Price Discrimination

Reading Assignment

Please read the section on Price Discrimination in Chapter 10, "Price-Searcher Markets with Low Entry Barriers." In the most recent version of the book, this is on pages 198-200.

Because we have a deadweight loss in a monopoly, some social wealth is not collected. This means that a society is poorer, in total, because of the existence of a monopoly. But it is possible for a producer to capture some of this lost wealth. This can be done by using price discrimination. Price discrimination refers to charging different prices to different customers. In a perfectly competitive market, this is not possible, because there are many firms competing for the price; but it is possible in a monopoly, because people have no other place to buy.

If the seller is able to discover just what price the buyer is willing to pay (what the buyer’s Reservation Price is), and offer a price incrementally below the reservation price, then the seller is capturing basically all of the total surplus.

There are three general ways in which price discrimination can occur:

First degree (or perfect) price discrimination refers to charging a different price to every consumer. This is not very possible in real life.
Second degree price discrimination refers to charging different amounts for different sized purchases. If a car rental company buys 300 cars from a dealer, they will get a better price than if I go and try to buy 1 car. This is known as bulk pricing.
Third degree price discrimination refers to breaking up the market into different groups who have different demand curves and maximizing profit in each different market sub-group. For example, a restaurant might have a special children’s menu, with small portions at lower prices. Adults would not want to buy these small portions, but forcing adults to buy adult portions for children might make the customers decide to stay home.

Sample Question

The Philadelphia Zoo discovers that they have two groups of customers with two different demand curves. Locals have demand P = 40 – 0.2Q, and tourists have demand 50 – 0.1Q. What is the profit maximizing set of prices? (The marginal cost of visitors is zero.)

Solution:

In this case, we have two separate demand curves, and as a monopolist we wish to maximize profit by charging each separate part of the market a separate, monopolistic price.

For locals, demand is given as P = 40 - 0.2Q, so MR = 40 - 0.4Q.

Since MC = 0, then setting MR = MC gives us 40 = 0.4Q, or Q = 100.
Entering Q = 100 into the demand curve gives us P = 40 - 0.2(100) = 40 - 20 = 20

For tourists, demand is given as P = 50 - 0.1Q, so MR = 50 - 0.2Q.

Since MC = 0, then setting MR = MC gives us 50 = 0.2Q, or Q = 250.
Entering Q = 250 into the demand curve gives us P = 50 - 0.1(250) = 50 - 25 = 25

So, the answer is, if it wishes to maximize profits, the zoo should charge locals $20 for admission, and $25 to tourists. Of course, in this case, the trick involves being able to effectively separate locals and tourists.

Take Aways

After this lesson and the associated readings, you should be able to:

explain what first-degree price discrimination is;
explain what second-degree price discrimination is;
explain what third-degree price discrimination is.