Editing Monopoly (section)

== Price discrimination ==
{{more citations needed|section|date=October 2021}}
[[Price discrimination]] allows a monopolist to increase its profit by charging higher prices for identical goods to those who are willing or able to pay more. For example, most economic textbooks cost more in the United States than in [[developing countries]] like [[Ethiopia]]. In this case, the publisher is using its government-granted [[copyright]] monopoly to price discriminate between the generally wealthier American economics students and the generally poorer Ethiopian economics students. Similarly, most [[patent]]ed medications cost more in the U.S. than in other countries with a (presumed) poorer customer base. Typically, a high general price is listed, and various [[market segments]] get varying discounts. This is an example of [[framing (social sciences)|framing]] to make the process of charging some people higher prices more socially acceptable.{{citation needed|date=June 2012}} Perfect price discrimination would allow the monopolist to charge each customer the exact maximum amount they would be willing to pay. This would allow the monopolist to extract all the [[consumer surplus]] of the market. A domestic example would be the cost of airplane flights in relation to their takeoff time; the closer they are to flight, the higher the plane tickets will cost, discriminating against late planners and often business flyers. While such perfect price discrimination is a theoretical construct, advances in [[information technology]] and [[micromarketing]] may bring it closer to the realm of possibility.

Partial price discrimination can cause some customers who are inappropriately pooled with high price customers to be excluded from the market. For example, a poor student in the U.S. might be excluded from purchasing an economics textbook at the U.S. price, which the student may have been able to purchase at the Ethiopian price. Similarly, a wealthy student in Ethiopia may be able to or willing to buy at the U.S. price, though naturally would hide such a fact from the monopolist so as to pay the reduced third world price. These are deadweight losses and decrease a monopolist's profits. Deadweight loss is considered detrimental to society and market participation. As such, monopolists have substantial economic interest in improving their market information and ''market segmenting''.<ref>{{cite journal |last1=Bergemann |first1=Dirk |last2=Brooks |first2=Benjamin |last3=Morris |first3=Stephen |date=March 2015 |title=The Limits of Price Discrimination |journal=American Economic Review |volume=105 |issue=3 |pages=921–957 |doi=10.1257/aer.20130848 |url=http://cowles.yale.edu/sites/default/files/files/pub/d18/d1896-r.pdf }}</ref>

There is important information for one to remember when considering the monopoly model diagram (and its associated conclusions) displayed here. The result that monopoly prices are higher, and production output lesser, than a competitive company follow from a requirement that the monopoly not charge different prices for different customers. That is, the monopoly is restricted from engaging in [[price discrimination]] (this is termed [[first degree price discrimination]], such that all customers are charged the same amount). If the monopoly were permitted to charge individualised prices (this is termed [[third degree price discrimination]]), the quantity produced, and the price charged to the ''marginal'' customer, would be identical to that of a competitive company, thus eliminating the [[deadweight loss]]; however, all [[gains from trade]] (social welfare) would accrue to the monopolist and none to the consumer. In essence, every consumer would be indifferent between going completely without the product or service and being able to purchase it from the monopolist.{{citation needed|date=June 2012}}

As long as the [[price elasticity of demand]] for most customers is less than one in [[absolute value]], it is advantageous for a company to increase its prices: it receives more money for fewer goods. With a price increase, price elasticity tends to increase, and in the optimum case above it will be greater than one for most customers.<ref>{{Cite journal |date=2016-06-17 |title=5.1 The Price Elasticity of Demand |url=https://open.lib.umn.edu/principleseconomics/chapter/5-1-the-price-elasticity-of-demand/ |journal=UMN |language=en-us}}</ref>

A company maximizes profit by selling where marginal revenue equals marginal cost. A company that does not engage in price discrimination will charge the profit maximizing price, <math>P^*</math>, to all its customers. In such circumstances there are customers who would be willing to pay a higher price than <math>P^*</math> and those who will not pay <math>P^*</math> but would buy at a lower price. A price discrimination strategy is to charge less price sensitive buyers a higher price and the more price sensitive buyers a lower price.<ref>Samuelson and Marks (2006), p. 107.</ref> Thus additional revenue is generated from two sources. The basic problem is to identify customers by their willingness to pay.

The purpose of price discrimination is to transfer consumer surplus to the producer.<ref name="Boyes and Melvin p.246">Boyes and Melvin, p. 246.</ref> Consumer surplus is the difference between the value of a good to a consumer and the price the consumer must pay in the market to purchase it.<ref>Perloff (2009), p. 404.</ref> Price discrimination is not limited to monopolies.

Market power is a company's ability to increase prices without losing all its customers. Any company that has market power can engage in price discrimination. Perfect competition is the only market form in which price discrimination would be impossible (a perfectly competitive company has a perfectly elastic demand curve and has no market power).<ref name="Boyes and Melvin p.246" /><ref name=Perloff-394>Perloff (2009), p. 394.</ref><ref name=Besanko-449>Besanko and Beautigam (2005), p. 449.</ref><ref>Wessels, p. 159.</ref>

There are three forms of price discrimination. First degree price discrimination charges each consumer the maximum price the consumer is willing to pay. Second degree price discrimination involves quantity discounts. Third degree price discrimination involves grouping consumers according to willingness to pay as measured by their price elasticities of demand and charging each group a different price. Third degree price discrimination is the most prevalent type.<ref>{{Cite web|title=Monopoly II: Third degree price discrimination|website=Policonomics|date=19 May 2013 |url=https://policonomics.com/lp-monopoly2-third-degree-price-discrimination/|access-date=2020-08-18|language=en-US}}</ref>

There are three conditions that must be present for a company to engage in successful price discrimination. First, the company must have market power.<ref name="Boyes and Melvin p. 449">Boyes and Melvin, p. 449.</ref> Second, the company must be able to sort customers according to their willingness to pay for the good.<ref>Varian (1992), p. 241.</ref> Third, the firm must be able to prevent resell.

A company must have some degree of market power to practice price discrimination. Without market power a company cannot charge more than the market price.<ref name=Perloff-393>Perloff (2009), p. 393.</ref> Any market structure characterized by a downward sloping demand curve has market power – monopoly, monopolistic competition and oligopoly.<ref name="Boyes and Melvin p. 449" /> The only market structure that has no market power is perfect competition.<ref name=Perloff-393 />

A company wishing to practice price discrimination must be able to prevent middlemen or brokers from acquiring the consumer surplus for themselves. The company accomplishes this by preventing or limiting resale. Many methods are used to prevent resale. For instance, persons are required to show photographic identification and a boarding pass before boarding an airplane. Most travelers assume that this practice is strictly a matter of security. However, a primary purpose in requesting photographic identification is to confirm that the ticket purchaser is the person about to board the airplane and not someone who has repurchased the ticket from a discount buyer.{{citation needed|date=June 2012}}

The inability to prevent resale is the largest obstacle to successful price discrimination.<ref name=Perloff-394 /> Companies have, however, developed numerous methods to prevent resale. For example, universities require that students show identification before entering sporting events. Governments may make it illegal to resell tickets or products. In Boston, [[Boston Red Sox|Red Sox]] baseball tickets can only be resold legally to the team.

The three basic forms of price discrimination are first, second and third degree price discrimination. In ''first degree price discrimination'' the company charges the maximum price each customer is willing to pay. The maximum price a consumer is willing to pay for a unit of the good is the reservation price. Thus for each unit the seller tries to set the price equal to the consumer's reservation price.<ref>Besanko and Beautigam (2005), p. 448.</ref> Direct information about a consumer's willingness to pay is rarely available. Sellers tend to rely on secondary information such as where a person lives (postal codes); for example, catalog retailers can use mail high-priced catalogs to high-income postal codes.<ref>{{cite book | last1 = Hall | first1 = Robert E. | last2 = Liberman | first2 = Marc | title = Microeconomics: Theory and Applications | edition = 2nd | publisher = South_Western | year = 2001 | page = 263}}</ref><ref>Besanko and Beautigam (2005), p. 451.</ref> First degree price discrimination most frequently occurs in regard to professional services or in transactions involving direct buyer-seller negotiations. For example, an accountant who has prepared a consumer's tax return has information that can be used to charge customers based on an estimate of their ability to pay.{{efn|If the monopolist is able to segment the market perfectly, then the average revenue curve effectively becomes the marginal revenue curve for the company and the company maximizes profits by equating price and marginal costs. That is the company is behaving like a perfectly competitive company. The monopolist will continue to sell extra units as long as the extra revenue exceeds the marginal cost of production. The problem that the company has is that the company must charge a different price for each successive unit sold.}}

In ''second degree price discrimination'' or quantity discrimination customers are charged different prices based on how much they buy. There is a single price schedule for all consumers but the prices vary depending on the quantity of the good bought.<ref>Varian (1992), p. 242.</ref> The theory of second degree price discrimination is a consumer is willing to buy only a certain quantity of a good at a given price. Companies know that consumer's willingness to buy decreases as more units are purchased.<ref>{{Cite book |last1=Bamford |first1=Colin |url=https://books.google.com/books?id=gGXTCQAAQBAJ |title=Cambridge International AS and A Level Economics Coursebook with CD-ROM |last2=Grant |first2=Susan |date=2014-11-13 |publisher=Cambridge University Press |isbn=978-1-107-67951-1 |pages=184 |language=en}}</ref> The task for the seller is to identify these price points and to reduce the price once one is reached in the hope that a reduced price will trigger additional purchases from the consumer. For example, sell in unit blocks rather than individual units.

In ''third degree price discrimination'' or multi-market price discrimination<ref>Perloff (2009), p. 396.</ref> the seller divides the consumers into different groups according to their willingness to pay as measured by their price elasticity of demand. Each group of consumers effectively becomes a separate market with its own demand curve and marginal revenue curve.<ref name=Besanko-449 /> The firm then attempts to maximize profits in each segment by equating MR and MC,<ref name="Boyes and Melvin p. 449" /><ref>Because MC is the same in each market segment the profit maximizing condition becomes produce where MR<sub>1</sub> = MR<sub>2</sub> = MC. Pindyck and Rubinfeld (2009), pp. 398–99.</ref><ref>As Pindyck and Rubinfeld note, managers may find it easier to conceptualize the problem of what price to charge in each segment in terms of relative prices and price elasticities of demand. Marginal revenue can be written in terms of elasticities of demand as MR = P(1+1/PED). Equating MR1 and MR2 we have P1 (1+1/PED) = P2 (1+1/PED) or P1/P2 = (1+1/PED2)/(1+1/PED1). Using this equation the manager can obtain elasticity information and set prices for each segment. [Pindyck and Rubinfeld (2009), pp. 401–02.] Note that the manager may be able to obtain industry elasticities, which are far more inelastic than the elasticity for an individual firm. As a rule of thumb the company's elasticity coefficient is 5 to 6 times that of the industry. [Pindyck and Rubinfeld (2009) pp. 402.]</ref> Generally the company charges a higher price to the group with a more price inelastic demand and a relatively lesser price to the group with a more elastic demand.<ref>Colander, David C., p. 269.</ref> Examples of third degree price discrimination abound. Airlines charge higher prices to business travelers than to vacation travelers. The reasoning is that the demand curve for a vacation traveler is relatively elastic while the demand curve for a business traveler is relatively inelastic. Any determinant of price elasticity of demand can be used to segment markets. For example, seniors have a more elastic demand for movies than do young adults because they generally have more free time. Thus theaters will offer discount tickets to seniors.{{efn|Note that the discounts apply only to tickets not to concessions. The reason there is not any popcorn discount is that there is not any effective way to prevent resell. A profit maximizing theater owner maximizes concession sales by selling where marginal revenue equals marginal cost.}}

=== Example ===
Assume that by a uniform pricing system the monopolist would sell five units at a price of $10 per unit. Assume that his marginal cost is $5 per unit. Total revenue would be $50, total costs would be $25 and profits would be $25. If the monopolist practiced price discrimination he would sell the first unit for $17 the second unit for $14 and so on which is listed in the table below. Total revenue would be $55, his total cost would be $25 and his profit would be $30.<ref name=Lovell-266>Lovell (2004), p. 266.</ref> Several things are worth noting. The monopolist acquires all the consumer surplus and eliminates practically all the deadweight loss because he is willing to sell to anyone who is willing to pay at least the marginal cost.<ref name=Lovell-266 /> Thus the price discrimination promotes efficiency. Secondly, by the pricing scheme price = average revenue and equals marginal revenue. That is the monopolist behaving like a perfectly competitive company.<ref name=Frank-394>Frank (2008), p. 394.</ref> Thirdly, the discriminating monopolist produces a larger quantity than the monopolist operating by a uniform pricing scheme.<ref name=Frank-266>Frank (2008), p. 266.</ref>
{| class="wikitable"
|-
!Qd !! Price
|-
| 1 || $17
|-
| 2 || $14
|-
| 3 || $11
|-
| 4 || $8
|-
| 5 || $5
|}

=== Classifying customers ===
Successful price discrimination requires that companies separate consumers according to their willingness to buy. Determining a customer's willingness to buy a good is difficult. Asking consumers directly is fruitless: consumers do not know, and to the extent they do they are reluctant to share that information with marketers. The two main methods for determining willingness to buy are observation of personal characteristics and consumer actions. As noted information about where a person lives (postal codes), how the person dresses, what kind of car he or she drives, occupation, and income and spending patterns can be helpful in classifying. {{citation needed|date=June 2012}}