Review Questions

1. What are the two requirements of price discrimination?

   In order for a firm to price-discriminate, it must have market power and be able to prevent resale or arbitrage of its product.

2. Why is producer surplus maximized under perfect price discrimination?

   Under perfect price discrimination, the producer charges each individual customer the price equal to his willingness to pay for the product. As a result, the producer captures all available surplus of the market, maximizing his producer surplus.

3. What are the two types of direct price discrimination?

   Direct price discrimination encompasses two types of price discrimination. We discussed the first—perfect or first-degree price discrimination—in our answer to Question 2 above. The second, segmenting or third-degree price discrimination, is the practice of charging different prices to different groups of customers based on identifiable group characteristics.

4. What are some ways that a firm can segment its customers?

   Segmenting may be based on one of a variety of characteristics, including customer characteristics such as age or gender, past purchasing behavior, location, and overtime.

5. Contrast direct price discrimination and indirect price discrimination.

   Direct price discrimination hinges on the firm’s ability to distinguish customers’ demand for the product before purchase. In indirect price discrimination, the firm doesn’t have this knowledge; instead, it allows customers to choose among a variety of offered prices, effectively having customers sort themselves into groups based on their demand for the product.

6. What is incentive compatibility? Why is it necessary for an indirect price discrimination strategy to be incentive compatible?

   Incentive compatibility dictates that the price offered to each consumer group must be chosen by that group. Without incentive compatibility, the firm using indirect price discrimination will not be maximizing its producer surplus.

7. Provide an example of product versioning.

   A firm that offers different product options designed to attract different types of customers is using yet another pricing strategy—versioning. An airline that offers business class and coach tickets, for example, is betting on versioning to maximize its producer surplus.

8. What are the differences between the following three pricing strategies: block pricing, segmenting, and quantity discounts?

   When segmenting, the firm uses its knowledge of characteristics of specific groups of customers to charge different prices to the groups. Quantity discounting is a form of indirect price discrimination in which firms charge a lower per-unit price to customers who buy larger quantities. Similar to a quantity discount, block pricing reduces the price of a good when the customer buys more of the good. Unlike both segmenting and quantity discounts, however, block pricing does not depend on customers having different demand curves and price sensitivities; the firm still earns surplus by offering all customers the option of purchasing a greater quantity at a lower price.

9. What is the difference between mixed bundling and pure bundling?

   A firm that uses mixed bundling offers consumers the choice of buying two or more products separately or as a bundle, while pure bundling is a type of bundling in which the firm offers the products only as a bundle.

10. What are the two component prices of a two-part tariff?

    A firm using a two-part tariff breaks the product’s price into two components: the standard per-unit price and a fixed fee that must be paid to buy any amount of the product at all.