1 st degree price discrimination

1. 1st degree price discrimination A form of Monopoly Power

2. Our story of monopoly is incomplete. We have seen the case where the monopolist charges all customers the same amount. This is the single price monopoly case. Do not get me wrong, monopolies can change their price. But once they do, the single price monopolies will charge all consumers the same price. But, some monopolies charge different consumers different prices. This type of monopoly is a price discriminating monopoly. Our authors tell us that Microsoft discriminates when it sells Windows to the various computer makers. Some pay less than others. You have probably heard of cases where senior citizens pay less, or maybe college students get to pay less. These are other examples of discrimination.

3. Why discriminate? The answer is that it may be more profitable than charging a single price. Can every firm with monopoly power discriminate? Discrimination can only occur when both of the following hold. 1) The monopolist must have knowledge of how consumers differ in their demand for the good or service. Then the difference can be exploited. 2) Arbitrage must not be possible. Customers in the low price market segment must not be able to sell to the customers in the relatively high price segment. We typically distinguish between three types of discrimination. I will finish this section by considering price discrimination of the 1st degree.

4. Example that I will explain on next slides

5. Say we have consumer demand of the form in the first two columns of the table on the last screen. You can see the quantity demanded rises as the price falls. TRs and MRs refer to the total revenue and marginal revenue when we have a single price monopoly. For example, when the price is 9, 2 units are demanded and the total revenue is 18. At a price of 10 the TRs was 10, so the additional revenue of the second unit – what we call the marginal revenue – is 8. Remember that when we have a single price monopoly and the demand has the general form P = A – BQ, then the MRs = A – 2BQ. TRd1 and MRd1 refer to the total revenue and marginal revenue when we have a price discriminating monopoly using the first degree method.

6. 1st degree discrimination In 1st degree price discrimination the monopoly knows what the individual is willing to pay for each unit and is able to extract that amount. In the example we know the individual will pay 10 for the first unit. Since two units are demanded at a price of 9, we know the individual is willing to pay 9 for the second unit. So on the two units the monopoly can charge 10 for the first one and 9 for the second one. Think about a quantity discount idea. Pay 10 for one or get 2 for 19. The TRd1 for two units is thus 19 and the MRd1 for the second unit is 9. We follow the same idea the rest of the way down the columns. This is also called personalized pricing.

7. Note that the MRd1 and the P are the same. This is an example that shows that the price and marginal revenue are equal for a 1st degree price discriminator. Now if demand is P = A – BQ, then MR = A – BQ. The MRd1 curve is the demand curve for the 1st degree discriminator. Now, all businesses make the output where MR = MC, as long as they are not losing more that the variable costs of production. When you look at the table in the single price case if MC is 4 all the time the monopoly will make Q = 4 and charge $7 to each. If the MC is 4 always for a 1st degree discriminator, then the firm will sell 7 units, one for $10, one for $9 and so on down to one for $4.

8. $ Demand of consumer and MRd1 10 9 8 7 6 5 4 MC = 4 and special case of competitive supply Q 1 2 3 4 5 6 7 MRs

9. On the previous screen we see the demand in the market. If the market was competitive we know the S = D output level is 7 and P = 4. Consumer surplus would be the large triangle formed by the vertical axis, the horizontal line a $4 and the demand line. If the market was single price monopoly we would use the MRs line and the Q where MR = MC would be at 4 and the price on the demand curve is 7. The consumer surplus falls to a smaller triangle than the one before, here we have the horizontal line at 7 as the base of the triangle. The monopoly takes some of the consumer surplus that would have existed had the market been competitive.

10. Now, if the monopoly can discriminate in the first degree in this example, then it will charge 10 for the first unit, 9 for the second unit, on down to 4 for the 7th unit. It would not want to sell 8 or more units because the MRd1 on those units is less that the MC and thus take away from profit. NOTE 1st degree discriminator 1) sells same output as in competition, 2) charges a different price on each unit and the last unit has P = MC, 3) takes all the consumer surplus away from the consumer. Remember consumer surplus is what consumers are willing to pay minus what they have to pay and the 1st degree discriminator has the ability to get them to pay their willing amount on each unit.

11. Special way to look at 1st degree discriminator - two part tariff A two part tariff is a special way to get the consumer to pay all they are willing to pay for units they buy. If you think back to the graph, the discriminator extracts all the surplus from consumers. It can do the same thing in two steps. 1) charge a single price for all units - the competitive price - or when P = MC, 2) charge a fee to be able to buy any units at all and make the fee the consumer surplus that would result in competition. We see this type of pricing in buyer clubs, country clubs and other situations.