Quantity discount and quality choice

17 November 2008

1 Second degree of price discrimination

• If the monopoly is able to identify the willingness to pay of each consumer, it can
first degree price discriminate to charge each consumer her maximum willingness
to pay. In less ideal situations, the monopoly may be able to identify which
group a particular consumer belongs to, and if the aggregate demand curves of
the different groups are known, the firm can third degree price discriminate to
charge each group a different price. But what if the monopoly is not even aware
of which group a particular consumer belongs to? Does this means that it will
have no choice but to charge a single price to all?

• If the monopoly knows that among the population of consumers, some have
stronger demand than others, and also is aware of the distribution of consumers
by demand type, the firm may still be able to charge different consumers dif-
ferent unit prices to improve on the profit that can be earned by charging a
uniform unit price to all. Second degree price discrimination comprises all such
pricing schemes.

• The most common such pricing strategy is quantity discount.

— With quantity discount, high demand consumers, in purchasing a larger

quantity, pay a lower unit price than low demand consumers.

• A firm can also differentiate by offering goods of different qualities at different

prices to discriminate.

— Recall the 486 chip example. Intel offers a high performance version at a
higher price and a standard version at a lower price, even though the costs
of manufacturing the two versions are no different from each other.

• A multiple two-part tariff is another possibility.

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 — In this case, consumers pay a fixed fee T and a per unit charge p. The
firm can offer different such packages for consumers to choose from to
discriminate among the high and low demand buyers.

• The firm can tie-in the sales of several of its product into bundles, instead of only
selling the components individually, to extract greater surplus from consumers.

— When consumers’ relative valuations of the components differ, the firm can
offer one or more bundles to discriminate among consumers.

• These pricing strategies share the common feature that the unit price is often
variable, the exact amount depending on the quantities purchased. For this
reason, second degree price discrimination is sometime referred to as non-linear
pricing.
• We shall study quantity discount and quality choice in this lecture, and product
bundling in the next one. Due to time constraint, we cannot cover two-part
tariff. The interested students are encouraged to read the relevant section in
the references.

2 Quantity discount
• Not all quantity discounts qualify as price discrimination. If there are economies
of scale in serving the high demand consumers, the firm may simply be passing
some of the cost savings to these consumers. In many cases, the economies
of scale are not obvious, and it is hard to understand why firms offer quan-
tity discounts for reasons other than to discriminate high against low demand
consumers.

2.1 Quantity discount to price discriminate

• Suppose there are two consumer types, 1 and 2. Type i = 1, 2 consumers
have utility function ui (x) , where x is the quantity consumed. Assume that
u2 (x) > u1 (x); i.e., a type 2 consumer has a stronger demand than a type 1
consumer. Also assume that the MC is just equal to 0.
• If ui (x) denotes a type i consumer’s utility derived from buying x units of
the good, its derivative ∂ui /∂x > 0 is the marginal utility of consumption, or
equivalently the point on the demand curve.

• In figure 1, the inner curve is the demand curve for a type 1 consumer, and
the outer curve the demand curve for a type 2 consumer. The area under the
demand curve is the value ui (x) , i = 1, 2.

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 Figure 1: Two demand curves

• If the MC of production is equal to zero, a perfectly discriminating monopolist

would like to sell x01 units to each type 1 consumer, while charging her the
amount u1 (x01 ) = A. Similarly the monopolist would like to sell x02 units to
each type 2 consumer, charging u2 (x02 ) = A + B + C.

• But now the monopolist could not distinguish who belongs to which group.
Perhaps what he could do is to have two deals available for people to choose
between:

1. x01 units at a price equal to A,

2. x02 units at a price equal to A + B + C.

• The problem with this policy is that no one would choose the (x02 , A + B + C)
deal.

— A type 1 consumer choosing the (x01 , A) deal enjoys zero net surplus. A
type 1 consumer choosing the (x02 , A + B + C) deal suffers from a negative
net surplus. Type 1 consumers would indeed choose the (x01 , A) deal.
— A type 2 consumer choosing the (x02 , A + B + C) deal enjoys zero net sur-
plus. A type 2 consumer choosing the (x01 , A) deal enjoys a net surplus of
B. Type 2 consumers would also choose the (x01 , A) deal.

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• Effectively then there is only one deal being bought and sold in the market.
The monopolist fails to price discriminate.

• To price discriminate when the monopolist cannot distinguish the identities of

individual consumers, the monopolist has to make sure that consumers would
self-select into the appropriate deals. In particular, the deals have to be designed
to meet the incentive-compatibility constraints:

u1 (x1 ) − P1 ≥ u1 (x2 ) − P2 , (1)

u2 (x2 ) − P2 ≥ u2 (x1 ) − P1 , (2)

where P1 and P2 are the respective prices to charge for the two deals.

• Formally, the monopolist chooses (x1 , x2 , P1 , P2 ) to maximize

π = n1 P1 + n2 P2 ,

subject to (1) and (2), and that the utilities cannot be negative,

u1 (x1 ) − P1 ≥ 0,
u2 (x2 ) − P2 ≥ 0,

what is commonly known as the participation constraints.

• We know that the deals (x01 , A) and (x02 , A + B + C) meet the participation
constraints but fail the incentive compatibility constraints. How should the
monopolist amend the quantities and prices then?

• Where the problem is that the deal (x01 , A) is a better deal than (x02 , A + B + C)
for type 2 consumers, the monopolist could achieve incentive compatibility by
worsening and/or sweetening the former and the latter deals, respectively.

• In figure 1, for instance, the monopolist could alter the second deal to become
(x02 , A + C). Then type 2 consumers would enjoy a net surplus of B, the same
surplus from buying the (x01 , A) deal. Hence the (x01 , A) and (x02 , A + C) deals
would satisfy incentive compatibility. And the profit for the monopolist is higher
too. Where the monopolist is only effectively selling the (x01 , A) deals to both
types 1 and 2 consumers, the profit earned from each type 2 consumer is equal
to A. Now it increases to A + C.

• Inasmuch as the monopoly reduces the price for the x02 deal, while keeping the
price for the x01 deal unchanged, the unit price high demand type 2 consumers
pay, the amount P2 /x02 , tends to fall below the unit price low demand consumers
pay, the amount P1 /x01 . The quantity discounts are offered to induce self—
selection to help price discriminate.

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 Figure 2: Quantity discount

• But the monopolist can do even better. In figure 2 for example, the monopolist
could reduce the quantity in the (x01 , A) deal by a small amount and drop the
price by an amount equal to the blue area. The surplus a type 1 consumer
enjoys from buying the deal remains equal to 0, thus satisfying the participa-
tion constraints. Meanwhile the profit the monopolist makes from each type 1
consumer falls by an amount just equal to the blue area.

• What has also happened is that the surplus a type 2 consumer enjoys from
buying the revised deal has fallen by an amount equal to the red+blue area.
Then the monopolist can increase the price for the (x02 , A + C) deal by just this
amount, while still satisfying incentive compatibility. The profit the monopolist
makes from each type 2 consumer increases by the red+blue area. Total profit
tends to increase as a result.

• In general, the monopolist would find it optimal to continue to reduce the

quantity and price of the deal designed for the low demand consumer, while
raising the price of the deal for the high demand consumers until the increase
in the profit earned from the second group cannot compensate for the fall in
the profit earned from the first group.

• In figure 3, the monopolist offers two deals: (xm

1 , A) for the low demand con-
0
sumers; (x2 , A + C + D + E) for the high demand consumers.

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 Figure 3: Incentive compatible price discrimination

• It is interesting to note that high demand consumers benefit from the presence
of low demand consumers. Absent low demand consumers, high demand con-
sumers would pay a higher price and enjoy no surplus. With the presence of low
demand consumers, the monopolist has to cut the price for the high demand
consumers to induce them not to buy the deal designed for the low demand
consumers.

• In the absence of high demand consumers, low demand consumers would buy a
larger quantity. But they still end up with a zero surplus.

• Perhaps an instance of quantity discount that is closest to many of us is the

different plans offered by the mobile phone operators. Plans that allow for more
calling times are usually associated with a low per minute charge than plans
that allow for fewer calling times.

3 Quality choice
• The analysis above may also be applied to understand why sometime the high—
quality—high—price version of a good is usually a better deal than the low—
quality—low—price version.

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• Consider the case where each consumer will buy up to one unit of the given
good. Then ui (x) may be interpreted as the utility a type i consumer derives
from buying a unit of the good of quality x. The analysis then suggests that to
make the deals incentive compatible, the monopoly will offer a better deal to
high demand consumers in terms of the price per unit of quality.