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December 18, 2014 

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RIVAL CONSUMPTION: Consumption of a good by one person imposes a cost on, or prevents consumption of the good by, another person. Some goods, like food, have extremely rival consumption. One person, and only one person, gets the benefit. Other goods, like national defense, have no consumption rivalry, everyone can benefit simultaneously without imposing a cost on others. This is one of the two key characteristics of a good (the other is excludability) that distinguishes between common-property goods, near-public goods, private goods, and public goods.

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FIRST-DEGREE PRICE DISCRIMINATION:

A form of price discrimination in which a seller charges the highest price that buyers are willing and able to pay for each quantity of output sold. This is also termed perfect price discrimination because the seller is able to extract ALL consumer surplus from the buyers. This is one of three price discrimination degrees. The others are second-degree price discrimination and third-degree price discrimination.
As the alternative name "perfect" suggests, this is the ultimate in price discrimination. It is price discrimination to which price discriminators aspire, but seldom if ever achieved in the real world. To accomplish first-degree price discrimination, a seller needs to know the highest demand price that every buyer is willing and able to pay for each quantity purchased. Such information is seldom available.

Three Conditions

To be a successful price discriminator, a seller must satisfy three things: (1) to have market control and be a price maker, (2) to identify different prices that different buyers are willing to pay, and (3) to keep the buyers from reselling the good. In this way, a seller is able to charge each buyer the maximum price.
  • 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 can be illustrated using the accompanying diagram. The demand curve displayed here is that facing Feet-First Pharmaceutical, a well-known monopolist that controls the market for Amblathan-Plus, the only cure for the deadly (but hypothetical) foot ailment known as amblathanitis.

First-Degree
Price Discrimination
First-Degree


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.
A key point is that each subsequent ounce of Amblathan-Plus carries a different (lower) price than the previous quantities sold. Feet-First Pharmaceutical does not sell ALL 3 OUNCES for $9. Rather, it sells the first ounce for $10, the second ounce for $9.50, the third ounce for $9, the fourth ounce for $8.50, etc.

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

The first of two interrelated implications resulting from first-degree price discrimination involves the relation between marginal revenue, average revenue, and demand. Because a first-degree price-discriminating seller charges the maximum demand price for each unit sold, the demand curve facing the firm is also the marginal revenue curve. The demand curve reflects the incremental change in revenue. But if the demand curve is marginal revenue, it cannot be average revenue, too.

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 second implication resulting from first-degree price discrimination involves to efficiency. A monopoly firm that practices first-degree price discrimination actually achieves an efficient allocation of resources. Ironically, what appears to be inefficiency compounded with inefficiency results in an efficient allocation of resources. Monopoly is bad. Price discrimination is bad. Together they are efficient. How so?

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

First-degree price discrimination is one of three forms of price discrimination. The other two are second-degree and third-degree.
  • 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.

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Recommended Citation:

FIRST-DEGREE PRICE DISCRIMINATION, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2014. [Accessed: December 18, 2014].


Check Out These Related Terms...

     | price discrimination | second-degree price discrimination | third-degree price discrimination |


Or For A Little Background...

     | monopoly | market control | perfect competition | price elasticity of demand | consumer surplus | demand | demand curve | demand price | marginal revenue | marginal revenue curve | marginal cost | marginal cost curve | profit maximization | efficiency | equity |


And For Further Study...

     | perfect competition, profit maximization | monopoly, profit maximization |


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