Based on this simple concept, drugs can better extract surplus from consumers i.e.
the potential revenue generated by a drug is higher than that by a vaccine
Third-degree price discrimination
• Firm identifies different groups of consumers from observable differences in demand
• Firm sells same product to different groups @ different prices
• For example, consumers have different willingness-to-pay by age, gender, location
• Firm must be able to prevent arbitrage (resale from low-price to high-price market)
Second-degree price discrimination
• Per unit price of product will depend on quantity/quality of product sold
• Because consumer with high WTP can always pretend to be the low WTP consumer
• Firm must design a suite of prices that gives consumers an incentive to self-select accordingly
• Firm must reduce quantity/quality offered to low WTP consumers so as not to cannabalise sales at the high end
• An example of adverse selection or screening model Revelation principle
• Pricing scheme must be designed => consumers self-select quality & price package designed for them
• Choice of bundle reveals true type of each individual in market Trade off
To design optimal bundle, seller has to compromise, trading off gains in high WTP market with losses in low WTP market
Different classes of air travel
Suppose 500 leisure passengers and 100 business passengers
Uniform price
If airline offers single class of travel at one price which option is profit-maximising?
Second degree price discrimination Economy class + Business class
• Business traveller for economy seat has surplus ($4500 - $2000) $2500
• Reduce business traveller for business seat for ($10000-
$2500 surplus) at $7500 so they are indifferent
Suppose now airline can change economy class to misery class by shrinking seat space, slowing down check-in, reducing airline miles, and making working in economy difficult
Will airline offer economy or misery class?
Second degree price discrimination Misery class + Business class
• Business traveller for misery seat has surplus ($3000 - $1800) $1200 surplus
• Reduce business traveller for business seat for ($10000- $1200 surplus) at $8800 so they are indifferent
Information rents
• Ability of business class flyers pretend to be a different “type” ensures that they receive positive rents •
• Monopolist needs to “bribe” consumers to induce them to reveal private information about type
• Info is main weapon consumers have in maintaining consumer surplus
• Firms do many things to try to extract info about type & information rents o Product and menu design
o Frequent shopper cards
o Browser and Facebook scraping
When a menu of goods are offered, we usually see following
• Products intended for buyers with low WTP will often be designed to be inferior to reduce temptation of high-value buyers from purchasing them
• Products intended for buyers with high WTP will have to perfectly match characteristics these consumers desire
• Buyers with low WTP receive no surplus from trade fully appropriated
• Buyers with high WTP will receive information rents’
E. Game theory