Price Discrimination and Social Welfare

Price Discrimination: Theory, Welfare Implications, and Empirical Evidence
Executive This thesis was initiated with a purpose to find whether price discrimination influences social welfare and if so to what extent. In furtherance to the theoretical knowledge gained in the related area the research furthered to adapt two cases i.e. airline industry and UK package holidays. The studied theory was applied to the case studies to further evaluate and find whether price discrimination influence the social welfare. The results indicate that in case of the airline industry as well as the UK package holiday, it was imperative for both the sectors to apply price discrimination. If the airlines industry considered versions of offers for price discrimination, the UK package holidays considered differentiation of prices based on `Peak Load Pricing`. In both the cases customers had all the options to make a choice of the prices as such it is concluded to state that in case of the applied cases welfare was not influenced.
Signed Statement
I hereby declare that this Essay is my own Original work that all reference sources have been accurately reported and acknowledged and that this document has not previously in its entirety or in part been submitted to any University in order to obtain an academic qualification.
Signed……………………………………………………………. (Candidate)
Table of Contents
1.0 Introduction 6
1.1 Background 8
1.2 Price Discrimination 9
1.3 Social Welfare 10
1.4 Problem Statement 12
1.4.1 Research Question 12
1.5 Introduction to the Case Study Organisation 13
1.5.1 Air Line Industry 13
1.5.2 UK Package Holiday 15
1.6 Thesis Structure 17
2.0 Theoretical consideration 18
2.1 Price Discrimination 18
2.2 Types of price discrimination 19
2.2.1 First Degree 19
2.2.2 Second degree 20
2.2.3 Third Degree 23
2.2.4 Combination 25
2.3 Conditions for price discrimination 27
2.4 The impact of consumer welfare 30
2.5 Producer surplus and profit 33
3.0 Application 35
3.1 Application of Price Discrimination to Airline Industry 35
3.1.1 Identified Areas 36
3.2 Varied Versions of Airline Ticketing 36
3.3 Application of Price Discrimination to UK Package Holiday 38
4.0 Conclusions 42
5.0 References 44
List of Figures
Figure 1: Consumer Surplus and Producer Surplus 10
Figure 2: Increase in quantity (Q2) increases consumer surplus and producer surplus 11
Figure 3: Quantity reaches maximum when reaches the equilibrium 11
Figure 4: Perfect Discrimination 19
Figure 5: Customer Classification 20
Figure 6: Market Separation & Segmented Consumers 24
Figure 7: Quality vs. Price-willingness 36
Figure 8: Peak and off-peak pricing 39
List of Abbreviations
PT: Package Tour
UK: United Kingdom
EU: European Union
Chapter One
The focal idea of this thesis is to find whether price discrimination influences the social welfare. If there is any such influence this research furthers to find to what extent it is prevalent. For practical evidences two industries have been considered for the inquiry. They include: Airline industry and UK package holiday.
Social welfare is evaluated by adding up consumer surplus and producer surplus. Consumer surplus is the difference of what the consumer actually pay and what actually they intend to pay whereas producer surplus is the difference between what the producer actually receives for the product they are willing to sell for.
On the other hand price discrimination or differentiation in prices that naturally is prevalent in the market where the sale of identical products or services by the same manufacturer or service provider however differs in prices. This thesis making an in depth inquiry of defining and discussing the theory and concepts of price discrimination and social welfare will further to apply these theories with the evidences gathered from the case study organizations.
The above indicated conduct of research gains its importance in the light of the fact that there is a wide range of empirical evidences discussing on the models of competitions allowing elaborations in the behavior of the firms and organizations more specifically on predictions of pricing. Discrimination in pricing is a common trend in the market. Different firms tend to apply different prices for the same product or service. Research argues that this may or may not hinder competition.
However, when contrasted with the social welfare, the price of a product or service has a specific equilibrium to reach when the quantity of the product and its relative price keeps on increasing. Upon reaching the equilibrium there hardly exist any sales or productions. This generally happens only with perfect competitive equilibrium. According to some studies within service industry like the Airlines or hospitality there hardly exists any perfect competitive equilibrium. Thus this research furthers to inquire and find the influence of price discrimination on social welfare.
Under the given circumstances it becomes an interesting topic to argue discrimination of prices does impact the social welfare that is on a larger scale mostly refers to `overall welfare` (Just et al., 2004). More importantly as Little (2002) argues that “… because price discrimination- goes challenged in most instances – even by dominant firms – “, it would be an interesting and challenging task for any student to understand that the task is not as simple as it appears. Thus the researcher is of the opinion that by discussing the price discrimination concept in the context of the social welfare to find whether the former has any impact on the later and if so to what extent would be an subject of inquiry.
In furtherance to the above this part of the thesis successively attempts to study and evaluate the concept of price discrimination and the social welfare followed by discussing and stating the identified problem that needs academic inquiry and investigation with a research question. Taking the clue from the poised research question the research is furthered to make a empirical study on related study area such as the types and kind of price discrimination with specific focus on the first through the third degree of price discrimination, the conditions for price discrimination and the impact of price discrimination on consumer welfare and finally evaluate the concept of consumer and producer surplus and the profit criteria.
With specific focus on `social welfare` the research of Pavel & Fundora (2008) argue that the `First Fundamental Theorem` of welfare economics claims that competitive equilibriums are Pareto-optimal this is true states the authors however can this really translate itself and conclude to state that `social welfare` can be considered as a `greatest` especially in the competitive market that is mostly decentralized. The answer given by the authors is a big `NO`. The author further to argue that most of the researchers have misrepresented this factor a further inquiry into this aspect reveal that the concern about the link between the social welfare and competitive market system is revealed in back centuries. The good outcome of a market economy was a certain concern and the question of what is exactly a `good society` prominently figured among the economists like Aristotle and accordingly it was difficult to resolve, argues Accinelli (2011).
The above stated discussion of literary evidences is a clear indication to argue that appropriate social welfare that is defined as consumer surplus and producer surplus leaves a question mark when it is contrasted with the competition prevailing in the decentralized market where the market players adapt different strategies for gaining competitive advantage (Motta, 2004) more specifically in the context of pricing the products (Jeffy, 2010) more specifically in the context of the argument of Frank (1921, p. 146) who stated that ” it is not to be noted that final object of an economic theorizing in human and ethical terms of the economic machine is a criticism and the theory of price and value is indispensable”.
In this context this research furthers to specifically focus on price discrimination and social welfare to find the impact of the former on the later one. Thus furtherance is made by studying each of the concepts to state the problem.
Price Discrimination
In the market economy price is the main core and the product`s characteristics like quantity, timing, quality, etc., are included in simple number. The market consisting of perfect competition is an idea for initiation of industrial economics. According to Pongracic (2007) firms are the price takers who move the prices to marginal cost and do not alter prices and competition. On the other hand the price discrimination exists when either the same products are sold to different consumers at various prices or the same price is taken from consumers even though the cost of supply of goods for every consumer is different. It occurs when the consumers paying different prices is not comparable to the cost the seller incurs for the product from the consumers. It is only possible to carry out a firm that has market power. According to the studies of Stolyarov, (2007) market power remains when it charges the price increased by the firm without the loss of sales. Certain tests were provided by the economists in order to recognize what exactly the notion explains. The price discrimination concept is not widely defined. An example from the famous antitrust book of Posner (2001, p.79) states that:
“Price discrimination is a term that economists use to describe the practice of selling the same product to different customers at different prices even though the cost of sale is the same to each of them. More precisely, it is selling at a price or prices such that the ratio of price to marginal costs is different in different sales […]”.
The above definition gives an objective principle i.e. various price ratios to marginal costs (i.e. return rates), identifying the existence of price discrimination. This even explains that the varied prices for the same product do not result in price discrimination and this variation is justified by cost variations.
Social Welfare
According to Pavel & Fundora, (2008) when consumer surplus and producer surplus are added it leads to social welfare (Social welfare = consumer surplus + producer surplus).
“Consumer surplus is the difference between what a consumer is willing to pay and what they actually pay” whereas “producer surplus is the difference between what a producer is willing to sell their product for and what they actually receive” Pavel & Fundora, (2008).
The authors further state that `aggregate consumer surplus measures consumer welfare` and `aggregate producer surplus measures producer welfare`. This is very well explained by the author graphically (figure-1)
Figure 1: Consumer Surplus and Producer Surplus
Source: Pavel & Fundora, (2008)
As can be seen in figure-1, the horizontal lines indicate the consumer surplus and the vertical lines indicate the producer surplus here quantity is Q1 & the P1 represents the price. However when the quantity is increased and the price is decreased the total area of the consumer surplus and the producer surplus increases (figure-2)
Figure 2: Increase in quantity (Q2) increases consumer surplus and producer surplus
Source: Pavel & Fundora, (2008)
The authors further argue that quantity keeps on increasing till it reaches its equilibrium (figure-3).
Figure 3: Quantity reaches maximum when reaches the equilibrium
Source: Pavel & Fundora, (2008)
At this juncture the author argues that one cannot cross the equilibrium however when such situation arises i.e. where the output levels are greater to that of the equilibrium consumers` purchases are below the equilibrium price, however the producers produce the products or services only equilibrium price as such there hardly exists any production or sales. In this regard the authors found that social welfare that is an amalgamation of producer and consumer surplus is maximum only when there is perfect competitive equilibrium.
Problem Statement
According to Posner (2001) the analysis of price discrimination has deep roots in the economics discipline, where it has long been recognized that it can be for good and for bad – and sometimes even necessary. In furtherance Motta (2004) states that the issue of whether price discrimination reduces or increases social welfare has been considered by economists since 1920. At that time, it was demonstrated that, under certain (restrictive) conditions, price discrimination will reduce social welfare (Carlton & Perloff, 1999). However Konkurrensverket (2005) argue that subsequent research has shown that price discrimination can increase social welfare and that a necessary (but not a sufficient) condition for welfare to rise is that total output with discrimination exceeds the no-discrimination level (Lichtenberg, n.d.).
In furtherance the more recent research of Jeffry (2010) found that since social welfare is lower under price discrimination, it follows that firm profits must be lower as well. Consumer`s purchase of a rival`s product in the first period implies a weaker demand of the consumer towards the firm`s product in the second period.
This motivates each firm to offer lower prices to its rival`s customers in the second period, or “paying customers to switch” if prices can be based on a consumer`s past purchases (Shaffer and Zhang, 2000). Such price discrimination in both models results in lower equilibrium profits for the competing firms and inefficient consumer switching. With a qualification, social welfare is reduced by price discrimination. As can be seen there seems to be a diversified opinion on the impact of price discrimination on social welfare as such this research furthers with a research question that would facilitate the researcher to further inquire into the issue.
Research Question
1. Does price discrimination influence the social welfare and to what extent?
Introduction to the Case Study Organization
The present study researches into two cases to further the investigation to gain practical knowledge of the identified problem they include 1) Airline Industry and 2) UK Package Holiday. This section gives a brief introduction to each of the organization under investigation.
Air Line Industry
An airline industry is in the middle of a dramatic restructuring which includes the basic changes when compared to the experienced which follow its deregulation in 1978. The industry remains fragile even after the three decades of deregulation and the several repeats of the successes as well as failures.
Online travel distribution channels, transparency of pricing facilitated by the internet, loss of consumer confidence in the air transportation system`s reliability and operating performance and the competitive pressure from low-cost carriers have resulted in a significant impact on revenues of the airlines and a decline in average fares.
From the year 2006 for the first time, fuel has become an expense of single large industry exceeding the cost of labor. The substantial stages are being faced by the industry which is still improving from the recent cycle of financial struggles.
Some quarters of profits connect to the full recovery which is a belief and also an aimful thinking -argues Bisignani (2006).
In furtherance Heimlich (2007) argue that the two main critical problems regarding the future of air transportation are the inadequate infrastructure capacity – airports as well as airspace and fast increasing costs to maintain as well as expand its infrastructure. An enormous investment is required for the maintenance and extension of the existing airports on the cost side or to form new ones and this was mainly responsible for the privatization trend of the airport. Quick growing costs of the aviation infrastructure (airports and air traffic control) have been resulted because of the increasing tax tendency directly to the airline passengers. Presently, the average domestic airline ticket cost has been increased due to the taxes as well as fees for infrastructure support and security.
The challenges that sustain airline profitability, ensure safety as well as security and develop enough air transportation infrastructures are limited not only to one but also to all the nations in the world. In the world, airlines are facing competitive pressures from new entrant low-cost airlines as well as re-structured legacy carriers. Every airline and its passengers were subjected to safety and security issues due to the quick growth of the global airline industry as well as the frequent attacks of terrorist threats.
The airport as well as the air traffic control needed an expansion of the aviation infrastructure and this is especially vital to the emerging world economies like China, Africa, the Middle East and India where many high rates of demand growth for the passenger as well as cargo air transportation are forecasted.
Under the given circumstances it would be interesting to know whether these could be the probable reasons for the airlines industry in applying price discrimination in varied area of their operations. For example, if a person pays a particular amount for a flight from `a` to `b` on a particular day the price is not the same for another day similarly if a person pays a particular amount for a one way ticket the price is not the same when he purchases a return ticket. In the former case the price for the same trip increases whereas in the later case it decreases. This is a clear example of the uncertainties for varied reasons and the airline operators seems to be on the safe side or to extract the costs incurring from uncertain conditions like taking care of transportation in case of delays as discussed.
UK Package Holiday
The market of the UK leisure travel industry is vast it is highly fragmented and is also competitive. Every year mostly 110 million holiday trips are being taken as a whole by the UK consumers. Among these holiday trips, there are few 36 million trips in the market which show a worth of Pound16 billion and these trips are for overseas (“Overseas Holidays”).The sector is segmented into transportation, destination, accommodation, flexibility & customer management, activity, duration, price and quality. This is a clear indication of the varied stakeholders involved in the sector however as the focus of the present research is on price-discrimination and its impact on the social welfare the case study as such focuses on the price issues as well as the trends of the customers in option for package holidays.
In UK the general format of package holiday involves operators who usually receive the components from the respective owners and then with the help of promotions and travel agents sell the package tours directly to the customers who pay the cost well in advance.
Depending upon the degree of services pack, package tours (PTs) are classified into various types. The tour operators allows the product owners to reduce their cost and risk by selling their stock in advance and also they provide the components with best quality in a branded context and ensures delivery of the product with legal liability. The holiday products are placed in a certain price range by the operators in any of the consumer market and this is an important issue to be considered here. The holiday products vary from unbranded to luxury and these are discounted and priced at Pound99. These are all-inclusive and vastly modified tour holidays charging Pound10,000 in excess per passenger. According to the statement given by Muller (2010), a larger protection is offered by the holiday package which yet requires the tour operators to stand up for the consumer rights when something goes wrong these conclusions were made by the author based on a case study done by them wherein the tour operators to resolve a issue also had to pay compensation to the passengers.
Markets mostly focus on image, brand and niche packages but tour operators focus only on price and product portfolios. A tourist will pay based on the usage he/she expects from each of the components and the market ruins because of its price sensitiveness. To reach the expectations of the consumers a PT can be combined as long as potential profit makes the tour operator to generate it. It is not much famous for domestic trips when compared to for first time and international travel.
Certainty and predictability plus: cheaper prices, familiarity with a destination, ability to see and perform more, convenience are the principle benefits perceived by the tourists. By providing the facilities to the traveler, the experts allow them to relax and gain the enough enjoyment they also provide a guaranteed quality of the hotel, safe restaurants and a unique representation of the local culture. The tour makes sure that the most important spots are necessary to be visited.
In decision-making, the tour operator must include various variables and depends upon the sensitive understanding of the market which is evident from the previous discussion. Depending upon the true understanding of the emerging domestic market requirements and its desires, UK has an inadequate, relevant and tailor-made package tour. Usually these packages show an option of high-cost. Thus this refers to involve the elasticity of the price as well as a careful marketing. Based on these basic facts discussed in the context of the case further application of the case will be done in the third chapter to find how price discrimination in the PTs may impact the social welfare and if impacts to what extent.
Thesis Structure
This thesis is constructed into four chapters. The first initial chapter has discussed the background to lay foundation to further identify and state the problem that needs academic study. Based on the background related literature pertaining to price discrimination and social welfare was studied this was furthered by evaluation of related literature in the problem statement and based on the same a research question was defined to further the investigation. Finally this chapter concluded by making a brief introduction to the cases.
In the second chapter related theories will be discussed and the literary perception of each of the considered area of research will be discussed and critically evaluated such that the researcher is facilitated to further to apply the theories practically with the identified case study organizations to find answer to the poised research question which will be done in the third application chapter. Finally in the fourth conclusion chapter, the discussed and evaluated data will be concluded in the light of the research question.
Chapter Two
Theoretical consideration
In the previous introductory chapter upon discussing the background problem identification was done to poise a research question. In furtherance to inquire into the related area for researching this chapter will further to assess and evaluate the literary evidences for facilitate the researcher to find answers to the defined research question. As such the related theoretical concepts, perceptions and literary evidences related to general idea of price discrimination the types of price discrimination – and the related combinational impact and influence of the types conditions of price discrimination followed by welfare effects and impact of consumer welfare will be discussed and evaluated finally an attempt will also be made to focus on producer surplus and profit will also be discussed. All of these discussions will be done in the light of the poised research question.
Price Discrimination
According to studies, discrimination of price in general occurs because of trader for charging the same product with unequal prices to different customers or charging equal prices to consumers though supplying goods` costs are unequal (Arrow et al., 2002). The discrimination in price remains as long as there is unequal price being imposed to different customers. Also it retains if the cost paid by customers are not in proportion to that of cost of seller while delivering or selling the products to customers. However price discrimination is more likely to organizations that have a command in the market. The supremacy of a firm exists if it can enhance the charges of goods without losing its sales. For a firm which is wholly competitive will not employ discrimination of price (Konkurrensverket, 2005).
Types of price discrimination
An effective discrimination in prices requires classification of customers among various groups and with each group having different price flexibility. The discrimination in prices needs to avoid goods transfer from one party to another otherwise a party that is charged with lower price will try to sell the goods to those who are charged with a higher price. The efficiency of price discrimination can be improved only either in monopoly or oligopoly situation its efficiency can be improved under competitive market. However price discrimination is categorized into three types: 1) first degree 2) second degree and 3) third degree.
First Degree
When a firm successfully discriminate customers and takes the pleasure of charging highest prices to their customers and also the customers without any hesitation get ready to pay for that then such price discrimination is referred as first degree. However Mishan (1980) in his studies termed it as a perfect discrimination (figure-4).
Figure 4: Perfect Discrimination
As can be seen in the above figure QC represents the competitive output that is equal to market output that is the monopolists charge (PC) only to the last unit this is termed as perfect discrimination the horizontal lined area (green) is the total surplus APCB.
The studies of Krugman (2003) found that through haggling customers try to tackle first degree discrimination in price on the other hand it is also stated that such situation no more exist in real-world. However, Parrot (2005) in this regard argues that by setting up different price to individual customers a seller can extract the surplus goods and in such attempt customers are charged with maximum prices and also they get ready to pay for it. Parrot further states that when it is required theoretical concepts will become useful for theoretical analyses.
The traders are of the behavior that often tries to find reservation prices of customer and on the other side consumers likewise try to conceal the reservation prices from traders and behaves in a manner such that their reservation prices are lower.
Similarly Motta (2004) states that in a first degree price discrimination traders charge customers with reservation price – the customers are compelled to pay the maximum for a unit of goods and further to argue that the practice of first degree will not be observed in this scenario since the firm possesses complete knowledge of customers` pay intentions and are of the assumption that it cannot be fulfilled in most of the markets.
Second degree
According to the studies of Buamon (2003), the second degree of discrimination in price takes place when traders become aware that consumers have flexible demands but are not in position to divide. Hence, the traders merely places a price schedule before the consumers so that they self-select price category subjected to various constraints. A successful drawn up of the price schedule assist in classifying the group of consumers (figure-2).
Figure 5: Customer Classification
Source: Buamon (2003)
The above figure indicates the classification of customers. In this regard Dana (2001) state that price discrimination reach to second degree if a firm prescribes charge on unit based with varying volume of units that customers purchase. This is attained through discounts and with prices based on the purchases made by the consumers or with the implementation of two-part tariff in which the consumers have to pay flat fee irrespective of the purchased quantity including variable fee.
Further Perrot (2005) has forwarded the differential method within second degree price discrimination where the trader offers variable price charges depending on the sales number for example discounts over quantity purchased as well high/low peak prices in order to allow the consumers to self select the price and pay as per their intentions.
In a two-part tariff according to Schlereth et al., (2010), a lump-sum is charged to the customers on goods along with per – unit charge. Consider an example of a country club where the consumers are charged with a membership fee as well as imposed with charges for the services being offered. In the case of park, an entrance fee is charged and further charges are imposed on various internally offering services.
It is actually for the seller that the two-part tariff is imposed in order to set lump-sum payment equivalent to consumer surplus for low demands and is then for the product as well as services based on per-unit price equivalent to marginal cost. However, two-part tariff may not be always useful in improving welfare but occasionally observed to be useful. As such more people under a single-price policy align towards consuming the goods and services.
The studies of Ellison (2003) informs that air fares is a related instance of second degree since the discrimination of its price relies on time when the tickets were purchased and to what period of time travelers prepare to reside at that destination. However travelers are used to charged excess by most of the airlines for their reluctance to wait till the whole Saturday night. This way the airlines classify their business flyers from that of tourists and pleasure flyers, since the latter had more elastic demand schedule compared to former.
Giving a simplified view and examples Krugman (2003) states that for price discrimination, second degree is more accurately applicable to asymmetric data, which is then provided with a catalogue of tariffs from the firm to their customers through self selection strategy, and the latter reaps most benefitted deals. Either in the case of vertical relationship or with respect to final customers as that in mobile tariff, second degree of price discrimination can be observed in which the manufacturer offers and signs an agreement with the retailers.
A multiple version of self selection method is presented as a package where the consumers are allowed to purchase different items or a package that includes more than one item according to their choice of preference.
According to Srinivisan (2012), it is presented that for the same product a consumer having a coupon will pay a lesser price than other consumers. Therefore the sellers often make an attempt to capture and classify them into two groups and distinguishing them from one another.
However, in some cases it happens that some of the consumers get ready to pay higher prices on their own will to avoid spending time in searching such coupons. While others try to bring such coupons in order to lower their costs by keeping such coupon books and clipping the required coupons.
In furtherance the studies of Alderighi et al., (2011) indicated that sellers by issuing the coupons to their consumers hold them in capturing the sales. In both of the conditions sellers are still not confident about what groups of customers can be exactly outright.
Hence, preparing a schedule of prices will only allow the customers to circulate within the groups to find out what is more useful.
Third Degree
The studies of Galera (2003) states that third degree price discrimination come into effect if varied groups of consumers are charged with unequal prices by a firm based on the intensity of demand. The authors further argue that this is most frequently found and form of discrimination for a similar product for different segmented people in the market.
However the key remains with consumer`s willingness to pay this is a clear indication of application of varied prices irrespective of the cost of production. In this regard Langer (2011) state that market is usually separated by time or by geography (figure-6)
Figure 6: Market Separation & Segmented Consumers
Source: Langer (2011)
As can be seen in the figure, A and B are the marginal revenue curves representing the demand. The figure indicates consumers pay higher price (Pa) to that of the consumers (Pb). The reason being that for Pa there is an inelastic demand and on the other hand for Pb there is elasticity for demand.
The point to be noted here is that when there is peak market the production of the firm is MRa=MC where the price is Pa, and on the other hand during the off-peak market, the production of the firm is MRb=MC where the price is Pb. From the above it can be understood that during the peak market conditions the demand is inelastic and during off-peak market conditions the demand is elastic.
The conclusions of the above figure are that the firm aim to charge a maximizing profit for each of the group of consumers.
Customers of high demand intensity would be charged with higher prices when compared to those of low demand customers.
The studies of Inderst (2003) found that the third degree price discrimination also occurs if traders charge customers of varied groups with varied unequal prices depending upon the characteristics (age, wealth or geographic location) of customers. Specifically focusing on demographic characteristics and price discrimination Langer (2011) found that customers are restrict to self-select.
The sellers possess the capability to determine what price customers can pay by knowing their characteristics. This further assists the sellers to classify the consumers into groups according to the intensity of their demand for the product. Similar is the opinion of Perrot (2005) who states that purchasers often ask prices that reflect their characteristics under third degree of price discrimination for example children, students and the elderly ones are offered lower prices. Further Perrot (2005) states that price discrimination also visible within the context of asymmetric information which also represents the circumstances where cost charged to the customers relies on their choice of preferences. However in strategic and informational context this is obviously would lead an impact upon consumers and firms for their excess goods. In the further up comings it will be observed that price discrimination can intensify or decrease the level of competition if it taken as strategic tool in the context of oligopoly.
The authors Carlton and Perloff pointed out from the studies of Motta (2004) that the primary purpose behind all the implementation methods of price discrimination is “to acquire as much excess consumers as possible”. This can be attained by various types of price discrimination. If a monopolist engages completely in price discrimination then monopoly would be lost.
The seller will acquire ex-customer surplus as well as earlier deadweight loss of monopoly. Moreover in the monopoly, efficient level of output can be achieved through the engagement of first degree price discrimination. Therefore from the social perspective a firs degree is considered more beneficial for price discrimination. Also from the studies of Azhar (2003), it can be state that a flourishing first degree indicates the whole loss of customer surplus.
The customers who were reluctant to pay earlier monopoly maximum benefit cost can now disburse the amount with lower price and receives the required product. Some of the customers will be worse off and the rest will be better off because of price discrimination. In economics such desirability is not evaluated for their effects whether their improvements can matter or value judgments (Berry et al., 2004).
In the second and third degree of price discrimination, a substantial and intricate analysis is needed to reach at the welfare allegations under specific circumstances. Also a considerable uncertainty would exist in this case. In ideal circumstances only second degree price discrimination can successfully achieves alike results to that of first degree but this rarely occurs. Moreover, price discrimination of any kind of degree taken into consideration will always improve efficiency. In general efficiency of price discrimination can be improved each time an output increases. The outcome strictly relies on if there is a drop in consumer surplus with respect to price policy that is to be outweighed through the achievements of producer surplus. It this is maintained definitely improvement of efficiency would be visible in price discrimination (Graddy, Kathryn, and Hall 2009). The research studies of Langer (2011) furthered states that price discrimination subsists in the circumstance where there is a less demand for a product than its mean total cost provided at each point.
If a single price is maintained then in such case the products are not supplied at any cost. This is the case of doctors in a country who do not possess sufficient revenue to infringe even if all the patients are charged equal price. Price discrimination enables the doctors to reside in small towns and villages only the rich are charged with high price whereas the patients of moderate-income are charged lower prices and the least charged are the poor patients.
If the charges levied by the doctors are such that whole revenues compensate the total costs, then under such case it appears sensible to remain in business through price discrimination. The studies of List (2004) discovered that price discrimination is most common among the colleges and is accomplished by means of scholarships. Students who projected their reservation price as low and their respective claims for services as highly elastic are imposed with a lower price to complete their education.
Conditions for price discrimination
According to Don, Kemp & Sinderen (2009) there must have various conditions to be fulfilled in order that price discrimination takes place. Initially the firm should possess power over the market for example it should have the capability to establish competing costs to introduce price discrimination which would otherwise may not help it to lead. However, competition is found to be prefect rarely as many of the firms possess limited power over the market. This makes price discrimination high in the competitive markets. In this regard Davis (2010) contends that domination of price discrimination is not imperative though it may exploit within EU competition law. Secondly the firm should possess the capability of sorting customers based on the willingness they have regarding the payment per unit. The extent to which the information is used by the firm upon their consumers will consecutively assist in determining the various forms exhibit by price discrimination.
However the research of Preston (2008) found that most of the firms possess inadequate information of their consumers regarding their pay intentions that will only enable the firm to discriminate the price in an imperfect manner.
Within the third level, the ability of the firm is considered that determines to what extent the firms will prevent or restrict the process of resale in terms of goods and services to reflect the paying of the consumers according to whom the lower price is imposed to those who disburse higher prices. In this regard Hal (1985) argue that in certain circumstances resale would become infeasible because of excess transaction costs for example the cost of transportation would be high in low cost areas. Conversely other firms will try to implement contractual or adopt other measures in order to avoid the arbitrage existing between the consumers for example prevention of resale (Carlton & Perloff, 1999).
However the studies of Kamlesh (2010) stated that a profitable and effective price discrimination needs three conditions to be fulfilled they include: 1) Monopoly firm 2) Market segmentation and 3) Market Sealing. For a firm that is monopoly, a perfect knowledge as well as perfect mobility contributes in developing a perfect competition and can be achieved despite of having the numerous sellers in the market however a discrimination of price become infeasible in such perfect competition. In the case of market which have been got segmented, it becomes imperative for the sellers to sub-divide the total market by isolating the consumers into various groups or into sub-markets depending upon the elasticity of price discrimination. Consider an instance of consumers where they are segregated into poor and rich, and based on their nationality as national and foreigners that allows in imposing different prices. Moreover, it has been discussed that resale of products is also impossible for which it has been banned.
As such the traders have to avoid the resale of products in the markets by varying the prices from lower to higher. The leakage of such information by the consumers within the markets or sub-markets will result in the neutralization of the effect arising out of differentiation in price.
Consider an example of doctors and lawyers where it can be state that their services cannot be resold in the market. Similarly, the local consumers are not allowed to sell the products in international markets because of the variations exist in the incomes of people of different locations. Generally, prices in the markets vary depending upon the intensity of demand, changes in high price occur due to inelastic demand whereas the changes in low price are due to elastic demand.
The above discussions further presented that when the conditions become predominant, the success may not be achieved in the case of price discrimination. Even if it is assumed that price discrimination can be happened, anticipation of its success cannot be determined. One more condition presented by Alka states that with the help of tie-in sales, customers are allowed to purchase a product only if they come to an agreement that they will buy the another good from themselves. However, two types of tie-in sales are there that include: 1) bundling and 2) requirement.
In the case of bundling tie-in sales fixed proportion of purchase is imposed on the consumers where they have to buy the goods in fixed quantity. Assume that, a unit of X good is purchased by the consumers from the seller then it becomes imperative for the customers to have k unit of Y good from the same seller. In the case of Microsoft company, bundling tie-in sales can be viewed clearly where the firm has tied its product i.e., Internet Explorer along with Windows operating system.
One more example in this regard is the movie theatre which often tries to bundle two movies – a popular movie as well as less popular movie within the same location. In most of the cases, the bundling is done keeping the customers in view as they have variable perceptions over bundling of goods.
Under certain conditions it may happen that a seller can charge lower reservation prices to the customers for each and every individual good however this will no more helps in increasing money since the consumers are charged for bundle of goods with lower reservation prices.
Within the type of requirements tie-in sales, consumers are allowed to buy goods in different proportions for example McDonald`s organization maintain individual restaurants to buy paper cups from McDonald`s itself. However the paper cups bought depends on the requirement of specific restaurants. Also in the case of Can-closing manufacturing firm customers are retained by enabling them to purchase the cans from their unit itself. Finally the customers will wind up paying differentiable amounts for the similar kind of product. Hence this policy indicated a typical form of price discrimination.
The impact of consumer welfare
In most of the cases consumer surplus gets reduced and it leads to the loss of consumer welfare. The price charged for the most of the consumers is considerably beyond the marginal cost of production. In the market with an inelastic demand consumers in the segments prefer back to the regular pricing, by firms having monopoly power. According to Olczak, 2009 this power is searched as well as their welfare is lessened.
As per the studies and argument of Yoon-Ho & Brown, (2005) the consumers are benefited though they buy at a low price. Formerly the consumers might have been disqualified to consume it. Only if the supplier aims to charge the consumers with a lower price than the low-income consumers might be priced in the market.
Consumers of low-income are charged with lower prices only if the supplier is intended to provide. In this case the better examples could be considered from legal and medical field where the charges of services being offered rely upon the levels of income. More benefits can be yield by allowing the services with greater access which will become an inference for the inclusive levels of social welfare as well as for equity which is considered useful for allocating the scarce resources.
As per the extensive studies of the economists, Bishop& Walker (2002) the welfare effects of price discrimination consisting of three degrees were discussed. Of these three degrees the first degree of price discrimination having the welfare effect does not contain an extensive discussion because such type of discrimination does not occur in practice according to Yoon-Ho & Brown, (2005).
By quoting an example Olczak (2009) explained that including these effects necessarily rely on the welfare standard which is selected. This is because the every consumer who is able to pay is charged maximum for either the service or the given product. It is capable in a position to derive the entire consumer surplus.
Therefore, the first degree price discrimination improves the whole welfare (i.e., the sum of consumer and producer welfare).Since the consumer surplus is entirely engaged by the producer it reduces the consumer welfare on the other side.
According to the arguments of Faull & Nikpay (1999) a greater degree of attention is needed into the welfare effects of second and third degree price discrimination.
This will allow firms to provide goods for groups of customers which otherwise would not be provided in the non-existence of price discrimination. In third degree discrimination an instance of variable tariffs such as peak and off-peak of train travel when considered which will allow the price sensitive customers to use the uniform price in order to obtain access for such transportation.
A similar kind of outcome can be achieved from second degree by taking the form of rebates into consideration since such rebates will allow new groups of customers to purchase goods which according to them could not be afforded uniform price.
In continuation to the above discussions Ridyard (2002) opined that price discrimination in its various forms is broadly admitted and critically evaluated to estimate whether such discrimination would really enhance the total output. For example it is not necessary that introduction of rebates on the products increases their demands rather it will alter market shares owned by the producers. However in an act of predation, the competitors drop out from the market because of increasing pressure resulting from the effects of rebates which further give rise to reduction in the output. Also a similar kind of outcome may yield from discriminating price cut offs.
According to Ridyard (2002), the price discrimination most probably boosts the output production where the average total cost has to be declined by the seller and is deemed as a keystone in economics. In this similar context, the studies of Jones & Sufrin (2004) opined that output expansion by means of price differentiation is assumed to be a requisite strategy that will enable the firms to deal with fixed cost recovery problems. However, all firms practically make substantial investments that enable them to confront fixed costs and assist in spreading the fixed cost even on surplus units besides expanding the output.
Also if the marginal costs remain low as that in the case of network industries, any affirmative cost will permit the firms to lead with fixed costs. Therefore, the prohibition of price discrimination forbid fixed costs recovery sooner or later giving rise to negative influence upon the investments. If the levels of outputs shrinks on regular basis then under such circumstances rebates will create some sense in industries for example postal sector often deal with stern substitution effects.
Overall, prohibition of per se on price discrimination is unjustifiable according to economic theory since the price discrimination depend upon conceptions of each case.
Producer surplus and profit
In the interest of businesses achieving greater profits the price discrimination is seen. The consumer surplus changes into extra supernormal profit and it is extracted by the discriminating monopoly.
Through an aim of maximizing profit businesses may not be motivated. The revenues can be maximized only when the company receives maximum amount from the customer who wishes to pay.
The use of price discrimination may be as predatory pricing tactic which means that the prices are set low to few customers so as to affect the supplier`s level as well as to increase the market power.
Such a kind of anti-competitive practice which is difficult to be proved comes under the study of authority of UK and European Union competition. It is discussed that price discrimination is a path to make the market competitive in a long run. An extensive use of the price discrimination with the consumers is connected with the success of the low cost airlines. (Alderighi, Cento, Nijkamp & Rietveld, 2011).
The profits gained by the firms in one market can be utilized the same to overcome the loss incurred during the course of activities or services which is considered to be very imperative in case of social benefits. An example explains that the profits brought in commuter rail or bus services enable the transport companies to carry the loss making rural or night-time services. The inability to price discriminate makes the services to withdraw and also affect the employment. Many cases show unfavorable aggressive price discrimination towards the business survival when there is a recession or immediate downturn of market.
The total output increases when the extra units are sold at lower price and this may be helpful for the monopoly supplier to find the economies scale thus reducing the long run average costs.
Chapter Three
In the previous first chapter giving a brief introduction to the area of research it was discussed varied literary perceptions of price discrimination in the context of the social welfare.
Based on the discussed background related literary evidences were presented to justify the conduct of the research to inquire into and find: does price discrimination influence the social welfare and to what extent? To further the investigation two cases were considered to be studies to find the impact of price discrimination on the social welfare they included `airline industry` and the `UK package tours` justification for adapting the case was discussed in the introduction to the cases.
This chapter furthers to apply the case study to the theory studied in the previous section. The idea is to draw related conclusions in the light of the key research question. Application of the theory to the case will be done individually for each of the case as they are different sectors however as both seems to be depending on one another an attempt will be made to amalgamate both of them.
Application of Price Discrimination to Airline Industry
A closer look at the discussed data and the introduction it is evident that the airline industry has undergone due to drastic changes in its functional area. The most drastic change is an attempt by low cost players and the growth of information technology that has compelled the industry to be more transparent in pricing.
In this context application of price discrimination aspect to the industry is anticipated to gain an insight to find how it influences the social welfare if so to what extent.
Identified Areas
A closer look at the airline industry statistics indicate that in principle there seems to be three areas where price discrimination can be seen. They include 1) different versions 2) discounts to large customers and 3) frequent flyers. Each of these areas where price discrimination can be seen has their own distinction and vastness and are potential enough to make an in-depth study of social welfare however this may require a statistical analysis which is not being done by this research. As such this research focuses on the first area: different versions.
Varied Versions of Airline Ticketing
One of the most common versions of air ticketing in terms of price is `expensive` or `cheap` ticket. An expensive ticket is more flexible when compared to a cheaper ticket having lots of restrictions. One such example is the air-ticket may demand a `Saturday-stay-over` or an `advance purchase` or something else. This is a clear indication of two factors: 1) the quality of the product and 2) the customers` willingness to pay. Most of the airline operators apply this method of ticketing. This can be better understood when presented in picture format (figure-1).
Figure 7: Quality vs. Price-willingness
Source: Steen and Sørgard (n.d.)
Application of the above model for the present research is considered as follows:
1. Q1 is the high quality version of the ticket that is more flexible. This kind of ticket facilitates the customer to not only re-schedule the flight at any given time but also facilitates to cancel the ticket without any extra costs attached to it. This is mostly for the people whose willingness to pay is more.
2. Q2 is low cost ticket (is also discussed as `damaged version` for the ease of discussion) that is a restrictive in nature and carries varied kinds and types of restrictions. This is mostly for the people whose willingness to pay is less.
As can be seen in the above figure the quality increases with the customer`s willingness for payment. Demonstrating the model Steen and Sorgard state that customers who show the greater will towards the pay have lower attractive choice. This indicates that high prices can be charged on quality products by the firms to ensure the purchase of quality version by the customers.
Here the author says that the lesser the customers willingness to pay, less is the quality. Here we need to understand that minimizing the quality means damaging the services and as discussed above damaging the product in case of airline is nothing by putting varied kinds of restrictions on the price of the ticket.
At one glance of the above model wherein the percentage of damage increases with the decrease of customer`s willingness to a direct implication drawn would indicate that this is detrimental to welfare. However the studies of Steen and Sørgard argue that this may not be true in all circumstances especially when there exists higher percentage of the consumers who value the extra quality and willing to pay more and on the other hand for the second group (customers whose willingness to pay is less) the degradation is less i.e. the damage caused to the product in case of the airline industry a fewer number of restrictions are implied.
The point to be noted here is that products are degraded in its quality so that they are appear less attractive for the customers who show a greater will towards its pay. However, this act as a motivational factor in airline industry when some restrictive tickets are introduced by them.
The above discussions are monopoly in nature. When applied to the airlines industry the results may vary as Varian (1996) state that where the output is more versioning will certainly yield in higher welfare. However, the studies of Borenstein and Rose (1994) observed that distribution of price in airline industry is more in the competitive market when compared to monopoly market. This represents that in the competitive market, the price discrimination is more prevailed by the firms. Considering the growth of the airline industry and more importantly due to hefty competition this research argues that the competition within the industry where there is numerous operators` segmentation is already made in terms of `quality` and `willingness to pay`.
Till now it is not stated anything about the reduction of price whether it would result in high quality or low quality. It is just a question of empirical form. However, in some of the theoretical studies this issue has been raised to represent that increase of price discrimination occurs due to increase of competition in the market. If it is true, the conclusion is furthered strengthened to specify the importance of versioning in competitive strategy among the consumers whose will to pay is low since they are allowed to gain much from the low price setting.
Application of Price Discrimination to UK Package Holiday
As discussed in the initial first chapter Package Holidays (PH) considered as a means of gaining sales with increasing volume and declining the cost of per unit and availing the operators to buy different components in bulk such as accommodation, catering, flight and etc thereby allowing the consumers with some savings.
Such a strategy generally fills the tour operators with excess capacity allowing them to apply the second degree of price discrimination this occurs mostly when the seller to off-load themselves offer the available spares to buyers. However studies indicated that if there is a delay from the consumers this may not happen more specifically in case of package holidays – `Peak Load Pricing` (PLP). This is a clear indication to admit that holiday packages are a pure example of discriminatory pricing. Thus the research furthers to apply the price discrimination concept to the holiday package with the conceptual framework of PLP. Application of PLP shows two demand curves (figure-2).
Figure 8: Peak and off-peak pricing
Source: Tutor2u (n.d.)
As can be seen in the above figure there demand curves are two in number the peak demand is indicating a higher level of demand where the elasticity is naturally very less whereas the more elastic off peak demand indicates the lower demand.
From the above figure when applied to the UK package holidays it can also be assumed that there exists a plenty of spare capacity when the supply reaches a capacity limit. This is when the tour operators with discounted prices fill the spare capacity with discounted prices. The customers on the other hand anticipating that the price will be higher due to demand may take up the discounted offers however the fact is that the tour operators generally make the maximum profits only during the peak times as they are already have a capacity that is generally reached with an agreement that is mostly done 12-14 months prior to the peak demands.
However one cannot ignore customers` evaluation that also impacts the anticipated returns of higher profits from peak demands for example the London bomb blast (July 5, 2005) left many tour operators ending up with little or no profits of the peak demands that is generally because of the Summer School Holidays that are generally during the period of late July to September end. This is a clear indication of the unpredictable occurrences more importantly because tour operators` anticipations of peak-demand are in the context that: `peak demand occurs at predictable times during the day or season`.
The above argument of the research stands in the context of the consumer`s evaluation of the product for the price discrimination which is stated as `an inter-temporal setting in which individual uncertainty is resolved over time` by Issac et al., (2010 p. 382) who further states that consumers make the purchase with regular price when the valuation realized by them is high – a wait and purchase approach.
However considering the report of turot2u that of the UK holiday-makers that are estimated to take-in 36 million overseas holidays each year 50% of them are taken by the “packaged holidays” (tutor2u, n.d.) there is no dearth for consumers purchasing a total holiday package that includes transportation (flights), accommodation (hotels) etc all of which are bundled in one price. However, Nocke et al., (2011) argue that though there attained oligopoly features, UK package tour sector is certainly a competitive in the market with few numbers of tour operators striving vigorously to gain the share in the market.
Chapter Four
This thesis furthered to inquire whether price discrimination would influence the social welfare and if so to what extent. In this context, this research initially furthered to probe into the background wherein it is found that most of the research seems to have misrepresented the factor of social welfare in terms of evaluating it being influenced by price discrimination. Appropriate social welfare which is defined as consumer surplus and producer surplus leaves a question mark when contrasted with competition prevailing in the decentralised markets and in a decentralised markets, market players often adopt different pricing strategies to gain competitive advantage.
The research furthered into discuss the concept of price discrimination in the context of social welfare it is found that implementation of price discrimination is mostly to acquire as much as excess consumers as they can be from the market. In a monopoly efficient level of output can be attained when the first degree of price discrimination is engaged, an indication of beneficial from social perspective. However when the same flourishes, the first degree indicates loss to consumer surplus whereas to reach the welfare allegations under specific circumstance substantial and intricate analysis becomes imperative in second and third degree of price discrimination. However within the ideals are concerned, the second degree price discrimination successfully achieves similar results but this occurs very rarely. Price Discrimination subsists in circumstances where the demand is less for a product when compared to mean total cost provided at each point. However, maintaining single price lead to deficiency of product supply.
Irrespective of the intentions for the price discrimination to take place it is imperative that there are varied conditions. For example, the firm initially needs to possess power in the market and the capabilities to establish the competing costs resulting in higher rate of price discrimination in competitive market. Another important factor is firms` disability to specifically apply price discrimination as they lack the information of customers paying intentions. Based on the discussions of the application of the theory to the case study organizations this research concludes to state that welfare in case of airline industry and package holidays is not influenced by price discrimination. The following reasoning is anticipated to explain the stated conclusion. In case of airline industry this research applied price discrimination to the concept of versioning wherein it was found that more versioning will yield higher welfare the reason being that customers` choice of quality and the marginal willingness to pay for the services. From the argument it can also be concluded to state that due to heavy competition in the airline industry wherein there is a diversification in services provided giving a wider choice of selection to the customers leading to less or no influence on welfare. The main reason for considering the second case of UK package holiday was to further gain insight of the price discrimination from within the studied variation of prices from the airlines sector. As discussed in the previous section the second quality of customers are those who are willing to pay less as a result of which they may have to invite restriction and one such restriction is a forced stay-back on the week-ends i.e. Saturday. As discussed in the earlier section most of the airline operators have adapted this strategy and that in a competitive environment this may not impact the welfare but on the other hand will facilitate the customers to be benefitted from it. To further justify how this could happen the second case of `UK Package Tour` was considered for application.
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