Three Conditions

• Market Control: First and foremost, a seller must be able to control the price. Monopoly is quite adept at price discrimination because it is a price maker, it can set the price of the good. Oligopoly and monopolistic competition can undertake price discrimination to the extent that they are able to control the price. Perfect competition, with no market control, does not do well in the price discrimination arena.


• Different Buyers: The second condition is that a seller must be able to identify the price that each buyer is willing to pay. If buyers are willing to pay the same price, then price discrimination is pointless.


• Segmented Buyers: Lastly, price discrimination requires that buyers cannot resell the good to the other buyers. Price discriminate is ineffective if trade among buyers is possible. Those buyers charged a higher price can simply purchase the good from those who paid a lower price.

A Different Price for Everyone

First-Degree Price Discrimination

As a monopoly supplier, Feet-First Pharmaceutical has sufficient market control to practice price discrimination. To accomplish this, it must identify the maximum demand price that every buyer is willing to pay for every ounce of Amblathan-Plus purchased. This is a tall order and one that inevitably prevents a monopoly from undertaking first-degree (perfect) price discrimination.

Ignoring this bit of realism, how would Feet-First Pharmaceutical pursue first-degree price discrimination? This is accomplished by moving down the demand curve, identifying the maximum price for each quantity, then charging this price.

• A buyer is willing to pay $10 for the first ounce of Amblathan-Plus. Feet-First Pharmaceutical thus charges $10 to the buyer purchasing this first ounce. Click the [1 Ounce] to highlight this alternative.


• The second ounce carries a maximum price of $9.50. First-degree price discrimination involves Feet-First Pharmaceutical charging the buyer of this second ounce $9.50 to make the purchase. Click the [2 Ounce] to highlight this second ounce purchase.


• Moving down the demand curve, a buyer is willing to pay $9 for the third ounce of Amblathan-Plus. Click the [3 Ounce] to illustrate that first-degree price discrimination involves selling this good for $9.

Of course, the amount of information needed by the seller can be quite extensive. Most firms that seek to undertake price discrimination have more than a handful of buyers. They are likely to face thousands, hundreds of thousands, or even millions of buyers, each willing and able to pay a different price.

Marginal Revenue

An average revenue curve does exist, it is just not the demand curve as is the case for other firms. It is related to the price-discrimination-based marginal revenue curve in the same way that any average is related to its corresponding marginal. The marginal lies below the average when the average is declining. As such, the average revenue curve lies above this marginal revenue curve.

Compare this with the demand, average revenue, and marginal revenue relation for a "normal" monopoly. The demand curve and average revenue curve are one and the same and the marginal revenue curve lies below the demand/average revenue curve.

Efficiency

The key rests with the profit-maximizing equality between marginal revenue and marginal cost. A non-discriminating monopoly equates marginal revenue to marginal cost and charges a price that is greater than marginal cost. This is not efficient.

A first-degree price-discriminating monopoly also maximizes profit by equating marginal revenue to marginal cost. The difference, however, is that price is equal to marginal cost for the discriminating seller. As such, the profit-maximizing decision to equate marginal revenue and marginal cost results in the equality between price and marginal cost--which is the key criterion for efficiency.

Of course, even though efficiency is achieved, there is an equity downside. Every bit of consumer surplus generated by buyers is transferred to the monopoly seller. Society gains with an efficient allocation of resources. The monopoly seller gains with profit. But buyers lose with less consumer surplus.

The Other Two Degrees

• Second-Degree Price Discrimination: Also termed block pricing, this form occurs when a seller charges different prices for different quantities of a good. Such discrimination is possible because the different quantities are purchased by different types of buyers with different demand elasticities. Block pricing of electricity, in which electricity prices depend on the amount used, is the most common example. The key is that regular households tend to use very little electricity compared to retail stores, which uses less compared to large manufacturing firms.


• Third-Degree Price Discrimination: This is the most common of price discrimination, and occurs when the seller is able to separate buyers based on an easily identifiable characteristic, such as age, location, gender, and ethnic group. Senior citizen discounts are a common example. Higher gasoline prices on highways are another.