Second-Degree Price Discrimination

Second-degree price discrimination is the practice of offering a menu of contracts (typically quantity-price pairs or two-part tariffs) so that consumers self-select into the contract designed for their type. The monopolist knows the types but cannot identify which individual is which, so the menu must satisfy Incentive Compatibility — each type must prefer its own contract over any other. Also known as Screening.

When to use

Use second-degree PD whenever types are unobservable but heterogeneous — the textbook setting for airline fare classes, software-license tiers, insurance menus, and quantity discounts. The optimal menu distorts the low-type's bundle downward by $\Delta q$ until the marginal loss $b$ (forgone revenue on the removed units) equals the marginal gain $a$ (the extra surplus the monopolist can now extract from the high type by making mimicking less attractive). The high type's bundle is undistorted ("no distortion at the top") and keeps an Information Rent equal to its surplus on the low-type bundle.