Discussion Paper No. 800

THE WELFARE EFFECTS
OF THIRD-DEGREE
PRICE DISCRIMINATIONIN A DIFFERENTIATED OLIGOPOLY

Takanori Adachi
Noriaki Matsushima

January 2011

The Institute of Social and Economic Research
Osaka University
6-1 Mihogaoka, Ibaraki, Osaka 567-0047, Japan

The Welfare E¤ects of Third-Degree Price Discrimination
in a Di¤erentiated Oligopoly
Takanori Adachiy

Noriaki Matsushimaz

January 17, 2011

Abstract
This paper studies the relationship between horizontal product di¤erentiation andthe welfare e¤ects of third-degree price discrimination in oligopoly. By deriving linear demand from a representative consumer’s utility and focusing on the symmetricequilibrium of a pricing game, we characterize the conditions relating to such demand properties as substitutability and complementarity for price discrimination to
improve social welfare. In particular, we show that price discrimination can improvesocial welfare if …rms’ brands are substitutes in a market where the discriminatory
price is higher and complements in one where it is lower, but welfare never improvesin the reverse situation. We verify, however, that consumer surplus is never improvedby price discrimination; welfare improvement by price discrimination is solely due toan increase in the …rms’pro…ts. This means that there is no chance that …rms su¤erfrom a “prisoners’dilemma,” that is, …rms are better o¤ by switching from uniform
pricing to price discrimination.
Keywords: Third-Degree Price Discrimination; Oligopoly; Social Welfare; Horizontal
Product Di¤erentiation; Substitutability; Complementarity.
JEL classi…cation: D43, D60, L11, L13.

We are grateful to Hiroaki Ino and seminar participants at Kwansei Gakuin University and the University of Tokyo for helpful comments. Adachi also acknowledges a Grant-in-Aid for Young Scientists (B)from the Japanese Ministry of Education, Science, Sports, and Culture (21730184). Matsushima acknowledges a Grant-in-Aid for Scienti…c Research (B) from the Ministry (21730193). Any remaining errors are
our own.
ySchool of Economics, Nagoya University, Chikusa, Nagoya 464-8601, Japan.
E-mail:adachi.t@soec.nagoya-u.ac.jpzInstitute of Social and Economic Research, Osaka University, 6-1 Mihogaoka, Ibaraki, Osaka 567-0047,
Japan. E-mail: nmatsush@iser.osaka-u.ac.jp

1

Introduction

Product di¤ erentiation is one of the main reasons why …rms can enjoy market power; itenables them to sell products that are no longer perfect substitutes. For example, Coca
Cola and PepsiCo sell similar types of soda, though it is arguable that they di¤er intaste. Each …rm thereby attracts some consumers over another. It is often the case that…rms’di¤erentiation of their products leads consumers to value the variety. Examples ofcomplementary products abound and include such products as beer and breakfast cereal.
If …rms have some control over the price that consumers pay, they naturally want totake advantage of it. Third-degree price discrimination is one marketing technique that is
widely used in imperfectly competitive markets. In third-degree price discrimination, theseller uses identi…able signals (e.g., age, gender, location, and time of use) to categorize
buyers into di¤erent segments or submarkets, each of which is given a constant price perunit. Behind the recent trend toward third-degree price discrimination is rapid progressin information-processing technology, notably including the widespread use of the Internetin the past two decades.1
This paper examines the welfare e¤ects of oligopolistic third-degree price discrimination, explicitly considering product di¤erentiation as a source of market power and strategicinteraction. In a story related to the example in the …rst paragraph, the New York Times
once reported (October 28, 1999)2 that Coca Cola was testing a vending machine thatwould automatically raise prices in hot weather. Although the article triggered nationwide controversy and Coca Cola had to abandon the project as a result, the plan could
have changed the regime of uniform pricing to one of regional price discrimination in thesoda market. How would the resulting change a¤ect consumer welfare and …rms’pro…ts?
In other words, is third-degree price discrimination is good or bad? Answering this question is important because it helps antitrust authorities to evaluate price discrimination in
two important characteristics of market: oligopoly and product di¤ erentiation.
In this paper, we focus on horizontal product di¤erentiation to consider substitutability
1

See Shy (2008) concerning how advances in the information technology have made ‘…ne-tailored’pricing
tactics more practicable for sellers.
2
http://www.nytimes.com/1999/10/28/business/variable-price-coke-machine-being-tested.html(retrived January 2011)1

as well as complementarity.3 By deriving linear demand from a representative consumer’sutility and focusing on the symmetric equilibrium of a pricing game, we characterize theconditions relating to such demand properties as substitutability and complementarity required for price discrimination to improve social welfare. In particular, we show that pricediscrimination can improve social welfare (especially) if brands are substitutes in a market
where the discriminatory price is higher and complements in the market where it is lower,
but never when the reverse situation holds. We verify, however, that consumer surplus isnever improved by price discrimination: welfare improvement from price discrimination
is solely due to an increase in …rms’pro…ts. This means that there is no chance that …rms
su¤er from “prisoners’ dilemma,”; that is, …lms are better o¤ switching from uniform
pricing to price discrimination.
Since Pigou’s (1920) seminal work, the central question in the analysis of third-degree
price discrimination is about its welfare e¤ects: what are the e¤ects of third-degree pricediscrimination on consumer surplus and Marshallian social welfare (the sum of consumer
surplus and …rms’pro…ts)? In the literature, however, little has been reported about thewelfare e¤ects of oligopolistic third-degree price discrimination since the publication of aseminal paper by Holmes (1989), which analyzes the output e¤ects of third-degree pricediscrimination in oligopoly, but not the welfare e¤ects.4 On the other hand, the welfaree¤ects of monopolistic third-degree price discrimination are relatively well known. Since
the work by Robinson (1933), it has been well known that when all submarkets are served
under uniform pricing,5 price discrimination must decrease social welfare unless aggregate
output increases. This implies that an increase in aggregate output is a necessary condition
3

With horizontal product di¤erentiation, some consumers prefer product A to B while others prefer B
to A. On the other hand, vertical product di¤erentiation captures the situation where all consumers agree
on the ranking of products. See, for example, Belle‡amme and Peitz (2010, Ch.5) for further discussion ofits distinction.
4
See Armstrong (2006) and Stole (2007) for comprehensive surveys of price discrimination with imperfectcompetition. In contrast to Holmes’ (1989) focus on a symmetric Nash equilibrium (where all …rms
behave identically ), an important work by Corts (1998) relaxes the requirement for symmetry to show thatasymmetry in …rms’best response functions is necessary for unambiguous welfare e¤ects (when prices drop
in all markets, the result is unambiguous welfare improvement, and when these prices jump, the result isunambiguous welfare deterioration). Our focus on a symmetric equilibrium is based on the assumptionthat all …rms agree in their ranking in pricing (see Stole (2008) for details), and is motivated by ourrecognition that this situation is more natural than the asymmetric cases in many examples of third-pricediscrimination.
5
Under uniform pricing, …rms may be better o¤ by refusing supply to some submarkets. See, forexample, Hausman and MacKie-Mason (1988) regarding this issue.

2

for social welfare to be improved by third-degree price discrimination.6 In particular,
price discrimination necessarily decreases social welfare if demands are linear because
aggregate output remains constant.7 The welfare consequences of oligopolistic third-degree
price discrimination, however, remain largely unknown. It is therefore important to study
oligopolistic third-degree price discrimination, because only a small number of goods aresupplied by monopolists in the real world and an increasing number of …rms use pricediscrimination for their products and services.
This paper investigates the relationship between product di¤erentiation and change
in social welfare associated with the regime change from uniform pricing to price discrimination when all submarkets are open under uniform pricing.8 To model price competition
with product di¤erentiation, we adopt the Chamberlin-Robinson approach (named by
Vives (1999, p.243)): a “representative”consumer (i.e., a virtual individual that is an aggregation of an in…nitesimal number of identical consumers) is assumed to value the varietyof goods. In this paper, we consider the (fully parameterized) linear demand structure toobtain an explicit solution as well as an explicit condition for all submarkets to be open
under uniform pricing. The bene…t of this speci…cation is that we do not have to simply
assume such endogenous events as a market opening. In addition, while Holmes (1989)
assumes substitutability of products, our formulation allows inclusion of complementarity
in a welfare analysis.
One important di¤erence between monopoly and oligopoly is that in a monopoly, theprice elasticity of demand in each submarket has a one-to-one relationship with the optimal
discriminatory price: the larger the price elasticity, the lower the discriminatory price is.
In oligopoly, however, this may not be the case because strategic interaction a¤ects the6

Aguirre, Cowan, and Vickers (2010) o¤er a comprehensive analysis, …nding su¢ cient conditions relating
the curvatures of direct and indirect demand functions in separate markets. While they allow nonlinear demand functions, they, like many researchers, restrict an endogenous event: all markets are simply assumed
to be open. Cowan (2007) o¤ers a similar analysis by restricting a class of demand functions.
7
For example, Schamalensee (1981), Varian (1985), Schwartz (1990), and Bertoletti (2004). In contrast
to these studies, Adachi (2002, 2005) shows that, when there are consumption externalities, price discrimination can increase social welfare even if aggregate output remains the same (see Ikeda and Nariu (2009)).
Ikeda and Toshimitsu (2010) show that if quality is endogenously chosen, price discrimination necessarily
improves social welfare.
8
In a similar study, Dastidar (2006) considers the welfare e¤ects of third-degree price discriminationin oligopoly by focusing on symmetric Nash equilibrium, as this paper does. In comparison to Dastidar’s(2006) study, ours explicitly takes into account such demand properties as substitutability and complementarity to characterize the conditions under which price discrimination improves social welfare.

3

pricing decision of each …rm. In particular, the price elasticity that a …rm faces in a
discriminatory market is generally di¤erent from the elasticity that the …rms as a whole(i.e., in a collusive oligopoly) face. In this paper, we show that in equilibrium this “…rmlevel” price elasticity has a simple expression in terms of product di¤erentiation. Morespeci…cally, it is veri…ed that, as in Holmes (1989), in equilibrium the …rm-level priceelasticity decomposes into “market-level” and “strategic-related” elasticity (the precise
meanings are given in the text). The latter elasticity simply coincides with the degree of
product di¤erentiation.9 It is observed from numerical and graphical analysis that this“strategic”elasticity plays an important role in the determination of discriminatory prices
and social welfare. One bene…t of using linear demands is that we can evaluate welfare
without the complications associated with demand concavity/convexity.
The rest of the paper is organized as follows. The next section presents a model andpreliminary results. Section 3 presents the welfare analysis. Section 4 concludes the paper.
Technical arguments are relegated to the Appendix.

2

The Model

In this section, we …rst set up the model and then provide the preliminary results necessary
for the welfare analysis in the next section.

2.1

Setup

Firms produce (horizontally) di¤erentiated products and compete in price to sell theirproducts (directly) to consumers. A …rm sells only one type of product, which can therefore
also be interpreted as a brand. Markets are partitioned according to identi…able signals(e.g., age, gender, location, and time of use).10 The quali…er “horizontally” denotes that…rms di¤erentiate by targeting consumer heterogeneity in taste rather than quality. For
simplicity, we assume that all …rms have the same constant marginal cost, c

0. Resaleamong consumers must be impossible, otherwise some consumers would be better o¤
9

Our analysis below shows that Holmes’(1989) decomposition also holds for the case of complementarity
with linear demands in the speci…cation of our paper.
10
There are no interdependencies between separate markets. Layson (1998) and Adachi (2002) study
the welfare e¤ects of monopolistic third-degree price discrimination in the presence of interdependencies.

4buying the good at a lower price from other consumers (arbitrage).
Following Robinson (1933) and most subsequent papers in the literature, we suppose that the whole market is divided into two subgroups: “strong”and “weak ”markets.
Loosely put, a strong (weak) market is a “larger” (“smaller”) market.11 Consumer preference in market m 2 fs; wg (s denotes (the set of) the strong markets and w the weakmarkets) is represented by the following quasi-linear utility function:
A B
Um (qm; qm )

where j m j <

m

A
B
(qm
+ qm
)

1
2

A 2
A B
m [qm ] + 2 m qm qm +B 2m [qm ],

m denotes the degree of horizontal product di¤erentiation in market m,jqm
is the amount of consumption/output produced by …rm j for market m (j 2 fA; Bg),andm

> 0.12 Notice that this speci…cation allows the cross-partial derivative to be

A @q B =expressed by just one parameter: @Um =@qmmm . Ifm > 0, the goods in market

m are called substitutes. On the other hand, they are called complements if
If

m

m

< 0.

= 0, they are independent. Notice that the direction of the sign is associatedwith the usual de…nitions of complementarity/substitutability: when the …rms’goods aresubstitutes (complements), the marginal utility from consuming an additional unit of thegood purchased from one …rm is lower (higher) when a consumer consumes more units ofthe good from the other …rms. Note that the lower the value of…rms’products are.13 The ratio

m= m 2 (m , the more di¤erentiated1; 1) is interpreted as a (normalized) measureof horizontal product di¤ erentiation in market m (see Belle‡amme and Peitz (2010, p.65)).
As we see in Section 3,

m = m plays an important role in interpreting the equilibrium

prices under price discrimination.
Utility maximization by the representative consumer yields the inverse demand funcj
tion for …rm j in each market m, pjm (qm; qmj ) =
11

m

j
m qm

j
m qm .

The demandMore precisely, following the literature, we de…ne a strong (weak) market as one in which the price isincreased (decreased) by price discrimination. Notice that this de…nition is based on an “equilibrium”result
from optimizing behavior (either in monopoly or oligopolistic pricing). Appendices A1 and A2 show theparametric restrictions by which a market is strong or weak in the model presented below.
12A
B
More precisely, we assume that the utility function has a quasi-linear form of Um (qm; qm) + q0 , whereq0 is the “composite” good (produced by the competitive sector) whose (competitive) price is normalized
at one. Thus, there are no income e¤ects on the determination of demands in the markets that are focused,validating partial equilibrium analysis. This quadratic utility function is a standard one that justi…es linear
demands (see Vives (1999, p.145), for example). Here, symmetry between …rms is additionally imposed.
13
In the case of independence in market m ( m = 0), each …rm behaves as a monopolist of its own brand.
Hence, the results from studies of monopolistic third-degree price discrimination with linear demands apply.

5

functions in market m are thus given by
8m>
A (pA ; pB ) =
> qm
>
m m
>
+
<
m
m
>
>
>
B (pA ; pB ) =
>
: qm
m m

m

m+

m
2
m

pA +
2 m
m

m
2
m

pB
2 m
m
(1)

m

+

2
m

m

pA
2 m
m

m
2
m

pB .
2 m
m

A (p0 ; p00 ) = q B (p00 ; p0 ). As stated
Notice here that the symmetry in …rms’demands, qm
mabove, we follow Holmes (1989) and many others to focus on a symmetric Nash equilibrium
where all …rms set the same price in one market.14 With little abuse of notation, letA (p; p). For a simpler exposition, there are two …rms and two discriminatory
qm (p) = qm

markets. These numbers can be arbitrary and the results presented below hold as long as
we focus on a symmetric Nash equilibrium.
Social welfare in market m is de…ned by
A B
SWm (qm; qm )A B
Um (qm; qm )

A
B
c (qm
+ qm
)

and thus the aggregate social welfare is given byX

A B
SW (fqm; qm gm )A B
SWm (qm; qm ).

m

We measure social e¢ ciency by this aggregate social welfare. We can also de…neaggregate consumer surplus by
X

B
CS(fpAm ; p m gm )B
CSm (pA
m ; pm )mwhere consumer surplus in market m is
B
CSm (pA
m ; pm )A A
B A
B
Um [qm(pm ; pBm ); qm (pm ; pm )]

A A
B
pA
m qm (pm ; pm )

B A
B
pB
m qm (pm ; pm ),and denote aggregate corporate surplus (pro…t) byB(fpAm ; pm gm )

XX
m

(pjm

j
B
c)qm
(pA
m ; pm )jso that the aggregate social welfare is divided in the following way:
A A
B A
B
A
B
A
B
SW (fqm(pm ; pBm ); qm (pm ; pm )gm ) = CS(fpm ; pm gm ) + (fpm ; pm gm ).
14

See Corts (1998) for interesting issues that arise from the asymmetric equilibrium.

6

We consider two regimes, uniform pricing (r = U ) and price discrimination (r = D):under uniform pricing, …rms set a common unit price for all separate markets. Under pricediscrimination, they can set a di¤erent price in each market. Throughout this paper, we
restrict our attention to the case where all markets are served under both regimes.
Because the pro…t of …rm j 2 fA; Bg is given by
j

B A B
(pA
s ; ps ; pw ; pw )

X

(pjm

j
B
c)qm
(pA
m ; pm ),mwe know that under symmetry, the symmetric equilibrium price under uniform pricing,p , is given by[qs (p ) + qw (p )] + (pc)

A (p ; p )@qsA (p ; p ) @qw
= 0,
+
@pA
@pA
m
m

(2)

while the equilibrium prices in market m under price discrimination, pm , are determinedby the following …rst-order condition:qm (pm ) + (pmc)

A (p ; p )
@qm
m m
= 0:
@pA
m

(3)

Again, one caveat here is the well-known problem in the literature concerning thirddegree price discrimination: under uniform pricing, when a market is su¢ ciently small,it may not be served by either …rm. While many papers in the literature simply assume
that all markets are open under uniform pricing, we provide a more speci…c structure in
the next subsection to guarantee this and to proceed further the analysis.
jNote also the di¤erences between Corts’(1998) study and this paper. Let BRm(pkm )

arg maxpj (pjjc)qm(pj ; pmj ) be …rm j’s best response function in market m under pricediscrimination, given …rm k’s price in market m, pkm . Corts (1998) makes four assumptions
concerning the pro…t functions and the best response functions. In our settings, Assumptions 1-3 in Corts (1998) are all satis…ed.15 However, Assumption 4 in Corts (1998), whichin this paper is denoted byj
BRm(p j ) > BRj m (p j )does not necessarily hold. In this sense, our model speci…cation puts fewer restrictions on
the economic fundamentals than Corts’(1998) study does.
15
Assumption 1 in Corts (1998) ensures the uniqueness of the best response, Assumption 2 strategic
complementarity, and Assumption 3 stability.

7

2.2

Solutions and Preliminary Results

As an innocuous normalization, we set the constant marginal cost to zero, c = 0.16 Giventhat
A (pA ; pB )
@qm
m m
=
@pA
m

from (1) and that qm (p) = ( mp)=( m +

m
2
m

2
m

m ) is the symmetric demand function, theequilibrium discriminatory prices are (from (3))
pm =

m( m

m)

2 m

m

and from (2) the equilibrium uniform price isp =( ww )( ss )[( w + w ) s + ( s +222 ) + (2(2 w
w )( sss )( wsunder the regime of uniform pricing (where

( s;

w ),

s) w ]
(
2)
w

( s;

p ( ; ; ))w ) and

( s;

w ))

if both markets are open. Appendix A2 shows that the weak market must be su¢ ciently
large for neither …rm to have an incentive to deviate to close it. It must also be smallenough for the strong market to remain strong (i.e., the equilibrium prices under pricediscrimination are higher than under uniform pricing; see Footnote 10). Thus, we restrict
the relative size in intercepts,
are functions ofandw = s 2 ( w = s;

w = s ).

These upper and lower bounds, and their precise expressions are given in Appendix A2.17

Notice that @pm =@ m =2m ) < 0, which implies that asm m =(2 mm becomes

larger the discriminatory prices decreases. In addition, the uniform price and the discriminatory prices converge to the marginal cost because lim m " m pm = 0 = lim m "min( m ) p
for all m. In contrast to the case of monopoly with linear demands, the di¤erence in equilibrium aggregate output caused by regime change is not necessarily zero (see Appendix
A1).
16

Notice the innocuousness of the zero marginal cost assumption: it is equivalent to assuming a constantmarginal cost if prices and consumers’willingness to pay are interpreted as the net cost (interpreting it as
c as m ).
m17
The “weak” market is smaller than the “strong” market in the sense that the marginal utility
A
B
j
A
B
@Um (qm; qm)=@qm
at (qm; qm) = (0; 0) is greater in the strong market.

8

3

Welfare Analysis

This section consists of two subsections. The …rst subsection presents analytical properties that are useful for welfare analysis. We then investigate the welfare e¤ects of pricediscrimination in the second subsection.

3.1

Analytical Properties

In symmetric equilibrium, social welfare under regime r 2 fD; U g is written as
SW r = 2( s qsr +rw qw )( s+r 2s )[qs ]( w+

r 2w )[qw ]D = q (p ) and q U = q (p ) are the equilibrium quantities in market m underwhere qmm m
mm

the regimes of price discrimination and of uniform pricing, respectively (see Appendix
A1 for the actual functional forms). Let
SW D

SW be de…ned by the equilibrium di¤erence

SW U . It is then given bySW=

SW ( ; ; )
2

D
s (qs

( s+

where

qm

qsU ) +

D
w (qw

qsD

qsU

s)

( s+

U
qw
)

qsD + qsU

( w+

D
U
s )(qs + qs )] +qw [2 w

w)

D
qw

U
qw

( w+

D
U
qw
+ qw

D
U
w )(qw + qw )],=qs [2 sDqm

U . It is further shortened, and thus we have the following propositionqm(see the proof in Appendix A3):
Proposition 1. The equilibrium di¤ erence
SW ( ; ; ) =

SW =

X

m2fs;wg

where

pm

pm

SW ( ; ; ) is given bypm(pm + p ),
+
m
m

p .

This expression has the following graphical interpretation. Figure 1 shows the relationship between
( m+

m)

pm andqm . As Appendix A1 demonstrates, we havepm =qm . This relationship can be interpreted as the situation where in symmet-

ric equilibrium any …rm faces the “virtual” inverse demand function, pm =
9

m

( m+

Figure 1: Equilibrium Changes in Quantity and Price in Market m (for any …rm)m )qm , in market m (notice the di¤erence from the original inverse demand function,jjjj
pm (qm; qmj ) = mm qm
m qm ). The welfare change in market m is depicted by

the shaded trapezoid in Figure 1 (in this example, it is a welfare gain). Thus, its size iscalculated by the sum of the upper and bottom segments (pm + p ) multiplied by height( qm =

pm =( m +market m, we havem )), divided by two.

pm (pm + p )=( m +If it is positive (when
(when
of

Noting that two identical …rms exist inm ) as a welfare change in market m.

pm < 0), then it is a welfare gain. Similarly, if it is negativepm > 0), then it is a welfare loss. Other things being equal, the greater the value

m , the gentler (and hence more elastic) the equilibrium inverse demand curve becomes.

Complementarity between the brands makes the equilibrium inverse demand curve steep,and substitutability makes it gentle.
We have the following property of the price elasticity. A simple calculation leads tothe following lemma:
Lemma 1. Let the price elasticity of demand in market m in equilibrium be de…ned bydqm (pm ) pm,
D
dpm qm"m (pm )where qm (pm ) = ( mpm )=( m +m ). Then, the equilibrium price elasticity of demandis expressed by"m (pm ) =

1
|{z}

m

+

market elasticity

|

m

{z

.
}

cross-price elasticity

10

(4)

D or even the interNotice that "m (pm ) is a constant, and does not depend on either qm

cept,

m.

This decomposition is a special result of Holmes’(1989, p.246) general result:…rm-level elasticity is the sum of the market elasticity and the cross-price elasticity.18
The market elasticity of demand is a unit-free measure of responsiveness of the …rms
as a whole. However, strategic interaction distinguishes it from the elasticity on which
each …rm bases its decision making: the cross-price elasticity measures of how much each…rm “damages”the other …rm in equilibrium. In our model, strategic interaction is createdby the very fact that …rms (horizontally) di¤erentiate their products or services. Noticethat the market elasticity is exactly one as in the case of a one-good monopoly with alinear demand curve (remember that price elasticity of demand is one when the marginal
revenue curve crosses the constant marginal cost curve (i.e., the horizontal axis)).
As we mention in Section 2, the ratio

m= m 2 (1; 1) is interpreted as the normalizedmeasure of horizontal product di¤erentiation in market m. The cross-price elasticity inHolmes (1989) is simply expressed by the negative of the ratio alone. From (4), we havethe relationship, "m (pm ) S 1 if and only if

m R 0. That is, if the brands are complements( m < 0), then the …rm-level elasticity in equilibrium is greater than one, meaning that a
one percent price cut by one …rm creates more than a one percent increase in its demand,and thus an increase in revenue (hence in pro…t). On the other hand, a less than one
percent increase in demand follows if the brands are substitutes ( m > 0). These facts
imply that complementarity (resp. substitutability) in market m keeps the equilibrium
prices relatively high (resp. low).
As to changes in equilibrium aggregate output,

Q (see Appendix A1 for the deriva-tion), it is shown that if the aggregate output is not increased by price discrimination,then social welfare deteriorates, as veri…ed by Bertoletti (2004) in the case of monopolies
with linear and nonlinear demands (see Appendix A4 for the proof).19
Proposition 2. Social welfare must be decreased by price discrimination if a change inaggregate output is not positive (i.e.,Q0)

SW < 0).

18
Holmes (1989) shows the decomposition under the assumption of symmetric demands between …rms:
it also holds o¤ equilibrium. The term “market elasticity” is borrowed from Stole (2007) (Holmes (1989)
originally called it the “industry-demand elasticity”).
19
Bertoletti’s (2004) result is a generalization of the well-known result of Varian (1985) and Schwartz(1990) who state that Q < 0 ) SW < 0.

11Given that market s is strong ( s = w >s = w ), we have the following relationship:

Q R0,

s
s

R

w

,

w

which is a special case of Holmes’(1989) result that includes nonlinear demands. Holmes(1989, p.247) shows that a change in the aggregate output resulting from price discrimination is positive if and only if the sum of the two terms, the “adjusted-concavity condition”
and “elasticity-ratio condition”, is positive. As its name implies, the …rst term is related
to the demand curvature, and in our case of linear demands, it is zero. The second term
is written as
cross-price elasticity in market smarket elasticity in market s

which is equivalent tos= scross-price elasticity in market w,
market elasticity in market w

w = w from Lemma 1. The result that the output change,

Q , can be positive in oligopoly is in sharp contrast with the case in monopoly where
the output change is always zero with linear demand. In the next subsection, we explore
the possibility of

SW > 0 in the di¤erentiated oligopoly.

However, a positive change in social welfare is solely due to an improvement in the…rms’pro…ts. This is because a change in aggregate consumer surplus is always negative.
Let

CS be de…ned by the equilibrium di¤erence between aggregate consumer surpluses

under price discrimination and under uniform pricing (CS D

CS U ). We then have thefollowing result (see Appendix A5 for the proof).
Proposition 3. Price discrimination always deteriorates aggregate consumer surplus (i.e.,
CS < 0 for all exogenous parameters).

3.2

Welfare-Improving Price Discrimination

We now explore the possibility ofSW ( ; ; ) > 0. After some calculus, we have thefollowing statement:
Proposition 4.

SW ( ; ; ) > 0 if and only ifw>swhere Li
j)

( i

(2 i

i )( jj )((2 i2i) ( ji ) j )); i = w; s, j 6= i.

12

Lw
;
Ls
2
2
j) ( j + j)+( i

2 )(2
j
i

j )(2 i ( jTo further interpret this equation and explore the possibility that

SW ( ; ; ) > 0,

we now reduce the number of the parameters. More speci…cally, we assume thatw

> 0. This is because price discrimination never improves welfare if

formal proof is available upon request). Thus,

s

=

s =1>
w

(the

s = w > 1 is necessary for social welfare

to improve.
In the following analysis, we …rst consider the case of symmetry in product di¤erentiation in the strong and weak markets ( s = s =w = w ).

We then allow asymmetricproduct di¤erentiation. To do so, we …rst construct an intuitive argument why price discrimination improves social welfare. Given the equilibrium discriminatory price is higher(lower) than the uniform price in the strong (weak) market, we know that (note that,qm =pm =( m +m ))SW > 0 ,For the latter inequality to hold, (1)qw (p + pw ) >qs (p + ps ).

qw or (p + pw ) is su¢ ciently large, and/or (2) j qs jor (p + ps ) is su¢ ciently small. Figure 2 shows the asymmetry between the strong andthe weak markets. Notice that the upper segment of the trapezoid of the welfare loss inthe strong market and the bottom segment of the trapezoid of the welfare gain in the weakmarket have the same length (p ). Thus, the larger j qs j, the larger (p + ps ) is. On theother hand, the larger

qw , the smaller (p + pw ) is. Hence, the smaller j qs j, the better

it is for welfare improvement, while
3.2.1

qw should not be too small or too large.

The Case of Symmetric Product Di¤erentiation

Let the situation be called symmetric product di¤erentiation if the measures of horizontal
product di¤erentiation coincide in the two markets (i.e.,s= s =

w = w ).

In this case,the two markets are homothetic in the sense that the only di¤erence in the two markets isin the intercepts of the inverse demand curves. It is shown that if
then

s =

w and

s =

w,

Q = 0 (see Appendix A1). This means that j qw j = j qs j. Because ps is greaterthan pw (which comes from the assumptions >w ), the loss in the strong market isalways larger than the gain in the weak market. We thus have the following proposition:
Proposition 5. In the case of symmetric product di¤ erentiation, social welfare is neverimproved by price discrimination (i.e.,

SW < 0 for all exogenous parameters).
13

Figure 2: Asymmetry between the Strong and the Weak Markets

We therefore need to consider the case ofs w 6=

product di¤erentiation, to study the possibility that
3.2.2

SW > 0.

The Case of Asymmetric Product Di¤erentiations =To simplify the analysis, we assume thatthe e¤ects of ( s ;s =lettingwithw s , which is called asymmetrics =w ) on social welfare.

s;

By so doing, we are able to focus onMore speci…cally, we allows andw to di¤er,

w to avoid unnecessary complications (Appendix A6 gives an analysis

w to show the e¤ects ofs =w on social welfare).

and graphical arguments on the domains ( s ;of ( w ;w.

w ) that makeWe present numerical

SW > 0 for …xed valuesw ).

Figure 3 depicts the region of

SW > 0 withw = 0:85 andarea).20 Consider …rst the case of substitutable goods ( s > 0 and= 1:0 (the shaded
w > 0).

Rememberfrom Proposition 2 that for the total social surplus to be improved by price discrimination
it is necessary thatQ >0,

s= s >

w = w , that is,s >w in this speci…cation.

Substitutability in the strong market must be larger than that in the weak market for awelfare improvement. Remember that the slope of the equilibrium demand in the strong
market( s+s ) is steeper than that in the weak market.

This is associated with a20
It is veri…ed that all of the model parameters in the analysis below satisfy the restriction conditions
provided in Appendix A2.

14

Figure 3: The Region of

SW > 0 for the Case of

w = 0:85 ands =w = 1:0larger increase in output in the weak market rather than a decrease in output in thestrong market. Why is there a bottom right boundary of the region for

SW > 0? It

derives from the restriction that market s and w are strong and weak markets respectively:

w= s <

w = s(; ) (the details are available upon request). In the unshaded

southeastern area, this inequality does not hold. That is, ps < p < pw in equilibrium. In
other words, market s and w are actually “weak” and “strong” markets, respectively. In
this area, the substitutability in the actual strong market (market w) is lower than thatin the actual weak market (market s), i.e.,

w <

s.

As mentioned earlier,

only if the actual strong market is more elastic. Therefore,

SW > 0

SW < 0 in the unshaded

southeastern area.
Notice that price discrimination never improves social welfare in the second quadrant( s < 0 <w ).

That is, if the two brands are complementary in the strong market( s < 0) while the …rms sell substitutable goods in the weak market ( w > 0), then pricediscrimination necessarily deteriorates social welfare. This result seems to hold for otherparameter values because
separated by

s

=

SW

0 if

s =

s =

w : in the northwestern region

w , social welfare would be negative.

The intuitive reason is that

15

w and

complementarity in the strong market makes the price change caused by discrimination
more responsive, which creates more ine¢ ciency, while substitutability in the weak market
makes the price change less responsive. The latter positive e¤ect is not su¢ ciently large
to outweigh the former negative e¤ect.
On the other hand, it is possible that price discrimination improves social welfare if
the …rms’ brands are substitutes in the strong market ( s > 0) and are complements inthe weak market ( w < 0). Figure 3 also shows that the combination of a high degree ofcomplementarity in the weak market and a low degree of complementarity in the weakmarket (i.e., j w j larger than j s j) is suited to welfare gain. This result is as expected:
strong complementarity in the weak market keeps the discriminatory price low enough too¤set the loss from the price increase in the strong market. However, it has been veri…edthat consumer surplus is never improved by price discrimination (Proposition 3).
Analytical arguments for these results are provided as follows. Fix
and notice that

SW = 0 if ( s ;w ) satis…es

w = s(; ) =w = s.

( s( s2 w) w]w) w

w

2 ( 1; 1),

This equality is

rewritten as
=

( s
( w

,

s =

w
s

Substituting

s into @s )(2 ww)

w )(2 ss)s [2( s

w) w

(2 s

w) w

s.

SW =@ s , we have the following result:
@ SW
@ s

< 0:
s= s

Thus, we have the following proposition:
Proposition 6. There exists

0 such thats

In other words, given the values ofslight decrease ins enhances

SW > 0 for

w and

0
s 2 ( s;s that satisfys ).

w = s(; )=w = s, a

SW . This is consistent with the result in Figure 3.

Lastly, we focus on one case of asymmetric product di¤erentiation. Table 1 shows theresult for the case of

w = 0:85 ands =w = 1:0. The …rst case, where the two brands

are substitutes in the strong market while they are complementary goods in the weakmarket, has smaller changes in both prices and output than the second case has. Social
16

( s;

p
ps ( ps =p )pw ( pw =p )qs ( qs =qs (p ))qw ( qw =qw (p ))
SW
CSs
CSw
Q

w) =

(0:1; 0:1)
0:45880:4737 (3%)
0:4452 ( 3%)
0:0615 ( 3%)0:0150 (3%)
0:00090:0145
0:01200:00340:0014( 0:1; 0:1)
0:4663
0:5238 (12%)
0:4026 ( 14%)0:0640 ( 11%)
0:0578 (17%)
0:0131
0:0646
0:0481
0:00340:0061

Table 1: Asymmetric Product Di¤erentiation ( w = 0:85 and= 1:0)

welfare is improved by price discrimination in the …rst case. The price di¤erentials in thelatter case are greater: what happens after the regime change from uniform pricing toprice discrimination is that while competition in the weak market becomes …ercer due tosubstitutability, complementarity softens the competition to increase discriminatory pricein the strong market.

4

Concluding Remarks

In this paper, we study the relationship between horizontal product di¤erentiation andthe welfare e¤ects of third-degree price discrimination in oligopoly with linear demands.
By deriving linear demands from a representative consumer’s utility and focusing on symmetric equilibrium in a pricing game, we characterize conditions relating to such demand
properties as substitutability and complementarity for price discrimination to improve social welfare. In particular, we show that price discrimination can improve social welfare(especially) if …rms’brands are substitutes in the market where the discriminatory priceis higher and are complements in the market where it is lower, but it never improves in
the reverse case. We verify, however, that consumer surplus is never improved by pricediscrimination: welfare improvement by price discrimination is solely the result of an increase in the …rms’ pro…ts. Accordingly, this means that there is no chance that …rms
will su¤er from “prisoners’dilemma”, that is, …rms are better o¤ switching from uniform
17

pricing to price discrimination.
In the present paper, we focus only on symmetric equilibrium of the pricing game togain analytical insight. In particular, the equilibrium amount of output is common for
all …rms under either uniform pricing or price discrimination. This limitation would beparticularly unappealing if one wished to compare the equilibrium predictions from ourmodel with empirical data.21 This and other interesting issues await future research.

Appendices
A1. Changes in Equilibrium Prices and Quantities by Price Discrimination
Equilibrium quantities produced by each …rm under price discrimination in market m areqm (pm ) =m mm )( m +(2 mwhere the denominator is positive because j m j <

m)

,

m.

Under uniform pricing, if both markets are open (see Appendix A2 for the veri…cationof market opening), then tedious calculation shows that the equilibrium uniform price is
p =

( m

m0 )[ m ( m0 +Um )( m0where m 6= m0 (m; m0 2 fs; wg) andm0 ) +

P2
m6=m0 ( mU

m0 ( m +

2 )(2
m0
m

nator and the numerator are also found to be positive because j m j <

m )]

;

(A1)

m0 ). The denomim . One can verify

that the equilibrium quantities under uniform pricing in market m 6= m0 are then givenbyqm (p ) =2m [ m ( m0

2 )+
m0

2
m0 ( m(2 )] + (
m
m
U
+
)
m
m

2
m0 )( m

2 )(
m0
m

m0 )

.

(A2)
Now, let
pm

pm

p =

( 2m

2 )[
m( m
m

m )(2 m0

(2 m

21

m0 )
m)

m0 ( m0m0 )(2 mm )]UGalera and Zaratieguia (2006) consider duopolistic third-degree price discrimination with heterogeneity
in constant marginal cost and show that price discrimination can improve social welfare even if the total
output does not change. This favors the low-cost …rm to cut its prices signi…cantly, and this cost saving
may overcome the welfare losses from price discrimination.

18

be de…ned as the changes in the equilibrium prices resulting from a move uniform pricing
to price discrimination in each market. Thus, if we de…ne the strong (weak ) market as that
where the equilibrium price increases (decreases) by price discrimination, then market m
is strong if and only if
m >

( m0
( m

m0 )(2 mm)m )(2 m0

m0 )

m0 .

This implies that, in contrast to the case of monopoly with inter-market dependencies (seeAdachi (2002)), the condition on the intercepts,m >and su¢ cient condition for market m to be strong: if

m0 , is not exactly the necessary
m0 m is much larger than(note that either or both can be negative), then market m with
Of course, if

m =

and

m0

m =

m0 , then

m >

m >

m m0

m0 can be weak.

m0

is the necessary and su¢ cient

U

(A3)
m )]
: (1)

condition for market m to be strong.
Turning our attention to output, we haveqm=

qm (pm )( m

qm (p )m )[ m ( mm )(2 m0

m0 )

(2 m

m0 ( m0m)m0 )(2 mas the equilibrium changes in output resulting from a more from uniform pricing to pricediscrimination for each …rm in strong and weak markets, respectively. It is then veri…edthat

pm andqm are related in the following way:
pm =

( m+

m)

qm ,

(A4)

so that we have qm (pm ) > qm (p ) if and only if pm < p . One can also derive the change
in equilibrium aggregate output:
Q

qs +

qw =

( w s

s w )[ s ( ss )(2 w

(2 sw)s )(2 w

w

w( w
) U

w )(2 ss )],which does not necessarily coincides with zero, as opposed to the case of monopoly withlinear demands.
Now, although market m is strong even ifm0 ) > ( m0m0 )(2 mm =m0 as long as ( mm 6=

m0 . This is because ifm ), we assume thatthen we haveQ =m ( m0 m(2 m

m )(2 m0

192
m m0 )m0 )U0,m )(2 m0
m =

m0 ,

pm =
and most importantly,

2
m( m

2 )(
m m0
m

(2 m

m)

m0 m )U

SW , the di¤erence in social welfare under price discrimination

and under uniform pricing (introduced in Section 3), can never be positive (the formal
proof is upon request). Thus, unequal values of intercepts of the two markets are necessary
for price discrimination to improve social welfare. Hence, for markets s and w to be strong
and weak, respectively, it is necessary for the weak market to be su¢ ciently small:
w

< min

s

( s
( s

s )(2 ww)s )(2 w

w)

;1 .

The reason why this is not a su¢ cient condition is that we must verify the parameter
restrictions for market w to be su¢ ciently large to be open under uniform pricing. We
verify them in Appendix A2.
For later use (Appendix A3), we also calculate the sum of a …rm’s output underuniform pricing and the under price discrimination in each market m 2 fs; wg:
qm (pm ) + qm (p ) =m (3 m( m+

m)m )(2 m

m)

p
m+

:

(A5)

m

A2. Market Opening under Uniform Pricing
Remember that the symmetric equilibrium under uniform pricing in the main text and Appendix A1 is obtained, given that both markets are supplied by either …rm under uniform
pricing (qs (p ) > 0 and qw (p ) > 0). In this appendix, we obtain a (su¢ cient) condition
guaranteeing that in equilibrium each …rm supplies to the weak market under uniform
pricing. To do so, we consider one …rm’s incentive not to deviate from the equilibrium bystopping its supply to the weak market.
Suppose …rm j supplies only to the strong market, given that the rival …rm supplies
both markets with the equilibrium price, p (see Appendix A1). Let …rm j’s price when
deviating from the equilibrium price under the uniform pricing regime be denoted by p0 .
Then, when …rm j closes the weak market, its pro…t is written by22e(p0 ; p ) = p0 qsj (p0 ; p )jGiven p , the upper bound of p0 such that qsj (p0 ) 0 is larger than that such that qw(p0 ) 0 if and0
j0
only if s > ( w
0,w )(2 ss ) w =(( ss )(2 ww )). That is, for any p such that qw (p )j0qs (p )
0. In other words, given p , the strong market opens if the weak market does. The upper0j0bound of p0 such that qsj (p0 ) 0 is ( s
0 iss ) s + s p . The upper bound of p such that qw (p )2220

Figure 4: Pro…t when Deviating from the Equilibrium Price under Uniform Pricing

where
qsj (p0 ; p ) =

s
s+

s
2
s

s

2
s

s

p0 +

2
s

2
s

p :

Now, it is veri…ed thatarg maxe(p ) =
0
p 6=p

s( s

2

s)

+

s

2

p (

p00 ).

Note that …rm j’s pro…t function when it deviates to any price other than the equilibrium price would not necessarily be (globally) concave because it would be kinked at
the threshold price where the weak market closes, as depicted in Figure 4.
( ww) w +[( s

wp. The former minus the latter iss )(2 wsw) s
2w (( s2( ww )(2 ss ) w ]( s ( w
2
2 )(2
2 )(2
s
w
w) + ( w
w
s

21

2
w) +
s ))

2
w( s

2
s ))

> 0.

If p00 attains the local maximum as in Panels (1) and (2) in Figure 4, then one needs tosolve for the restriction on the set of parameters guaranteeing that the equilibrium pro…twhen both markets are open
p

s

p

s+

+
s

w

p

w+

w

is no smaller than the maximized pro…t when …rm j deviates to close the weak market
max e(p ).

p0 6=p

It is, however, too complicated to obtain the set of parameters from this inequality.
Thus, we instead focus on the case that corresponds to Panel (3) in Figure 4. This givesa su¢ cient condition for the weak market to open. Notice that by de…nition, p00 mustjsatisfy qw(p00 ; p )0, given p . If this is violated, then it is the case of Panel (3) in Figure

4. It shortens tow >2w )( w2s )( ws )[2( w( s( w

w )[2(2 s2w )( s2s )( s2)
w s + (2 w
2)w s + (4 s

2)
s w]
2)
s w]

s:

Together with the argument in Appendix A1, throughout the paper, we assume therelative size of the intercept of the weak market satis…es
w

w

=

s

w = s 2 ( w = s;

w = s ), where

( ; )

s

( s
( w

2
w )( w2s )( ws )[2( w
w )[2(2 s2)w s + (2 w
2)w s + (4 s2w )( s2s )( s

2)
s w]
,
2)
s w]

and
w

w

=

s

( ; )

s

min

( s
( w

s )(2 ww)

w )(2 ss)

;1 .

These restrictions are su¢ cient for markets s and w to be actually strong and weak andto be open under uniform pricing.

A3. Proof of Proposition 1 (Calculating
and pw )By using equations (A1-A5), we can calculateXSW =[2 m (qm (pm ) qm (p )) ( m +m2fs;wg

22

SW as a Function of p , psm )[qm (pm )qm (p )][qm (pm ) + qm (p )]]=X

m2fs;wg=X

m2fs;wg=

Xm )(qm (pm ) + qm (p ))]

pm
+
m
m

m)

2 m+( m+pm+mmm2fs;wg=pm[ 2 m+( m+
m+ m

X

m( m

m)

2 m

m

m (3 m( m+

m)m )(2 m

m)

p
m+

m

p

pm
(pm + p ):+mmm2fs;wg

A4. Proof of Proposition 2
Using the explicit forms forpm and for
Q =which implies thatQ

Q (derived in Appendix A1), we have
ps
+
+
s
s

2

pw
+
w
w

,

0 if and only if
pss+ sNow, suppose that

pw
.
w+ w

Q < 0. Then, we have

SW

ps
pw
(ps + p )(pw + p )
s+ s
w+ w
ps
ps
(ps + p ) +(pw + p )
+
+
s
s
s
s
ps (ps ps )(ps + p ) < 0.
s+ s

=

=

A5. Proof of Proposition 3
We have
CS

=

f(2 s

2
s ) (2 w

22w ) [( s[ s( ss )(2 ww)

f s( ss )(2 ww)[( 2s
+ (2 s2s )(3 s2s )( w2s )(2 ww( ws )(2 w

w )(2 s2w )(2 s21s )] g

s )]

2
w)

2
w )(4 s w

232w) + ( w

4 s w+2 s w

s w+

s w )]

w (2 ss )( w

[( 2s

w)

2
s )(2 w

w )(4 s w

2 2s) ( w+ (2 s

4 w s+2 s w

2w )(3 w

which can be seen as an increasing function of

w s+

s w)

w )]g,w.

Remember from Appendix A2 thatw < mins( ss )(2 ww)

( w

w )(2 s

s)

;

,

s

and it is veri…ed that
s( s
( w

s )(2 ww)

w )(2 ss)s( ss )(2 ww)

( w

w )(2 s

s)

min
if

s w+

;

=

s

s

s w > 0, and

min

;

=

s

s( s

s )(2 ww)

( w

w )(2 ss)otherwise. Noting the continuity, we show below that

CS as an increasing function of

w is negative for
s( s
( w

w = minFirst, if
CS

=

w =

s , then we have

f(2 s

2
s ) (2 w

2
s(

s w+

[( 2s

s )(2 w2s )(3 s;s.

2w) + ( ws) w )s )(2 s w + ( ws w+

then the term in the expression of

[( 2s

2
s )(2 w

w )(2 s w + ( sw =f s( ss)s w)

2w )(2 swhich is negative becausew)w )(2 s22w ) [( s2s )(2 w

+ ( 2ws )(2 ww ) s )],

s w > 0. On the other hand, ifs( ss )(2 ww)

( w

w )(2 s

s)

CS ,
w)
s )(2 w

2
w)

24

,

2
w )(2 s21s )] g( ;pps ( ps =p )pw ( pw =p )qs ( qs =qs (p ))qw ( qw =qw (p ))
SW
CSs
CSw
Q

s;

w) =

(0:3; 1:0; 0:75)
0:3582
0:4118 (15%)
0:3188 ( 11%)
0:9412 ( 8%)0:0375 (8%)
0:0063
0:0507
0:03840:00600:0037(0:3; 0:75; 1:0)
0:3644
0:3750 (3%)
0:3500 ( 4%)0:0101 ( 2%)0:0111 (3%)
0:0005
0:0127
0:01090:00230:0009( 0:3; 1:0; 0:75)
0:52350:5652 (8%)
0:4958 ( 5%)0:0596 ( 9%)
0:0615 (8%)
0:0022
0:0543
0:04190:01020:0019

Table 2: Substitutability versus Complementarity with2s )( w+(2 s
w (2 s2w )(4 s w

s )( ws 6=( 0:3; 0:75; 1:0)
0:5423
0:5833 (8%)
0:4804 ( 11%)
0:0912 ( 9%)0:0884 (20%)
0:0123
0:0797
0:05980:0076
0:0028w ( w = 0:85)

4 s w+2 s w

s w+

s w )]

w s+

s w)

w)

[( 2s

2
s )(2 w

w )(4 s w

4 w s+2 s w

+(2 s

2 2
s) ( w

2
w )(3 ww )]gis simpli…ed to
2 s( ss )(2 w

w )( s w

s w)

[( 2s

2
s )(2 w

2w) + ( w2w )(2 swhich is positive becauses w > 0, which implies thats w

A6. Welfare Analysis when
Let

s =

w.

We allow

s and

s )],

CS < 0 in this case.

m is Common
w to di¤er and provide numerical analysis to con-trast substitutability with complementarity for a …xed value of ( w ;arguments on the domains ( s ;w ) fors;w ), and graphical

SW > 0, with the value of ( ;Table 2 shows the result for the case ofcorresponds to the case of substitutability (w ) …xed.

w = 0:85. The …rst and the second column= 0:3), while the third and the fourthcorrespond to the case of complementarity ( =0:3). The di¤erence between the …rst

and the second (the third and the fourth in the case of complementarity) columns is25

whether the own slope of the inverse demand curve in the strong market is greater thanthat in the weak market (i.e.,s >welfare only in the second case (( ;particularly small (2%), whilew ). Notice that price discrimination improves socials;w ) = (0:3; 0:75; 1:0)). In this case, j

qs j=qs (p ) isqw =qw (p ), is also not too large (3%), in comparison withthe other three cases.
First, consider the case of substitutable goods ( > 0). Notice that whens >w , thestrong market has a higher value of price elasticity than the weak market (see equation (4)).
The equilibrium price in the strong market ps , however, is at a higher level than in the caseofs <w (0:4118 vs. 0:3750). This seemingly paradoxical result is due to strategic e¤ects:

the …rms want to “cooperate” because they are afraid of retaliation when the market ismore price elastic. Now, if the market is “integrated”(i.e., uniform pricing is forced), thenthe market price in the strong market is expected to drop to a larger extent than in thecase ofs <w , because the strong market has a higher value of price elasticity (it is morecompetitive) than the weak market when

s >

w.

In Table 2, we see the price in thestrong market drop from 0.4118 to 0.3582 ( 6%) when ( ;ps drops from 0.3750 to 0.3644 ( 3%) when ( ;s;s;w ) = (0:3; 1; 0:75), whilew ) = (0:3; 0:75; 1:0).

To summarize,

when the strong market is less price elastic, the regime of uniform pricing does not lower
the price in the strong market su¢ ciently. As a result, uniform pricing may harm social
welfare. In other words, price discrimination may improve welfare.
Even though the products are complements, a similar logic can apply to the property of price discrimination. When the products are complements, the price changes andthe associated production changes are large due to the greater elasticity created by complementarity. In fact, welfare loss is larger in the fourth case (where the strong market
has a higher value of price elasticity than the weak market does) than in the third case(j0:0123] > j

0:0022j). As to the changes in equilibrium aggregate output, it is positivein our second and third cases but negative in the other two. These results are consistent with Proposition 2: an increase in the aggregate output is necessary for welfare to be
improved by price discrimination, as in the case of monopoly.
The di¤erence between substitutability and complementarity is further investigatedgraphically. Figures 5 and 6 depict the region of

26

SW > 0 for the cases of substitutability

Figure 5: Substitutability ( = 0:3) in the Case of( = 0:3) and of complementarity ( =
( s;

w)

0:3), respectively (withw = 0:85

w = 0:85). Notice that

= (0:75; 1:0) in Table 2 is contained in the shaded region of Figure 5. The

result for the case of substitutability is expected from the argument above. For the case ofcomplementarity, the combination of “highs and low

w ”works for welfare improvement,

the reverse of the situation in the case of substitutability. Notice that complementarity
makes the demand in each market more price elastic. With elasticity already su¢ cienty
high, a higher value ofs raises the uniform price, and thus the price change introduced

by price discrimination is reduced because of the high value ofs , reducing the ine¢ ciency

of price discrimination in the strong market.
In Figure 5, the white area around the top right corner violates the condition thats= w >

withs = w . The violation means that the discriminatory price in the strong market

s is lower than that in the weak market withw (note that

s >

w ).

In otherwords, the discriminatory price at the market with a higher intercept ( s ) is lower thanthat in the market with a lower intercept ( w ). Following the de…nition of a “strong”
market in Section 2, we now rede…ne the former as the “weak market” and the latteras the “strong’market.” On this white area wheres <w holds, the rede…ned “weak”

market with a higher intercept is more elastic than the rede…ned “strong” market witha lower intercept. As mentioned above, when the “weak” market is elastic, the increase27

Figure 6: Complementarity ( =0:3) in the Case of

w = 0:85

in quantity in the weak market is not high enough to o¤set the loss from the decreasein quantity in the strong market; that is,

Q < 0. In fact, in this white area, pricediscrimination deteriorates the total social surplus.
Lastly, it is veri…ed that consumer surplus is never improved by price discriminationin the cases of ( ;w ) = (0:3; 0:85) and of (;w) = (

0:3; 0:85). Thus, this and othernumeral results suggest that welfare improvement from price discrimination is solely due
to an increase in the …rms’pro…ts. In particular, it means that there is little or no chancethat …rms will su¤er from “prisoners’dilemma”; that is, …rms are mostly or always betterby switching from uniform pricing to price discrimination.

A7. Proof of Proposition 6
Substituting

s into @@ SW@ sSW =@ s , we have=2( sw) w( ws= sw )[ s w + ( s3s s (2 ww) Mw )( w

3
w )]

where
M

w )( w +2w) s+ s w f2 s (2 ww)

= (2 w( w
28w )( w +w )g3 s 2w ( ww)Notice that

s >

w,

w >

w,

s w +( sw )( w

be shown that M is a concave function ofw.

maximized at

w = 0, M = (2 w

When

w =

w = 0 ors, M =

w =

2(
s s+

s.

When

w )( w +0 such thatsw 2 [0;w.

It cans ], this function is locallyw )( w +2w ) s > 0.

w ) > 0. Therefore,

@ SW
@ s
Thus, there exists

Forw ) > 0, and 2 w

< 0.
s= s

SW > 0 for0s 2 ( s;s ).

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