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Chapter 12
Pricing and Advertising
Chapter Outline
12.1 Conditions for Price Discrimination
Why Price Discrimination Pays
Which Firms Can Price Discriminate
Application: Disneyland Pricing
Preventing Resale
Application: Prevent Resale of Designer Bags
Not All Price Differences Are Price Discrimination
Types of Price Discrimination
12.2 Perfect Price Discrimination
How a Firm Perfectly Price Discriminates
Graphical Analysis
Calculus Analysis
Solved Problem 12.1
Perfect Price Discrimination Is Efficient but Harms Some Consumers
Application: Botox Revisited
Transaction Costs and Perfect Price Discrimination
Application: Google Uses Bidding for Ads to Price Discriminate
12.3 Group Price Discrimination
Group Price Discrimination with Two Groups
DVD Example
Prices and Elasticities
Application: Smuggling Prescription Drugs into the United States
Solved Problem 12.2
Identifying Groups
Application: Buying Discounts
Solved Problem 12.3
Welfare Effects of Group Price Discrimination
Group Price Discrimination Versus Competition
Group Price Discrimination Versus Single–Price Monopoly
12.4 Nonlinear Price Discrimination
12.5 Two–Part Pricing
Two–Part Pricing with Identical Consumers
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Two–Part Pricing with Differing Consumers
Application: Pricing iTunes
12.6 Tie–In Sales
Requirement Tie–In Sales
Application: IBM
Bundling
Pure Bundling
Mixed Bundling
12.7 Advertising
Deciding Whether to Advertise
How Much to Advertise
Solved Problem 12.4
Application: Super Bowl Commercials
Teaching Tips
Chapter 12 continues the presentation of monopoly models but switches emphasis to price–setting
behavior. The material on price discrimination is worth covering in detail for several reasons. First, students
generally find the topic quite interesting, as they are aware of some types of price discrimination but
haven’t thought about them much (e.g., movie ticket prices) and are completely unaware of other types
(such as dry cleaning prices). Also, price discrimination is an effective way to emphasize the importance
of market power—for example, by comparing a monopolist charging a single price to the same firm
practicing a perfect price discrimination. Finally, it is a good topic for generating class discussion. If you
challenge the class to come up with illustrations of price discrimination, they sometimes will raise new and
interesting examples. When discussing the conditions necessary to price discriminate, you might emphasize
the ability to prevent resale. Finally, be sure that the class understands that price differences that result
from cost differences are not price discrimination.
Section 12.5 on two-part prices and Section 12.6 on tie–in and bundled sales are topics where the class
should be able to take the lead in providing examples. Although they are often simply another tool for
firms to extract consumer surplus, two-part tariffs and tie–ins do not seem to provoke the same reaction
as price discrimination. This may be the case due to the pro–efficiency effects of many bundled products
(such as tires and cars). On the other hand, the Internet browser offered by Microsoft as part of the
Windows package evoked strong debate over what constitutes a separate but bundled commodity, and
what should be considered an integral part of the original commodity. As an exercise, you might ask the
class to draw up a set of guidelines that regulators should follow when deciding if a product bundle
increases efficiency or is a source of monopoly rents.
The last section covers advertising. You might want to discuss that in the case of advertising, what matters
is if consumers believe that there is a meaningful difference between products rather than whether the
products are meaningfully different or not. For example, beer makers spend enormous sums of money on
advertising in an attempt to convince consumers that their product has a unique taste. The uniqueness is
largely a perceived one, however, as most consumers cannot identify “their” brand in taste tests. If you
have time, a fun classroom experiment is to demonstrate this result using soda. You will need to poll the
class to see if they prefer diet or regular soda as a group. Then buy three or four types of cola and have
students try to identify their brand (which they preidentify by writing it on a 3 × 5 card) using unmarked
cups. Students have great confidence in their abilities to identify brands but are not usually very successful.
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Additional Applications
Gasoline1
Because only firms with market power can price discriminate, price discrimination is not observed in
competitive markets. It may be possible, however, to price discriminate in monopolistically competitive
markets. If retail gasoline stations are monopolistically competitive rather than purely competitive, they
may be able to price discriminate. Borenstein (1991) finds that they do discriminate. The difference
between the price and marginal cost is greater for unleaded than leaded gasoline.
The residual demand elasticity that a station faces depends on the market elasticity of demand for gasoline
and the willingness of consumers to switch stations. If a gas station raises its prices, some customers may
buy less gasoline while others may switch to another dealer. Those customers who cut their purchases
are treating the gas station like a monopoly. The customers who switch dealers view the various dealers as
substitutes for each other. Gas stations have markups that range from 5 percent to 10 percent above
marginal cost, which implies that they face elasticities of –10 to –20. These elasticities are much greater
than the price elasticity of demand for gasoline, which is less than –2. Thus the residual elasticity facing a
station appears to be primarily determined by the willingness of customers to switch dealers.
Buyers of leaded gasoline are likely to differ from purchasers of unleaded. In the earlier 1980s, many cars
still burned leaded gasoline. At that time, consumers who purchased unleaded were wealthier and more
likely to use credit cards for their purchase, which made them less willing to switch stations. Since 1986,
however, many stations have stopped carrying leaded gasoline, increasing the average distance between
sellers. As a result, it became more costly for a purchaser of leaded gas (but not unleaded) to switch dealers,
and the dealers’ market power over buyers of leaded gas increased relative to their power over buyers of
unleaded. These factors explain why the markup of price over marginal cost for regular unleaded increased
relative to leaded until 1986 and then decreased thereafter.
1. Do you think that the “pay at the pump” technology employed by some companies is an effort to save
on labor costs or decrease demand elasticity?
2. What would you predict about the elasticity of demand for diesel fuel for automobiles? Why?
Ethnic Pricing on Airlines2
“Ethnic pricing” is a form of price discrimination that has long been practiced both in developing countries
and Europe. Under ethnic pricing, individuals of some nationalities are able to purchase airline tickets at
a substantially lower cost than others. Remarkably, this includes individuals who are married to one another.
Brendan McInerney and his Japanese wife wanted to fly from Frankfurt, Germany, to Osaka, Japan, for
Christmas in 1997. Although they were both able to buy tickets in the same level of seating on the same
Lufthansa flight, Mr. McInerney was initially charged 2,700 marks, compared to the 1,700 marks charged
to his wife. The sole reason for the price difference was their ethnicity. She is Japanese; he is not. Although
illegal in Germany, the practice appears to be fairly commonplace there. Airline industry experts note that
the agencies that receive the complaints have no police power to stop them. McInerney eventually received
the same fare as his wife after complaining. “In America, this is called racial discrimination,” he protested.
1Severin Borenstein, “Selling Costs and Switching Costs: Explaining the Retail Gasoline Margins,” Rand Journal of Economics
22(3), Autumn, 1991: 354–369.
2Brandon Mitchener, “‘Ethnic Pricing’ Means Unfair Air Fares,” Wall Street Journal, December 5, 1997: B1, B14.
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The policy was apparently designed to allow guest workers (a generic term for an individual not working
in his or her home country) the opportunity to visit relatives back home. The fares were only available on
request through specified travel agencies that had made special deals with the air carriers. Some examples
appear below.
Airline
Route Normal Price “Ethnic Price”
Lufthansa
Frankfurt–Tokyo $1,524 $960
Lufthansa
Frankfurt–Seoul
$1,524
$903
British Airways
Istanbul–London $ 385 $199
Lufthansa officials did not deny that such pricing occurs, but claimed that they resorted to it only to match
the prices of other airlines that were doing the same thing. The British Airways special was called the
“Ho Ho Ho Special” for British citizens in Turkey. With a British passport, the airfare was reduced 48
percent. U.S. air carriers also practiced ethnic pricing until 1988, when official U.S. Department of
Transportation policy finally banned it.
1. Should it still be considered price discrimination if the tickets based on ethnicity are cheaper and not
more expensive?
2. How is this practice different from senior citizen discounts in the United States?
Discussion Questions
1. Give some examples of markets where products differ physically, but consumers treat the products as
nearly perfect substitutes.
2. Give some examples of where products do not differ physically, but consumers treat the products as
imperfect substitutes.
3. Why might an individual be strongly opposed to racial or gender-based discrimination, but not
opposed to the type of price discrimination discussed in this chapter?
4. Should the government permit price discrimination? Under what circumstances?
5. U.S. firms may discriminate against consumers, but not other firms. Can you think of a justification
for treating these two types of buyers differently?
6. Many economists argue that laws prohibiting price discrimination were designed to protect small
businesses from paying higher prices than large businesses. Why might the government want to
protect this group? Should this law be changed?
7. Should the U.S. government enforce export restrictions on software by anyone other than the
manufacturer? (Such restrictions would allow U.S. firms to charge higher prices than in the domestic
market by preventing resales.)
8. Does the sale of personal seat licenses (“psls”), wherein fans pay large up-front fees for the right to
purchase season tickets, constitute price discrimination?
Additional Questions and Problems
238 Perloff • Microeconomics: Theory and Applications with Calculus, Third Edition
©2014 Pearson Education, Inc.
1. “All you can eat” buffets are an example of which pricing strategy discussed in this chapter? What
about hotels that have a “kids eat free in the hotel restaurant” policy?
2. A monopolist sells in two states and practices price discrimination by charging separate prices in each
state. The monopolist produces at constant marginal cost MC = 10. Demand in market 1 is Q1 = 50 – p1.
Market 2 demand is Q2 = 90 – 1.5p2. What price will be charged in each market? Suppose a third
party enters the market, not as a producer but as a reseller, capable of reselling by transporting the
goods from market to market at a cost of $4 per unit. How does this affect the monopolist?
3. Suppose a monopolist’s costs are described by the function C = 200 + 2Q2, and it faces a demand
curve of Q = 240 – p. If it cannot price discriminate, what are the profit-maximizing price and
quantity? What are the profits? If the monopolist uses block pricing by setting an intermediate price
but cannot charge more than two different prices in total, what would be the best prices to choose?
How does the use of an intermediate price change profits and consumer surplus compared to the
single price result?
4. Suppose that instead of block pricing in the question above, the firm is able to practice perfect price
discrimination. What are the values of output, profit, and consumer surplus?
5. True or false; explain your answer. If all consumers have identical tastes and preferences, perfect
price discrimination is impossible.
6. Tuan lives in a town with only one movie rental store. Suppose Tuan’s demand for movie rentals per
month is Q = 16 – 2P. The movie store currently charges $5 per movie but is thinking of adding
a flat monthly cardholder fee and dropping the price to $2 per rental. At this new price, what is the
largest cardholder fee that Tuan will pay? If the rental store has a constant marginal cost of $2, which
strategy is more profitable?
7. In most cases, when a consumer purchases season tickets for a professional sports team, the consumer
must purchase preseason games as well at the same price as regular season games. What type of
pricing strategy does this represent?
8. Why do firms place ads with coupons in the paper, instead of simply offering a sale price in the
same ad?
9. A firm believes the elasticity of demand it faces in its own country is −1.1 and in the other country is
−1.5. Suppose the firm can charge $1 for its products in its own country and can prevent resales
between these two countries. What price will it charge in the other country?
10. Perfect price discrimination generates higher total welfare than imperfect price discrimination.
Explain why?
Answers to Additional Questions and Problems
1. “All you can eat” buffets are examples of product bundling. Consumers cannot purchase the items
individually, nor can they choose to not purchase certain items in the line. Most consumers end up
paying for menu selections that they do not select. “Kids eat free” plans are an example of a product
tie-in because the children cannot eat free unless they are accompanied by a paying adult. The only
way to get the low (free) price for children is to purchase a more expensive adult meal.
2. To get the profit-maximizing output and price levels, set marginal cost equal to marginal revenue in
each market and solve.