Academic journal article Economic Inquiry

The Welfare Effects of Third-Degree Price Discrimination in a Differentiated Oligopoly

Academic journal article Economic Inquiry

The Welfare Effects of Third-Degree Price Discrimination in a Differentiated Oligopoly

Article excerpt

This article examines the welfare effects of third-degree price discrimination under oligopolistic competition with horizontal product differentiation. We derive a necessary and sufficient condition for price discrimination to improve social welfare: the degree of substitution must be sufficiently greater in the "strong " market (where the discriminatory price is higher than the uniform price) than in the "weak" market (where it is lower). It is verified, however, that consumer surplus is never improved; social welfare improves solely owing to an increase in the firms' profits in the case of linear demands. (JEL D43, L11, L13)

I. INTRODUCTION

This article examines the welfare effects of oligopolistic third-degree price discrimination, explicitly considering product differentiation as a source of market power and strategic interaction. Product differentiation is one of the main reasons why firms can enjoy market power; it enables them to sell products that are no longer perfect substitutes. For example, Coca Cola and PepsiCo sell similar types of soda, although it is arguable that they differ in taste. Each firm thereby attracts some consumers over another.

As a form of price discrimination, Coca Cola was once reported to be testing a vending machine that would automatically raise prices in hot weather. (1) Although the plan triggered nationwide controversy and Coca Cola had to abandon the project as a result, it could have changed the regime of uniform pricing to one of price discrimination in the soda market. How would the resulting change affect consumer welfare and firms' profits? In other words, is third-degree price discrimination good or bad? Answering this question is important because it helps us to evaluate price discrimination under oligopoly.

In this article, we focus on horizontal product differentiation to consider substitutability as well as complementarity. (2) By assuming a linear-quadratic utility function of a representative consumer and focusing on the symmetric equilibrium of a pricing game, we characterize the conditions relating to such demand properties as substitutability and complementarity required for price discrimination to improve social welfare. More specifically, we derive a necessary and sufficient condition for price discrimination to improve social welfare: the degree of substitution must be sufficiently greater in the "strong" market (where the discriminatory price is higher than the uniform price) than in the "weak" market (where it is lower). It is also shown that aggregate output must increase for price discrimination to improve social welfare. We verify, however, that consumer surplus is never improved by price discrimination: welfare improvement from price discrimination is solely owing to an increase in firms' profits.

In the example above, the degree of substitution would be higher in the strong market (i.e., when the temperature is high) because consumers care less about which brand when it is hot weather. Our analysis below implies that social welfare might improve in this case. The degree of substitution can vary across markets even if consumers in each market face exactly the same products because consumers' taste depends on various market-specific factors such as geographical and natural conditions. If the strong market is where consumers demand a product more eagerly, caring less about which brand (in the above example, individuals demand soda more eagerly in hot weather), then our results suggest that price discrimination has large potential to improve social welfare. (3)

Why does allowing price discrimination improve social welfare? Notice that there are two forces that determine equilibrium prices in price-setting oligopoly: a larger market size raises the price, whereas a larger substitutability parameter lowers the price. For price discrimination to raise social welfare, it is necessary that a high degree of substitutability mitigates an increase in the discriminatory price in the larger market. …

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