Monopoly - Price Discrimination

Price Discrimination

Improved price discrimination allows a monopolist to gain more profit by charging more to those who want or need the product more or who have a greater ability to pay. For example, most economic textbooks cost more in the United States than in "Third world countries" like Ethiopia. In this case, the publisher is using their government granted copyright monopoly to price discriminate between (presumed) wealthier economics students and (presumed) poor economics students. Similarly, most patented medications cost more in the U.S. than in other countries with a (presumed) poorer customer base. Perfect price discrimination would allow the monopolist to a unique price to each customer based on his or her individual demand. This would allow the monopolist to extract all the consumer surplus of the market. Note that while such perfect price discrimination is still a theoretical construct, it is becoming increasingly real with advances of information technology and micromarketing. Typically, a high general price is listed, and various market segments get varying discounts. This is an example of framing to make the process of charging some people higher prices more socially acceptable.

It is important to realize that partial price discrimination can cause some customers who are inappropriately pooled with high price customers to be excluded from the market. For example, a poor student in the U.S. might be excluded from purchasing an economics textbook at the U.S. price, which the student might have been able to purchase at the China price. Similarly, a wealthy student in China might have been willing to pay more (although naturally it is against their interests to signal this to the monopolist). These are deadweight losses and decrease a monopolist's profits. As such, monopolists have substantial economic interest in improving their market information and market segmenting.

There is important information for one to remember when considering the monopoly model diagram (and its associated conclusions) displayed here. The result that monopoly prices are higher, and production output lesser, than a competitive company follow from a requirement that the monopoly not charge different prices for different customers. That is, the monopoly is restricted from engaging in price discrimination (this is termed first degree price discrimination, such that all customers are charged the same amount). If the monopoly were permitted to charge individualised prices (this is termed third degree price discrimination), the quantity produced, and the price charged to the marginal customer, would be identical to that of a competitive company, thus eliminating the deadweight loss; however, all gains from trade (social welfare) would accrue to the monopolist and none to the consumer. In essence, every consumer would be indifferent between (1) going completely without the product or service and (2) being able to purchase it from the monopolist.

As long as the price elasticity of demand for most customers is less than one in absolute value, it is advantageous for a company to increase its prices: it then receives more money for fewer goods. With a price increase, price elasticity tends to increase, and in the optimum case above it will be greater than one for most customers.

Price discrimination is charging different consumers different prices for the same product when the cost of servicing the customer is identical. A company maximizes profit by selling where marginal revenue equals marginal cost. A company that does not engage in price discrimination will charge the profit maximizing price, P*, to all its customers. In such circumstances there are customers who would be willing to pay a higher price than P* and those who will not pay P* but would buy at a lower price. A price discrimination strategy is to charge less price sensitive buyers a higher price and the more price sensitive buyers a lower price. Thus additional revenue is generated from two sources. The basic problem is to identify customers by their willingness to pay.

The purpose of price discrimination is to transfer consumer surplus to the producer. Consumer surplus is the difference between the value of a good to a consumer and the price the consumer must pay in the market to purchase it. Price discrimination is not limited to monopolies.

Market power is a company’s ability to increase prices without losing all its customers. Any company that has market power can engage in price discrimination. Perfect competition is the only market form in which price discrimination would be impossible (a perfectly competitive company has a perfectly elastic demand curve and has zero market power).

There are three forms of price discrimination. First degree price discrimination charges each consumer the maximum price the consumer is willing to pay. Second degree price discrimination involves quantity discounts. Third degree price discrimination involves grouping consumers according to willingness to pay as measured by their price elasticities of demand and charging each group a different price. Third degree price discrimination is the most prevalent type.

There are three conditions that must be present for a company to engage in successful price discrimination. First, the company must have market power. Second, the company must be able to sort customers according to their willingness to pay for the good. Third, the firm must be able to prevent resell.

A company must have some degree of market power to practice price discrimination. Without market power a company cannot charge more than the market price. Any market structure characterized by a downward sloping demand curve has market power – monopoly, monopolistic competition and oligopoly. The only market structure that has no market power is perfect competition.

A company wishing to practice price discrimination must be able to prevent middlemen or brokers from acquiring the consumer surplus for themselves. The company accomplishes this by preventing or limiting resale. Many methods are used to prevent resale. For example persons are required to show photographic identification and a boarding pass before boarding an airplane. Most travelers assume that this practice is strictly a matter of security. However, a primary purpose in requesting photographic identification is to confirm that the ticket purchaser is the person about to board the airplane and not someone who has repurchased the ticket from a discount buyer.

The inability to prevent resale is the largest obstacle to successful price discrimination. Companies have however developed numerous methods to prevent resale. For example, universities require that students show identification before entering sporting events. Governments may make it illegal to resale tickets or products. In Boston Red Sox tickets can only be resold legally to the team.

The three basic forms of price discrimination are first, second and third degree price discrimination. In first degree price discrimination the company charges the maximum price each customer is willing to pay. The maximum price a consumer is willing to pay for a unit of the good is the reservation price. Thus for each unit the seller tries to set the price equal to the consumer’s reservation price. Direct information about a consumer’s willingness to pay is rarely available. Sellers tend to rely on secondary information such as where a person lives (postal codes); for example, catalog retailers can use mail high-priced catalogs to high-income postal codes. First degree price discrimination most frequently occurs in regard to professional services or in transactions involving direct buyer/seller negotiations. For example, an accountant who has prepared a consumer's tax return has information that can be used to charge customers based on an estimate of their ability to pay.

In second degree price discrimination or quantity discrimination customers are charged different prices based on how much they buy. There is a single price schedule for all consumers but the prices vary depending on the quantity of the good bought. The theory of second degree price discrimination is a consumer is willing to buy only a certain quantity of a good at a given price. Companies know that consumer’s willingness to buy decreases as more units are purchased. The task for the seller is to identify these price points and to reduce the price once one is reached in the hope that a reduced price will trigger additional purchases from the consumer. For example, sell in unit blocks rather than individual units.

In third degree price discrimination or multi-market price discrimination the seller divides the consumers into different groups according to their willingness to pay as measured by their price elasticity of demand. Each group of consumers effectively becomes a separate market with its own demand curve and marginal revenue curve. The firm then attempts to maximize profits in each segment by equating MR and MC, Generally the company charges a higher price to the group with a more price inelastic demand and a relatively lesser price to the group with a more elastic demand. Examples of third degree price discrimination abound. Airlines charge higher prices to business travelers than to vacation travelers. The reasoning is that the demand curve for a vacation traveler is relatively elastic while the demand curve for a business traveler is relatively inelastic. Any determinant of price elasticity of demand can be used to segment markets. For example, seniors have a more elastic demand for movies than do young adults because they generally have more free time. Thus theaters will offer discount tickets to seniors.