Class # 3 Highlights

In this class, we studied how using a combination of price and quality, a firm can alleviate the information problem. Here, we considered a situation of a monopoly firm choosing price and quantity when there are two types of consumers who differ in their valuation of a unit of quality.

In an equilibrium where both types of consumers are served in the market, the monopolist must pay attention to individual rationality (IR) conditions, so that consumers find it in their interest to purchase the item as well as incentive compatibility (IC) conditions, so that each type finds it optimal to buy the bundle designed for them.

We saw that the IR condition was binding for the lowest type. The reason is that these guys cannot profitably pretend to have a higher willingness to pay (WTP). The IC condition binds for higher types since they can pretend to have lower WTP.

Combining these conditions yields the optimal quality strategy:
1. High types are offered the socially efficient quality, but at a discounted price.
2. Low types are offered a downward distorted quality at a price that leaves them indifferent between buying or not.

Intuitively, the firm distorts the quality for the lower types to save on the "information rent" paid to high types. This rent is the amount paid to get them to tell the truth.

While this equilibrium partially solves the information problem, it involves distortions, so it is not efficient. In principle, the firm could perfectly solve the information problem by offering the socially optimal quality to both types and discounting sufficiently for the high type. This, however, is not profit maximizing. Here, the difficulty lies in the market power exerted by the monopoly firm leading to an efficiency loss. Clearly, a policy maker could do better by simply implementing this outcome.


Key things should be able to do after this class:
1. Compute an optimal pricing scheme when buyers have private information about their willingness to pay.
2. Understand why optimal schemes distort the allocations of lower types but not the highest type and how this relates to the prices charged to each.