A monopoly seeks to price discriminate to increase profit. Price discrimination occurs when a firm charges different consumers different prices for identical goods.
1) Monopoly Power.
The firm must control the price and supply of the good.
2) Different Elasticities.
Different consumers must have different price elasticities of demand. A higher price is charged to those with a more inelastic demand. A lower price is charged to those with a more elastic demand. The monopoly must identify each consumer’s elasticity.
3) No Market Seepage (No Arbitrage).
A consumer must not be able to buy the good at a low price and re-sell it to another consumer for a higher price. Otherwise the monopoly does not benefit because it does not earn the higher prices and profits.
4) Market Separating Costs.
The costs of separating different consumers into different market segments must not exceed the additional revenue generated by price discrimination. Otherwise price discrimination is not profitable.
1st Degree (Perfect) Price Discrimination A consumer’s reservation price is the maximum price they are willing and able to pay for a good.
1st degree price discrimination occurs when each good is sold to the consumer with the highest reservation price for it.
A monopoly charges P1 for the first good, P2 for the second good, P3 for the third good and so on until it reaches where profits are maximized.
At the monopoly has appropriated all consumer surplus and turned it into producer surplus. There is no more consumer surplus. However, because there is also no lost consumer surplus nor any lost producer surplus, there is no welfare loss. So 1st degree price discrimination is Pareto efficient because the only way to make consumers better off (increase consumer surplus) is to make producers worse off (decrease producer surplus). Although this is Pareto efficient, it may be deemed unfair by society as there is no consumer surplus.
eBay is an example of 1st degree price discrimination. An auction occurs where consumers bid up prices until the maximum they are willing to pay. Consumers basically reveal and pay their own reservation price.
3rd Degree Price Discrimination 3rd degree price discrimination occurs when different groups of consumers are charged different prices for the same good. This is the most common type of price discrimination. Markets are usually separated by age, time or geography. Examples include student and senior citizens’ discounts, peaktime charges for travel and communication, and cheaper electricity charges in some parts of a country over other parts.
Markets are separated into inelastic and elastic demand.
The monopoly sets for each market segment to maximize profits. A high price P’ is charged to consumers with an inelastic demand and a low price P’’ is charged to consumers with an elastic demand. Both market segments earn the monopoly super-normal profit. As long as the red and green super-normal profits sum up to more than the blue super-normal profit, the firm will price discriminate because it earns more profit price discriminating than charging the same price P* to all consumers.
More super-normal profit is made by the firm, but some consumers also benefit. Consumers with an elastic demand may now be charged a lower price at P’’ than they were charged before at P*. Maybe some elastic demand consumers could not even afford the good before price discrimination.