Price Discrimination - Online Tutor, Practice Problems & Exam Prep

Price discrimination allows monopolists to charge different prices for the same good based on customers' willingness to pay, enhancing profits. Three conditions must be met: market power, the ability to segregate customers, and prevention of resale. Perfect price discrimination maximizes profit by charging each customer their maximum willingness to pay, eliminating deadweight loss and achieving an efficient market outcome. Real-world examples include Google AdWords, where advertisers bid based on their willingness to pay for keywords, ensuring efficient allocation of resources.

Price Discrimination

Alright. So sometimes monopolies can have the power to charge different prices to different customers. Let's discuss that now. So this idea of price discrimination, okay. Up to this point, we've been talking about a monopolist who charges the same price to all its customers, and that was a single price monopolist, okay? The same price, you're just charging one price to all your customers, but what if you could charge different prices to different people? You could probably make more money, right? So there's this idea of price discrimination. Price discrimination is selling the same good to customers at different prices, okay? The same good at different prices. Now I want to make a quick distinction. I've had students be confused about this before. Price discrimination isn't like other forms of discrimination; this isn't like racial discrimination or gender discrimination, right? It's not one of these kind of like social issues, right? Price discrimination is just talking about charging different prices to different people based on their willingness to pay, okay? So just make that quick distinction there.

So let's think about how price discrimination can come about, okay? There are going to be these three conditions for price discrimination. First, the firm has to have market power, right? And we said monopolies do have market power, right? So they must be a monopolist or possess the ability to control, you know, quantity and price, right? They have to have some sort of market power to control those variables, okay? Next, they have to be able to segregate the market, okay? So they have to be able to segregate the market into distinct groups. They have to be able to say okay, these payers, these customers over here would pay this amount, these customers over here might pay this amount, so they have to be able to you know, classify their customers into different groups, okay? And these different groups are going to be based on their willingness to pay, okay? The different willingness to pay of each group. Okay? And we'll have an example so you can see how this how this makes sense.

The last condition is that there's no resale, to discriminate and sell someone a lower price of the same product if they could sell it again, right? If they could go ahead, buy the product and then just go if they could sell it again, right? If they could go ahead buy the product and then just go ahead and flip it to other people, right? They're going to steal the profit from you, that you could have made yourself. So it has to be something that the customers cannot resell, okay? We're going to see some examples of price discrimination that actually occur in the real world, but first let's talk about this example right here. Okay? So we've got this company, Macrosoft, that sells its computer software to 2 groups of buyers, right? The small businesses and students.

So you can imagine that students are going to be more price conscious, right? The students are going to be price conscious and thus they're going to have a more elastic demand. They're not going to be willing to pay the same price that a small business owner might. Okay, and for simplicity, let's just assume that the average total cost is constant, no matter how many people they serve, the average total cost is the same, okay? That shouldn't make a difference here, it's just so we can analyze what happens in these markets. Okay, so the monopolist is going to be able to increase its profit by charging a higher price to small businesses and a lower price to students, okay?

So, notice what happens here. Look on the left-hand graph with small businesses, and on the right-hand, the students, right? So we've got the demand of the small businesses and notice that theirs is much more inelastic, right? They're going to need this software no matter what and theirs is more inelastic, so we've got this marginal revenue curve and the marginal cost is constant down there, right? So we've got this marginal revenue and marginal cost right here, right, we find where we're going to produce and then we go up and we charge this price way up here, right? We're going to charge this price, we go up to the demand curve to find the price, and in this case, since we kept our average total cost constant, it just makes it easier to illustrate this profit right here. So this is the price for small businesses, right? I'm going to put P for SB for small businesses, right? And we're going to supply this quantity right here. This is the quantity for small businesses, right. So we could imagine that there's some sort of license or some kind of keycode that you have to enter to use this software, right? So a student couldn't go and buy the student edition and give it to the small business, right? There would be some sort of reason why the small business can't use the student edition, right? There's going to be some sort of blockade there.

What do we see? Is that this green area that we have labeled here, that's our economic profit, right? Everything from the price to the average total cost, so this is the profit that they're getting from the small businesses. But notice we've also got another market, right? So they're selling the same product but now to students and now see the students have a much more elastic demand curve. That blue line, see how shallow the curve is. So it's much more elastic, they're not willing to pay those high prices that small businesses are willing to pay, right? The idea here is the students might say, hey, I'm not going to use this product, I'll go and buy a separate office product to use instead. Okay, so what we see here is now the company, it behooves them to split the market into these 2 sectors because if they charge the students this price right here, this lower price where their marginal revenue and marginal cost curves meet, right? At this quantity right here is where they meet. This is the quantity for students. I'm putting S for students. I guess I'll put ST because I don't want to get confused with supply, quantity supply. So that's the quantity for students and the price for students, right? Notice how their price is much lower than the price for small businesses but the monopolist is still able to profit, right, because they're still producing a smaller output than the point where the demand and marginal cost curve would cross would be the efficient point, so we're limiting that output to create some profit and increase the price a little bit.

Okay, So we see that by splitting the market into these two sections, the firm was able to increase its profit, right? Imagine if they had charged the small business price to everybody, right? If they had just one price, this small business price, well they would still get that profit from the small businesses, but they wouldn't get anything from the students, right? The students would no longer purchase. That price is too high for the students. Now what if they charge the student price to everybody? Well if they charge the student price to everybody, we would be way out here on the demand curve, right? We would be selling more quantity, but we would lose a lot of our profit, right? We would lose a lot of that profit that we're getting by charging the small businesses high prices, right? So by charging 2 different prices to the 2 customer groups, they're able to increase their total profit. Alright. So this is the idea of being able to split them up into 2 groups okay? Now we're going to talk about in the following video, perfect price discrimination Okay, we're able to split it up even more per customer. Okay, so let's go ahead and do that in the next video.

Perfect Price Discrimination

Alright. So here we're going to discuss the idea of perfect price discrimination. This is where we're going to charge every customer their maximum willingness to pay, okay? It's pretty tough to do this in real life, but there are actually some cool examples of this actually occurring. So let's think about this. The idea that we're going to charge every customer the maximum willingness to pay. How much are you willing to pay for this? That's what we're going to charge you. How much are you willing to pay for this? That's what we're going to charge you, right? So they're going to get every little bit of profit. So let's check this out. On the left, we've got that single price monopoly. They're charging one price to everybody, right? So if they're charging one price to everybody, well we're going to have this going on right here, right? They're going to produce where marginal revenue equals marginal cost, and this will be the quantity produced right down here. The quantity for the monopoly. Right? And what's going to be the price? Well, the price is going to be up here at the demand curve. Right? This is going to be the price of the monopoly. Let me give you a little more space. Price for the monopoly. Right. And where's our profit? So our profit is going to be, remember, we're keeping that average total cost constant there. It's just going to make this easier to show. So our profit is going to be everything, from price to average total cost, which is our marginal cost curve for this example. Our profit is going to be in there, right? So our profit is here, and what is the rest of this? Oh, I can't really see that. Let me write it over here. Profit, right? And that's that whole green area, but what about this area up here? You do it a little better there. Okay. This area up here that I just put in purple, well, that's still consumer surplus, right? That's everything above the price, but below the demand curve. So I'm going to put CS for consumer surplus in there, and what about everything to the right there? So notice, a perfectly competitive market would have produced out here, right? This would have been the perfectly competitive quantity where the marginal cost equals the price, right? So this would have been the quantity in perfect competition, which is the efficient quantity, but they restrict that, right? So what do you think this area is going to be right here? So what's that blue area? Well, that's going to be our deadweight loss, right? This is the deadweight loss from the trades that didn't occur that should have occurred, right? The benefits to the consumers were more than the cost to the producer. It should have been a trade that was made, okay? So now let's think about perfect price discrimination. Now we're in a situation where we can charge every customer what they want to pay. Let's say this is $20 up here, the maximum that any customer will pay, and this is like $5, let's say, right? So that first customer, the one who's willing to pay $20, we're going to charge him $20, right? And it's only going to cost us $5. We're going to make $15 off of him. How about the next guy who's willing to pay $19.99? We're going to charge him $19.99, $19.98. Everybody's going to get charged that maximum willingness to pay, and we're going to be left with everything here being profit. So now, notice, we're actually going to produce all the way up to that final efficient quantity. So technically, in this perfectly price discriminating situation, everything is profit, but that means we got rid of our deadweight loss, right? There's no deadweight loss over here. No deadweight loss, DWL, no deadweight loss. So we were able to get efficient. When we talked about efficiency in perfect competition, I mentioned that there was a situation where we could be efficient in a monopoly and this is it right here. This is it when we're perfectly price discriminating we get rid of the deadweight loss, right? Because we can even charge this person over here who's only willing to pay $5.1, we're going to charge them $5.1 and we're going to make that penny profit, right? All the way up to that final unit. So that is the only case where we're going to be efficient is where we've got this perfect price discrimination, okay? And again, this honestly doesn't really occur in the real world, but a good example is the use of Google AdWords. So what Google does is effectively they have their ads that go based on the keywords that people type into their search engine, right? So what Google does is they sell these words like a common word like tutoring, right? If you wanted to look up tutoring and you type it in the internet, the results that show up and the ads that show up at the top are based on who paid for that, and what's going to happen is Google basically auctions it off to the highest bidder, right? So everyone's going to be bidding until they reach their maximum willingness to pay, right? So everyone's going to be bidding for this word until it's the person whose willingness to pay, right? So everyone's going to be bidding for this word until it's the person who's willing to pay the most for that word, right? Whoever wants to pay the most for tutoring, they're going to get the best ad on tutoring, right? So everyone for every word, they're going to be charging everyone the maximum they're willing to pay based on this system that they get to see who should be the one that gets the word, right? And it's efficient because it ends up going to the person who wants it the most, right? The person willing to pay the most is essentially the person who wants it the most, so that's in essence an efficient outcome, right? But of course, there's something to be said about this, right? The consumer surplus is gone, there's something ethical going on with perfect price discrimination, right? So that's about it here. Let's go on in the next video, let's talk about some real-world examples of price discrimination. Okay, let's do that now.

Price Discrimination

Alright. So let's just quickly discuss some real-world examples of price discrimination. First one here, movie tickets, right? We see that there's different pricing for an adult and for a child, right? A child might be more elastic, they don't have as much money to go to the movies, right? They have to get the money from the parents, so they find that charging the children a lower price allows them to increase their profit. Also, matinee pricing, right? There are off times, like the early afternoons or a Sunday, right? The days when they're not so hot and packed, well they charge a different price to get people to come in at those off hours, right? So that's an example there.

Airline tickets. We'll see this is a great example where airline companies tend to charge business travelers a higher price because business travelers are less elastic, right? They need to go on this trip, they need to go wherever they're going to have this meeting, so they're much much less elastic with their demand for the airline ticket compared to a vacationer. So vacationers might see the price for the ticket and be like you know what, I'm not gonna go there, let me check somewhere else, maybe I can find a cheaper ticket, right? So they need to offer lower prices to the vacationers than they offer to the business travelers. But one thing they do to lock in those vacationers at the low price is offering them non-refundable tickets, right? So those low price tickets, they can't resell them to a business traveler or something, right? They can't exchange them or anything, they can't get a refund so they offer this lower price with these conditions, right?

How about college tuition? This is a really interesting one. So college tuition, what ends up happening is colleges like we see all the time in the news, right? Rising tuition costs, tuition costs are crazy, student debt is enormous, right? Well what ends up happening is that there are these really high prices for college and these high prices are usually what get paid by like middle class and upper class people end up having to pay these full tuition, right? Because they don't qualify for financial aid, right? So what they're doing is they're breaking up the group into these rich students that can pay the full tuition and then they offer financial aid to be able to let poorer students also pay to go to college but they pay a lower amount, right? So this is another really interesting ethical example of price discrimination there where there's the high tuition for students who don't qualify for aid and then there's the lower tuition with aid. Cool?

Alright, quantity discounts, so this is an interesting one too where a company might offer a lower price if you buy a second unit, right? Buy 1 get 1 50 percent off or something like that. They're trying to take advantage of your diminishing returns, right? Maybe when you buy the 1st slice of pizza, you're really hungry and you really want it but that second slice doesn't hit you just as strong as the first slice does. So they might offer you to buy 1 slice and the second slice is half off or something like that to try and capture a little more of your money, right? So they're discriminating on that second slice what they're gonna charge you. Pretty cool.

How about discount coupons? So the grocery store every week sends out you know coupons with 50¢ off of this box of cereal, this and that, this is another price discrimination because there are a lot of people who don't want to waste their time clipping the coupons, right? They're not going to go through and clip all the coupons to get the best deal and they're going to pay a higher price. But then they know that there are people who would put in the effort to clip the coupons for the discount, right? So they know that those people who clip coupons have a lower willingness to pay, so they offer them those discounts through the coupon and effectively charge higher prices to people who don't clip coupons, right? And like we saw in our example, that computer software, right? Having a student edition versus a professional edition, having 2 different editions that they can sell at different prices, right? To the different consumers. Cool. So that's some real world examples there. Let's do a little bit of practice with price discrimination before we move on to the next topic. Cool? Let's do that now.

If the firm's marginal cost is constant at $3.00, output for a perfect price discriminating monopolist is: 

• A. 2 units
• B. 3 units
• C. 4 units
• D. 5 units

The marginal revenue for the perfectly price discriminating monopolist from the sale of the third unit is: 

• A. $6
• B. $5
• C. $4
• D. $3

The total revenue for the perfectly price discriminating monopolist from selling five units of output is: 

• A. $5
• B. $15
• C. $18
• D. $25

If the firm's marginal cost is constant at $3.00, the perfect price discriminating firm will charge each customer:

• A. $3
• B. $5
• C. $8
• D. A different price

Here’s what students ask on this topic:

What is price discrimination and how does it work?

Price discrimination is a pricing strategy where a firm charges different prices for the same product to different customers based on their willingness to pay. This strategy is often used by monopolists to maximize profits. For price discrimination to work, three conditions must be met: the firm must have market power, it must be able to segregate the market into distinct groups based on willingness to pay, and it must prevent resale of the product. By charging higher prices to customers with inelastic demand and lower prices to those with elastic demand, firms can increase their total profit.

What are the different types of price discrimination?

There are three main types of price discrimination: first-degree, second-degree, and third-degree. First-degree price discrimination, also known as perfect price discrimination, involves charging each customer their maximum willingness to pay. Second-degree price discrimination offers different prices based on the quantity consumed or the version of the product. Third-degree price discrimination involves segmenting the market into different groups and charging each group a different price based on their price elasticity of demand. Examples include student discounts and senior citizen discounts.

What are the conditions necessary for price discrimination to be effective?

For price discrimination to be effective, three conditions must be met: 1) The firm must have market power, meaning it can control prices and output. 2) The firm must be able to segregate the market into distinct groups based on their willingness to pay. 3) There must be no possibility of resale, meaning customers who buy the product at a lower price cannot resell it to those who would have paid a higher price. These conditions ensure that the firm can charge different prices without losing profits to arbitrage.

What is perfect price discrimination and how does it eliminate deadweight loss?

Perfect price discrimination, or first-degree price discrimination, occurs when a firm charges each customer their maximum willingness to pay. This strategy allows the firm to capture all consumer surplus as profit, eliminating deadweight loss. In a perfectly competitive market, deadweight loss occurs when trades that would benefit both the consumer and producer do not happen. By charging each customer their maximum willingness to pay, the firm ensures that all mutually beneficial trades occur, leading to an efficient market outcome with no deadweight loss.

Can you provide real-world examples of price discrimination?

Yes, there are several real-world examples of price discrimination. One common example is airline ticket pricing, where prices vary based on booking time, seat class, and customer characteristics. Another example is movie theaters offering discounted tickets to students and seniors. A more modern example is Google AdWords, where advertisers bid for keywords based on their willingness to pay, ensuring that the highest bidder gets the best ad placement. These examples illustrate how firms use price discrimination to maximize profits by charging different prices to different customer segments.