We briefly touched upon the idea of price discrimination earlier in our monopoly series and, for the rest of our analysis on the monopoly firm, assumed that we were dealing with non-price discriminating monopolies. But say we have a monopoly that does price discriminate, what happens then? Lots of things, to put it simply.
To quickly recap, price discrimination is when a firm charges different prices for the exact same product and the reason they do this is to max out consumers’ willingness to pay. So if you’re selling coffee for $5 each, but you have consumers who are willing to pay $10 for the coffee, that is effectively money being lost. What a business ought to do, if they can, is root out the wealthier consumers and charge them more money in order to increase revenue without actually producing any more units.
Keep in mind that this doesn’t give price discrimination a 100% success rate. For that to happen, the market needs to be free of what’s known as arbitrage, which is when consumers exploit price differences in our case between the same products. In other words, the consumers can’t know about the price discrimination. If you’re being sold coffee for $5 each and you know other people who are willing to pay $7 for it, it would make sense for you to buy the coffee and sell it to those people. This takes advantage of the firm’s price discrimination and uses it against them by attracting customers.
Economists also distinguish between different types of price discrimination:
1st degree price discrimination:
Also known as perfect price discrimination, this is by far the most theoretical type, one that goes hand in hand with the perfect competition model. As the name suggests, the firm is able to max out each and every consumer’s willingness to pay by charging them exactly what they’re willing to pay.
2nd degree price discrimination:
This is when firms charge different customers different prices based on the quantity they’re going to buy. Think bulk discounts, where you get charged less if you buy more of something. In this case, the firm is discriminating based on how much a person is buying and charges accordingly.
3rd degree price discrimination:
Puts together the best of both worlds from the previous 2 degrees, that is to say it’s both realistic and relatively precise. 3rd degree price discrimination entails charging different people different prices depending on their characteristics. A common example would be age, in which museums for example might charge different prices depending on whether or not someone is a child, adult, or senior. This is slowly becoming a more common strategy as big data software allows firms to rigorously analyze their consumer base and what certain characteristics translate to in terms of willingness to buy.
Now, if a monopoly does not price discriminate, their marginal revenue curve is steeper than their demand curve:
The classic demand vs MR curve we’re familiar with. The reason for this is because they charge the same prices for everyone, regardless of their ability and willingness to pay for it. This will inevitably result in consumers paying for less than what they would have been willing to pay. But assume we have a monopoly engaging in perfect price discrimination:
Now that the monopoly does engage in perfect price discrimination, they thus max out a consumer’s willingness and ability to pay. As such, the demand curve (representing the consumer’s willingness and ability to pay) meets up with the marginal revenue curve. This fact alone has an important implication: the elimination of consumer surplus. This term describes when the price that consumers pay for a product or service is less than the price they're willing to pay.
Say you go to a coffee shop with $10 in your pocket that you intended to spend entirely on a cup of coffee. You walk in to discover that the coffee actually costs $4 - congratulations, you have just “made” $6 in consumer surplus. You were willing to pay $10, but instead paid only $4. But if this coffee shop is engaging in perfect price discrimination, they know that you’re willing to pay $10 and will charge accordingly.
This is in contrast to a non-price discriminating monopoly, in which it’s entirely possible for consumer surplus to exist, even if it’s much smaller than what it would be with a firm under perfect competition.
“DWL” stands for deadweight loss, by the way. From here, our entire cost analysis also changes.
What’s obvious here is that this graph is rather similar to that of a firm in perfect competition, or at the very least more similar than the previous graphs we’ve seen. Only visually speaking, however. Let’s ask ourselves a seemingly simple question: where is the monopoly’s price point here? Looking at the graph, it would be 5 units for $6 each, or where MR = MC, right? Not quite.
Remember, this monopoly is perfectly price discriminating, meaning each consumer’s demand is being charged to its limit. So in other words, the monopoly is also selling 4 units at $7 each, or 9 units at $2 each. In a sense, the price points are everywhere and spread along the demand curve. Under a perfectly price discriminating monopoly, there is no single price being charged.
One element, however, does remain even with a non price-discriminating monopoly: profit. But how could this exist? Since there isn’t any single price being charged, how can there be any single amount of profit? While it’s true that there’s no single amount of profit being made, since there exists no single price, there is a profitability zone. This area is anything below where the MC curve hits the demand curve - if your revenue exceeds the MC curve, you’re profiting, as shown below:
Notice how this graph fits in perfectly with the rationale for price discrimination: more profit. The other detail to observe is the quantity being produced. A price discriminating monopoly is actually producing the same number of units that a firm under perfect competition would, namely where demand (MR) hits MC. But it isn’t something to be overjoyed with exactly as the monopoly is still charging far more than the equilibrium price.
The idea of dedicating an entire article to showing what happens when a monopoly decides to employ a particular pricing strategy may initially seem absurd. But as shown above, simply changing their pricing strategy makes a huge difference: how economists study a company can completely change depending on how that company decides to go about charging consumers.
In terms of firm analysis, we’ve thus far looked at the extremes, the polar opposites so to speak. On one hand we have a firm under perfect competition, in which the allocation of resources is the most efficient it can possibly be under a market economy. On the other hand we have monopolies, in which resources are allocated in an inefficient manner. But hardly any markets in the real world represent either of these extremes. In fact, the more common form of market arrangements entails characteristics from both ends. What exactly are these market arrangements?
‘Till next time,
SoBasically