Two conditions must hold for a firm to practice price discrimination prof-
itably. First, the firm must be able to identify market segments that differ with
respect to price elasticity of demand. As we show shortly, the firm profits by
charging a higher price to the more inelastic (i.e., less price-sensitive) market
segment(s). Second, it must be possible to enforce the different prices paid by
different segments. This means that market segments receiving higher prices
must be unable to take advantage of lower prices. (In particular, a low-price
buyer must be unable to resell the good or service profitably to a high-price
buyer.) The conditions necessary to ensure different prices exist in the pre-
ceding examples. Sometimes the conditions are quite subtle. Business travelers
rarely can purchase discount air tickets because they cannot meet advance-
booking or minimum-stay requirements. First-run moviegoers pay a high ticket
price because they are unwilling to wait until the film comes to a lower-price
theater.
How can the firm maximize its profit via price discrimination? There are
several (related) ways to answer this question. The markup rule provides a
ready explanation of this practice. To illustrate, suppose a firm has identified
two market segments, each with its own demand curve. (Chapter 4 discusses the
means by which these different demand curves can be identified and esti-
mated.) Then the firm can treat the different segments as separate markets for
the good. The firm simply applies the markup rule twice to determine its opti-
mal price and sales for each market segment. Thus, it sets price according to
P [EP/(1 EP)]MC (Equation 3.13) separately for each market segment.
Presumably the marginal cost of producing for each market is the same. With
the same MC inserted into the markup rule, the difference in the price charged
to each segment is due solely to differences in elasticities of demand. For
instance, suppose a firm identifies two market segments with price elasticities
of 5 and 3, respectively. The firm’s marginal cost of selling to either seg-
ment is $200. Then, according to the markup rule, the firm’s optimal prices are
$250 and $300, respectively. We see that the segment with the more inelastic
demand pays the higher price. The firm charges the higher price to less price-
sensitive buyers (with little danger of losing sales). At the same time, it attracts
the more price-sensitive customers (who would buy relatively little of the good
at the higher price) by offering them a discounted price. Thus, by means of
optimal price discrimination, the firm maximizes its profit.^16100 Chapter 3 Demand Analysis and Optimal Pricing(^16) Here is another way to make the same point. Suppose the firm initially made the mistake of
charging the same price to both market segments. The markup rule says it can increase its profit
by raising one price and lowering the other. Let’s check that this is the case. At the common price,
let the first segment’s demand be more elastic. Now suppose the firm lowers the price charged to
the first segment and raises the price charged to the second in just the right amounts to maintain
the same totalsales. Given the differences in elasticities, it can do so while increasing the average
price at which it sells units. With a higher average price and the same total number of units sold,
the dual-pricing strategy has increased revenue. (The revenue gained from the first segment
exceeds the revenue lost from the second.) With total output unchanged, profit has increased.
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