Price Discrimination Questions and Answers

Q11.1 Your best income-earning opportunity appears to be an offer to work for a local developer during the month of June and earn $2,000. However, before taking the job, you accept a surprise offer from a competitor. If you actually earn $2,600 during the month, how much producer surplus have you earned? Explain.

Producer surplus is the amount that producers benefit by selling products at price P that is higher than the least that they would be willing to sell for. Opportunity = $2,000 is the relevant marginal cost, producer surplus = $2,600.

$2,600-$2,000 = $600 over the amount represents the value of your producer surplus.

Q11.3 After having declined during the 1970s and 1980s, the proportion of teenage smokers in the United States has risen sharply since the early 1990s. To reverse this trend, advertising programs have been launched to discourage teenage smoking, penalties for selling cigarettes to teenagers have been toughened, and the excise tax on cigarettes has been increased. Explain how each of these public policies affects demand for cigarettes by teenagers.

These penalties have a favorable effect by causing an inward shift in the demand curve for cigarettes. In both cases a reduction in demand will be observed with a tax and price increase, causing a decrease in the quantity demanded and an upward movement along the demand curve. Is estimate that for every 10 percent decline in the price, youth smoking rises by almost 7 percent. The most influential tool that policymakers have to reduce youth smoking is excise taxes that raise the price of cigarettes

Q11.6 In 1990, Congress adopted a luxury tax to be paid by buyers of high-priced cars, yachts, private airplanes, and jewelry. Proponents saw the levy as an effective means of taxing the rich. Critics pointed out that those bearing the hardship of a tax may or may not be the same as those who pay the tax (the point of tax incidence). Explain how the elasticities of supply and demand in competitive markets can have direct implications for the ability of buyers and sellers to shift the burden of taxes imposed upon them. Also explain how elasticity information has implications for the amount of social welfare lost due to the deadweight loss of taxation.

The demand for new luxury items produced and sold in the United States is relatively elastic, buyers can choose to not do the purchase, or buy them from producers not subject to tax, in order to minimize their discretionary tax payments. When demand is elastic and supply is inelastic, as in these case the largest share of tax burden falls on producers rather than buyers. The tax caused a steep to decline in domestic production, profits to plummeted and workers got laid off.  They didn’t keep in mind that the economic hardship of a tax can seldom be inferred by simply referencing the party responsible for paying the tax. The burden of a tax tends to fall on that side of the market that tends to be less elastic.

Elasticity has consequences in the amount of social welfare lost due to the deadweight loss of taxation.  When elasticity of demand is a constant the deadweight loss of a tax is small when supply is relatively inelastic. When supply is relatively elastic, the deadweight loss of a tax is large, holding supply elasticity constant. Deadweight loss of a tax is small when demand is relatively inelastic and when demand is relatively elastic the deadweight loss of a tax is large.

Q11.9The New York City Rent Stabilization Law of 1969 established maximum rental rates for apartments in New York City. Explain how such controls can lead to shortages, especially in the long run, and other economic costs. Despite obvious disadvantages, why does rent control remain popular?

Rent control is to make housing more affordable, especially for the elderly and the poor that lives in the city. Supply of apartments is inelastic in the short run, but imposition of rent controls has little effect on short-run supply. In the long run, landlords can exit the rental business given a rise to an upward sloping long-run supply curve for apartments. Short-run shortages in apartment availability will tend to be exacerbated in the long run. Rent control leads to long waiting lists and black market payments to landlords.  Disadvantages about  rent control system are that the wealthy disproportionately occupy rent controlled units, politicians and other bureaucrats unfairly benefit from the system, and that landlord bankruptcies cost State and urban taxpayers millions of dollars.

The popularity remains because anyone who continues to live in a rent-controlled apartment has the potential to benefit from “squatters rights.”  Rent control programs are very popular with the population that have higher incomes and benefits than the rest taking advantage of the system.

Q15.2 Explain why successful firms that employ markup pricing use fully allocated costs under normal conditions, but typically offer price discounts or accept lower margins during off-peak periods when excess capacity is available.

Fully allocated costs can be appropriate when a firm is operating at full capacity.  During peak periods, expansions are required to increase production.  Increase in production requires an increase in all plant, equipment, labor, materials, and other expenditures.  If a firm has excess capacity, as during off-peak periods the only costs that actually rise with production is the incremental costs per unit. When fixed costs represent a substantial share of total production costs, discounts for output produced during off-peak periods can be justified for lower costs.

An  example for this is the “Early Bird” movie theaters, cleaning expenses which vary according to the number of customers is the only actual expense incurred, most movie theater expenses are fixed.  Revenue generated by adding customers during off-peak periods can significantly increase the theater’s profit contribution and reduce the outcome.  Some of the things that will contribute to balance the lower cost in the tickets is the sale in concessions that still at regular price in the off-peak times. Ticket prices during peak periods reflect fully allocated costs when their staff (payroll) increase.

Q15.5 “One of the least practical suggestions that economists have offered to managers is that they set marginal revenues equal to marginal costs.” Discuss this statement.

Profit maximization requires that prices be set so that marginal revenues equal marginal cost, it is not necessary to calculate both in order to set optimal prices.  Using information on marginal costs and the point price elasticity of demand, the calculation of profit maximizing prices is easy.  MR = MC

The use of incremental analysis in the pricing practices of highly successful and profitable firms, like the use of markup pricing practices, can be interpreted as support for the practical equivalent of marginal analysis.

Q15.7 What is price discrimination?

Price discrimination is the practice of charging different markups for the same product.  Is the result when a firm charges different prices for the same product, or prices closely related products where the price differences are not proportional to cost differences. Price discrimination can exist when equal or unequal prices are charged different customers.