Essay Question 2 Many fast food chains pride themselves in offering various menus by adopting various pricing strategies.

For example, KFC offers discounts for students while McDonalds offers 6 -piece nuggets at $4.40 and 9-piece nuggets at $5.70. (a) (b) Explain the factors that are necessary for price discrimination to occur. [10] Discuss whether price discrimination in the fast food industry is desirable. [15]

Suggested Answer Scheme

(a) Explain the factors that are necessary for price discrimination to occur. [10]

Introduction Define price discrimination and state its purpose. Price discrimination is the practice of selling a given product at different prices to different consumers and these price differences are not caused by cost differences. Firms choose to engage in price discrimination as this would enable them to earn higher revenue which in turn would lead to increased profits. Body In order for firms to engage in price discrimination, the firms would need to ensure that the following factors/conditions are met: (Note: these are mandatory conditions that have to met in order to achieve price discrimination, whether 1st, 2nd or 3rd degree price discrimination. For 3rd degree price discrimination, there are other necessary factors to be considered.) 1) The seller must possess market power. This market power is essential before price discrimination can take place because it gives the firm control over either price or output. To price discriminate, the firm has to control prices by controlling the quantity supplied in the market/sub-market, since they are charging different consumers different prices. This is not to say, however, that the firm must be a monopoly1. Any firm that has even the smallest degree of market power faces a downward sloping demand curve (as opposed to the horizontal demand curve faced by price takers); thus, the consumers will have a surplus
1

Note that there is no need for the firm to be a monopoly. Mere market power, i.e. as long as there is no perfect competition, is sufficient. Being a monopoly only makes it easier. These can be seen from various examples in real life, such as spas and salons, which generally operate as monopolistically competitive firms. Salons for example, often engage in 3rd degree price discrimination, because they offer lower rates for haircuts (especially for males) for what is essentially the same service.

in the transactions. Price discrimination can transfer at least some of that surplus to the firm. Without control over prices, only a single price would prevail in the market, as perfectly competitive firms (with no market power) must charge whatever price the market dictates and this would therefore completely undermine price discrimination. The market power can arise from market imperfections, such as barriers to entry, differentiated products, consumer ignorance, etc. With reference to the preamble (the fast food industry), firms operate in an oligopolistic market. As they each sell a differentiated product, each firm has market power over their specific product. Moreover, these firms have large market power due to their large market share. They also have the ability to entrench their market power and share, because they are able to brand themselves effectively (either via advertisement or product differentiation or even innovation) and hence establish strong artificial barriers to entry. 2) There must be no (or in this case, practically very little) possibility of resale between the various consumers. As firms are selling the good to various consumers at different prices, price discrimination would be undermined if consumers are able to resell goods to other consumers. (arbitrage) If consumers are able to resell the goods purchased at a lower price to other consumers, this may actually restore price equality. In a situation of 3rd degree price discrimination, where KFC offers students meals: if students can purchase student meals and re-sell them to adults at higher prices, adults will choose not to buy the KFC at the adult price and instead, choose to offer a lower price to students (but a price higher than or equal to the student price in the resale market). This situation therefore would undermine the price discrimination conducted by KFC. In real life, such a situation is unlikely to occur, and hence KFC can price discriminate because: i) of the nature of the good sold by the fast food restaurants.

Fast food such as burgers or fried chicken are perishable goods (i.e. they turn cold and stale easily). It is impractical for adults to re-purchase such meals from students due to the increased likelihood of obtaining a stale meal. ii) there is no incentive for anyone to sell the set meals as the opportunity costs of queuing up to get the set meals and finding a buyer might not outweigh the benefit from selling the burger (at most one or two dollars earned from the resale). Furthermore, there are also search costs involved. A student willing to sell may not find it easy to find an adult willing to buy. Negotiation costs may also be a factor. (What price to sell? What price to accept?)

The preamble refers to a situation of third degree price discrimination where consumers are grouped into two or more independent markets and a separate price is charged in each market. In order for 3rd degree price discrimination to occur, there are two other conditions that have to be met. 1) Markets must be identifiable and separable2. As firms do not have perfect knowledge and wish to charge different consumers different prices (because different consumers have different willingness and ability to pay), they will need to find a way to identify and separate the markets. In the given context, students can be easily identified and separated from the other segments of the market by requiring that they show their student identity cards before they are allowed to purchase their set meals at the cheaper price. 2) For it to be profitable, these separable markets have to have different price elasticities of demand. In the context of fast food industry, the demand for fast food by working adults is less price elastic than the demand for fast food by students. This is because the price of the set meal constitutes a smaller proportion of their income. Students on the other hand get allowances which are arguably smaller. Hence, the price of the set meal may make up a larger proportion of their meagre allowances (incomes) from their parents. As a result, students would be more sensitive to price changes, more price elastic. Once the firm has determined the profit-maximising output, this output will be distributed between the two sub-markets. Since the consumers in the two sub-markets have different willingness and ability to pay, the firm will exploit that by charging them the maximum price that each sub-group is willing and able to pay. Doing so will allow them to increase their revenue and correspondingly, profit. Price discrimination would therefore allow them earn greater revenue in both markets compared to charging a single price across the two markets. (Note that production cost should not change as the output does not vary whether under normal pricing or price discrimination (MC=MR always determines profit-maximising
2

Note that this is also a condition that is necessary for first degree price discrimination. However, there is a slight difference. In 1st degree price discrimination, all consumers are assumed to be willing and able to pay different prices. Therefore, all consumers are identifiable and separable EACH as a separate market, i.e. the consumers can be classified into infinitely separable markets. For second degree price discrimination, the seller does not need to exogenously divide the consumers into classes. The schedule of prices is designed so that each consumer reveals his type by self-selecting a quantity to purchase with the corresponding marginal price.

output). Therefore, if there are any total cost increases, it should only be due to administrative costs as a result of the ACT/IMPLEMENTATION of price discrimination.) (b) Discuss whether price discrimination in the fast food industry is desirable. [15]

Introduction Briefly state that price discrimination could bring about benefits and costs to the producers, consumers as well as the society of the fast food industry (stakeholders). State that the benefits and costs to the producers, consumers and society could be measured by: 1) Producers profits 2) Consumer surplus or consumer welfare or level of consumption 3) Society efficiency and equity Body Thesis: Price discrimination in the fast food industry is desirable. [There are two possible approaches here. Students need only offer either to obtain credit. The preferred approach is explained here, while the alternative approach is placed at the end of the answer] PREFERRED APPROACH 3rd degree price discrimination Producers Increased profit KFC conducts 3rd degree price discrimination in a bid to increase total revenue. They do so by dividing the market into 2 sub-markets: students and non-students (which includes adults), as explained above. By engaging in third-degree price discrimination, KFC could earn greater revenue in both markets than by charging a single price (i.e. P1) across the two sub-markets. Having determined the profit maximizing output Q1 in the combined market, KFC could choose to price discriminate or not. If it chooses not to engage in price discrimination, it would end up earning total revenue of the rectangle P1 A Q1 0. Whereas, if it chooses to price discriminate, the firm can further increase total revenue, (P2 B Q2 0 + P3 C Q3 0) > P1 A Q1 0 To do so, it would extract the value of MC as determined in the combined market and equate that value separately with the different MRs in the sub-markets. This leads to a lower price, P2, charged in the student market (corresponding to their lower ability to pay).

For non-students (specifically targeted at working adults), their willingness and ability to pay is higher. Therefore, the firm would exploit this and charge the highest that the consumer is willing and able to pay for that quantity of goods, P3.3

Price ($) MC

Price ($)

Price ($)

P3 P1 MC ARy MR 0 Q1 0 Qty Q2 MRy 0 Qty A AR P2 B

MRx Q3

ARx Qty

Students sub-market
Diagram 2: Third Degree Price Discrimination

Non-student sub-market

As total cost does not change (since output has not changed), profits will rise as a result of the increased total revenue. [Note: depending on where the student has placed the above explanation, they do not need to repeat themselves but merely refer back if they had done so in (a)] Consumers Price discrimination may lead to higher prices paid by non-students and a lower price paid by students. Hence, consumer surplus falls in the non-student sub-market whereas, consumer surplus may rise in the student sub-market (the price falls). The overall effect should be that consumer surplus falls. It is almost always certain that the fall in consumer surplus in the non-student sub-market will be greater than the rise in consumer surplus in the student sub-market (on the assumption that there is a rise in consumer surplus in the student sub-market).

When a firm decides to price discriminate, the distribution of the good between the markets will change. Before price discrimination, the more demand price elastic consumer group pays a higher price and consumes less, while the less price elastic in demand consumer group pays a lower price and consumes more. When there is price discrimination, the tables are turned, the less price elastic in demand consumer group has to pay a higher price and consequently, quantity demanded will fall, but the more demand price elastic consumer group will experience a lower price and consume more.

Society Allows loss making firm to continue production Price discrimination is particularly desirable when firms are unable to make normal profits in the long run (cannot survive, hence shut down and discontinue production). Price discrimination increases the level of total revenue that can be earned, which may allow the firm to earn normal profit in the long run, ensuring firm survival. This means that goods which would not have been produced due to high costs of production can now be produced. The gain in total revenue from price discrimination is therefore extremely important in an industry where the average cost of production is higher than the price that consumers are willing and able to pay at all levels of output.
Price ($) MC

AC P1 AR MC MR 0 Q1 Qty

Greater level of equity As a result of different prices, some consumers are better off but some consumers are worse off. Those who are willing and able to pay, pay higher prices and those who are less willing, pay lower prices. More revenue for innovation The discriminating producer enjoys higher revenue and thus profits. This benefits society and consumers if these profits are re-invested on innovation, i.e. R&D leading to cost savings or product improvements. Analyse here: It is arguable whether fast food restaurants can conduct substantial innovation and hence improve their product. Often their product improvements are superficial, for example, different sauces, different flavours. It is hard to imagine how the profits can be re-invested to substantially improve consumer welfare, whether via a better product or offering greater choice and variety. Most likely, the consumer and society will simply lose out, since it is most likely that profits and income are redistributed towards the producer.

Anti-thesis: Price discrimination in the fast food industry is UNdesirable. Consumers and Society The root of the undesirability of price discrimination lies in the fact that consumer surplus is gouged for the benefit of producers. Students can therefore link this idea to inequity as mentioned in the previous paragraph. Further loss in allocative efficiency When a firm engages in 3rd degree price discrimination, output does not increase over the level of the nondiscriminating firm. Rather, relative to the nondiscriminating firm, the profit maximizing output is simply redistributed among consumers. In this situation, any deadweight loss that had existed with no discrimination still exists. (Remember that when a firm with market power profit maximizes, they equate MR=MC, but because P=AR > MR, P>MC!) There is, however, an additional welfare cost caused by the allocation of the good from those whose willingness to pay is higher to those whose willingness to pay is lower4. In other words, in this case, third-degree price discrimination is less efficient than no price discrimination. [Advanced: Hal Varian (a famous mathematical economist) has also argued that social welfare will increase under third-degree price discrimination if the ability to discriminate induces the firm to serve a new market, i.e. causes output to increase. If the single-price firm would choose not to serve a small market without the existence of price discrimination, the act of price discrimination would result in the same quantity produced for the large market and a positive quantity for the small market, resulting in a welfare gain.] As these fast food joints are large firms which could earn supernormal profits even if there is no price discrimination, the practice of price discrimination could worsen inequity since it results in a redistribution of income from the consumer to the producer. As price discrimination leads to higher profits for firms, this may lead to firms becoming increasingly complacent and slack. If the firm can earn supernormal profit as a result of the price discrimination, they may not find the need to keep costs at a minimum (Xinefficiency). Analyse here: However, these firms operate in an oligopolistic market structure. While price competition is avoided, these firms do occasionally engage in pricing strategies. The likelihood of X-inefficiency is unlikely, because this would affect their ability to compete on price.

Please see footnote 3 for the clarification on this point.

Here students may wish to link back to the point where profits are not re-invested into product innovation. Conclusion Whether price discrimination is desirable may depend on the underlying purpose of their actions. For example, if price discrimination seeks to increase total revenue so that the firm can make normal profits, this situation is obviously desirable because it will not deprive consumers of a good that otherwise cannot be produced. Furthermore, how much consumer surplus is transferred to the producer may be a factor. For example, whether the firm was already earning large amounts of supernormal profit initially. This would only worsen the inequity already present in the society. Students may also wish to question where the increased profits end up, in the hands of shareholders or are they redistributed in a different manner. To illustrate the second point (though not relevant to this question), some pharmaceutical companies actively conduct price discrimination on certain types of drugs (especially drugs that combat AIDS or symptoms of AIDS). Often, prices of such drugs in the USA are very exorbitant, while the prices of the same drugs are priced very cheaply in Africa. This is called cross-subsidisation. Obviously, this is not relevant to the fast food industry, but a comparison can be drawn in terms of whether this example of price discrimination can be desirable.

2nd degree price discrimination approach (note that this is a weak argument, because this example exemplifies bulk buying, rather than block pricing. This means that the consumer cannot buy 5 nuggets or 8 nuggets and pay the corresponding price of $3.65 or $5.26)5 Price (per unit nugget)

$0.73 $0.43

D Q1 Q2 Quantity

The firm/McDonalds charges different prices for different blocks of the same good/nuggets according to the amount the consumer buys. It sets the same price for the initial 6 nuggets sold ($0.73 cents per nugget) then a cheaper price of $0.43 per nugget until the 9th unit. This is therefore a form of tiered pricing that is derived from demand theory and the law of diminishing marginal returns from consumption. The first few units of nuggets consumed tends to bring higher levels of satisfaction to a consumer. As a consumer consumes more of the same unit, his satisfaction from subsequent units will diminish, which explains why they are more likely to demand the good at a lower price. This lower price seeks to incentivize consumers buy more units of the same good. In the above diagram, price discrimination will allow the firm to increase revenue as they are able to extract consumer surplus, by charging a higher initial price. There is a transfer of the shaded area from consumer surplus to producer revenue, which leads to an increase in profits, ceteris paribus. Consumer

Based on current McDonalds prices, McDonalds pricing scheme is actually based on bulk pricing, rather than block pricing (i.e. 2nd degree price discrimination). McDonalds sells 6, 9 and 20 pieces at $4.50, $5.95 and $11.50 correspondingly. If the scheme is based on 2nd degree price discrimination, this means that they sell the first 6 units at $0.90 each, the next three pieces at $0.48 cents each and the next 11 pieces at $0.50 each. Rather, what McDonalds is doing is charging $0.90 cents per unit for 6 pieces, $0.66 cents per unit for 9 pieces and $0.575 cents per unit for 20 pieces.

As a result, consumer surplus falls (to the detriment of the consumer). However, consumer welfare/satisfaction can rise because of the increased levels of consumption, more units of nuggets ingested.