Study Notes: Price Discrimination (Economics 9640)

Hello! Welcome to the exciting world of market structures. In this chapter, we are zooming in on a specific—and often controversial—pricing strategy used by firms with monopoly power: Price Discrimination. Understanding this concept is vital because it explains why you might pay a different price for the exact same movie ticket, plane seat, or university tuition fee than the person sitting next to you!

We will explore the specific type required by the syllabus (Third-Degree PD), the strict conditions required for it to occur, and its crucial impacts on both businesses and consumers.

1. Defining Price Discrimination

At its heart, price discrimination is simply charging different prices to different customers for the same good or service, where the difference in price is not justified by a difference in costs.

For example: An adult pays \$10 for a haircut, and a student pays \$7 for the exact same haircut by the same barber. The \$3 difference is price discrimination because the cost to the barber (scissors, time, shampoo) remains the same for both customers.

The Goal of Price Discrimination

The core motivation for a firm using price discrimination is to increase profit by capturing consumer surplus.

  • Consumer Surplus: The difference between what a consumer is willing to pay and what they actually pay.
  • By charging higher prices to those willing to pay more, the firm converts that surplus into extra revenue (producer surplus).

Quick Review: Price discrimination is about converting customer willingness-to-pay into profit, without changes in cost.

2. The Conditions Necessary for Price Discrimination

Price discrimination is not something every firm can do. There are three strict, non-negotiable conditions that must be met. Think of these as the ingredients for a successful PD strategy.

1. Monopoly/Market Power (Price Maker)

The firm must have some control over the price it charges.

  • If a firm operates in a perfectly competitive market (a price taker), it must sell at the market price or lose all customers.
  • Monopolies, oligopolies, or monopolistically competitive firms (with a differentiated product) all have some degree of monopoly power, allowing them to choose their price.

2. Ability to Separate Markets (Segmentation)

The firm must be able to divide its customers into different groups, often based on their Price Elasticity of Demand (PED).

  • The separate markets must have different demand characteristics.
  • A common way to segment is by time (peak/off-peak), age (student/senior), location (domestic/international flights), or income.

Did you know? Firms typically charge a higher price in the market segment with inelastic demand and a lower price in the market segment with elastic demand.

3. Prevention of Resale (No Arbitrage)

Customers who buy the good cheaply in one market segment must not be able to resell it at a higher price to customers in the expensive segment. This process of buying cheap and selling dear is called arbitrage.

  • If arbitrage occurs, the two markets merge back into one, and the price discrimination fails.
  • Examples of prevention: airlines require photo ID to match the ticket; professional services (like a doctor’s appointment) are non-transferable; goods sold across borders face high transport costs or tariffs.

Memory Aid (MAP): To remember the conditions, think of the firm’s strategy: Market Power, Ability to Separate, Prevention of Resale.

3. Third-Degree Price Discrimination (PD)

The syllabus focuses specifically on Third-degree price discrimination. This is the most common type and involves dividing the market into two or more distinct groups based on easily identifiable characteristics, usually linked to their PED.

Think of your local train operator: they charge higher fares during morning rush hour (peak time) and lower fares mid-day (off-peak).

Why the difference in pricing?

Consider the two groups:

  1. Peak Commuters (Inelastic Demand): These are often workers or students who *must* travel at a specific time. They have few substitutes for the time of travel, so their demand is inelastic. The firm charges a higher price.
  2. Off-Peak Travellers (Elastic Demand): These are leisure travellers or flexible workers who can choose when to go. If the price is too high, they might choose to stay home or drive, so their demand is elastic. The firm charges a lower price to attract them.
The Profit Maximising Rule

A firm practicing third-degree price discrimination maximises total profit by ensuring that the Marginal Revenue (MR) derived from the last unit sold in each market is equal to the Marginal Cost (MC) of producing that unit.

The overall profit maximisation condition is:
$$MR_1 = MR_2 = MC$$

Where \(MR_1\) is the marginal revenue in Market 1 (e.g., peak time) and \(MR_2\) is the marginal revenue in Market 2 (e.g., off-peak time).

Diagrammatic Representation (Description)

You are expected to understand and interpret diagrams for price discrimination. Although we cannot draw them here, imagine three separate sections on a graph:

  1. Market 1 (Inelastic): The demand (AR) curve is steep. MR is plotted below it. The equilibrium is found where \(MR_1 = MC\), resulting in a high price and low quantity.
  2. Market 2 (Elastic): The demand (AR) curve is relatively shallow. MR is plotted below it. The equilibrium is found where \(MR_2 = MC\), resulting in a low price and high quantity.
  3. Total Market: This combines the MR curves from both markets to find the overall optimal output where the combined MR equals MC.

The key point is that the monopolist calculates the price separately for each market, based on its respective demand curve, ensuring maximum profit from each segment.

Key Takeaway: Third-degree PD divides customers into groups based on their PED. Higher prices are charged where demand is inelastic, maximizing profit under the rule \(MR_1 = MR_2 = MC\).

4. Evaluation: Advantages and Disadvantages

Price discrimination is often seen as negative, but it can sometimes lead to welfare improvements (especially if it allows firms to stay in business or serve previously unserved groups). You must be able to assess its impact on both producers and consumers.

4.1 Impact on Producers (Advantages)

For the firm, the effects are generally positive:

  • Higher Profits: This is the main goal. By capturing consumer surplus, overall revenue and profits increase significantly compared to charging a single price.
  • Survival and Investment: Increased profits can help firms survive in volatile markets. Furthermore, these supernormal profits may be reinvested into R&D and innovation (which links to potential dynamic efficiency benefits).
  • Utilisation of Spare Capacity: Selling units cheaply to the elastic market (Market 2) helps fill empty capacity (e.g., empty seats on a plane) that would otherwise go unused. The revenue generated still covers the marginal cost, adding to overall profit.

4.2 Impact on Consumers and Economic Welfare (Mixed)

Disadvantages (Negatives for Welfare)
  • Exploitation of Inelastic Consumers: The group with inelastic demand (Market 1) pays a much higher price and sees their consumer surplus significantly reduced. This is often viewed as unfair or inequitable.
  • Misallocation of Resources: In a normal monopoly, the price is higher than marginal cost (\(P > MC\)), leading to allocative inefficiency. Price discrimination often exacerbates this problem, as some people pay very high prices far above MC.
  • Deadweight Loss: Although sometimes price discrimination reduces deadweight loss compared to a single monopoly price, it often just transfers consumer surplus to the producer without necessarily increasing total output significantly (unlike perfect price discrimination, which is not in our syllabus).
Advantages (Positives for Welfare)
  • Access to Goods: The low-price segment (Market 2, elastic demand) may now be able to afford the good or service. If the firm were forced to charge a single price, that price might be too high for this group, meaning they would be excluded entirely.
  • Cross-Subsidisation: The supernormal profits earned from the high-price market can be used to subsidise essential services in other markets, particularly if the firm operates a public service. Example: High fares on busy urban train lines subsidise less busy, but socially necessary, rural lines.
  • Funding Public Goods: If a natural monopoly uses PD, the extra revenue can fund infrastructure improvements or expansion that a single-price firm could not afford.

Common Mistake to Avoid: Do not confuse price discrimination with quantity discounts (e.g., buying in bulk) or genuine differences in quality (e.g., first-class vs. economy seats). Price discrimination must be for the exact same product or service with no difference in production cost.

Key Takeaway: Price discrimination is profitable for firms. Its welfare impact is debatable; it can be exploitative for some consumers but can also enable the provision of goods and services to others who would otherwise be excluded.