Price discrimination

One thing that monopoly and monopolistic competition  have in common is that, by setting a price above marginal cost, a deadweight loss is imposed on society, with output being lower than implied by the P = MC outcome. This section examines a special case of monopoly, in which a monopolist will produce the level of output that is allocatively efficient.

Consider the above diagram. Suppose that this market is operated by a monopolist who faces marginal cost MC. Under perfect competition the price and quantity would be the equilibrium point of demand and supply, at point C. What would induce a monopolist to produce at that level?

One of the assumptions made throughout the analysis so far is that all consumers in the market pay the same price for the product. This leads to the notion of consumer surplus. The consumer surplus under perfect competition is the difference between what the most inelastic consumers would pay and what they do pay – that is triangle ABC.

Now, what if the monopolist had the ability to charge the individual consumer an individual price? This would mean that the monopolist could charge a very high price to the least price responsive consumers, and a low price – even as low to AVC, to the most responsive consumers.

The original marginal revenue curve is lost – the average revenue curve becomes the new MR. This is because average revenue at a given quantity is now equal to the marginal revenue at that quantity. Say one consumer would pay up to £10 for the product, a second consumer would pay up to £9, and a third up to £8. Usually, the monopolist would price at £8, and gain £24 pounds of revenue. MR for each is 8 and 6. AR is 10, 9 and 8 respectively, because each consumer is paying the same price. But, if the consumer could price discriminate, and charge the consumer up to the exact amount they would be willing to pay, the average revenue now becomes the marginal revenue. If they sell one, this goes for £10. AR is 10. If they sell a second, they would target the next most inelastic consumer – the £9 one. TR is 19, AR is £9.5, MR is £9. Third, TR is 27, AR is £9, MR is £8. As you can see, the difference in total revenue at each output is equal to the amount the most responsive customer is willing to pay – MR = the previous AR.

This would mean that all the consumer benefit, ABC, would be turned into supernormal profit. The monopolist has hijacked the whole of the original consumer surplus as its profits.

From society’s point of view, total welfare is the same as is under perfect competition, and it is also more than what it would be if there was no price discrimination – this is because the monopoly is part of society. However, now there has been a redistribution, from consumers to the monopoly – and presumably to the shareholders of the the firm. This situation is known as perfect price discrimination or first-degree price discrimination.

Attempts at perfect price discrimination is surprisingly common in the real world, as it happens in any market where a consumer barters with a producer. For example, at a market stall, the stall holder will sell at many different prices depending on the amount that the consumer barters down the price. One consumer does not barter down the price for everyone. However, perfect price discrimination can only really happen when the producer knows the demand curve, and that a consumer does not react to a change in price with a change of elasticity. This, of course, is rare, as in a bargaining process the customer has as much ability to change the price of a good as the producer, as there is not symmetric information.

However, there are some situations in which partial price discrimination is possible. For example, students or old-age pensioners may get discounted bus fairs, cheaper access to sporting and cultural events etc. In these instances individual consumers are paying different prices for the same product because of their differing personal price elasticities of demand.

There are three conditions under which a firm may be able to price discriminate:

  1. The firm must have market power
  2. The firm must have information about consumers and their willingness to pay – and there must be identifiable differences between consumers (or groups of consumers)
  3. The consumers must have limited ability to resell the product

Market power

Clearly, price discrimination is not possible in a perfectly competitive market, where no seller has the power to charge anything other than the going market price. So price discrimination can only take place where firms have some ability to vary the price.

Information

From the firm’s point of view, it needs to be able to identify different groups of consumers with different willingness to pay. What makes price discrimination profitable for firms is that different consumers display different sensitivities to price and have different price elasticities of demand.

Ability to resell

If consumers could resell the product easily, then price discrimination would not be possible as consumers would engage in arbitrage. In other words, the groups of consumers who qualified for the low price could buy up the product and then turn profit by reselling to consumers in the other segment/s of the market. This would mean that the firms would no longer be able to sell at the high price, and would no longer try to discriminate in pricing.

Third degree price discrimination

In the case of student discounts and OAP concessions, the firm can identify particular groups of customers; and such ‘products’ as bus journeys or dental treatment cannot be resold. This is called third-degree price discrimination. But why should a firm undertake this practice?

The simple answer is that, by undergoing price discrimination, the firm is able to increase its profits.

This is shown in the above diagram. One of the submarkets is relatively inelastic compared with the other. If the two revenue curves are summed to the industry graph. At  some price points in the inelastic demand curve, there is no demand in the elastic submarket – this exaplains the ‘kink’.

MC = MR is worked out on the industry graph. This point then dragged across as the marginal cost curve for that point. When this line hits the MRb and MRa, the price these submarkets sell at can be obtained – Pb and Pa.

The optimal position is where marginal revenue is equal in both markets, where producing one extra unit in one market rather than another would cause a fall in total revenue.

We can see that consumers in market A who are more responsive to a change in price do quite well by this practice, as they can now consume more of the good. Indeed, it is possible that without price discrimination, prices would be so high that they would not consume the good at all.

Summary

  • In some markets a monopolist may be able to engage in price discrimination by selling its product at different prices to different consumers or groups of consumers.
  • This enables the firm to increase profits by absorbing the consumer surplus.
  • Under first-degree price discrimination, the firm is able to charge a different price to each individual consumer, and absorb all consumer surplus.
  • Under third-degree price discrimination, the firm charges a different price to different groups, or submarkets of the market as a whole. For example, seniors.
  • The firm can practise price discrimination only where it has market (price making) power, where consumers have differing elasticities of demand for the product, and where consumers have limited ability to resell the product.
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