Price Discrimination and its Effects on Efficiency in Monopolistic Markets

Discrimination is never considered a good thing, is it? Discriminating based on race, gender, or age is usually frowned upon. But in the business world, it is all too common. Consider some of the following example of price discrimination by businesses:

  • Movie theaters: Charge different prices based on age. Seniors and youth pay less since they tend to be more price sensitive.
  • Gas stations: Gas stations will charge different prices in different neighborhoods based on relative demand and location.
  • Quantity discounts: Grocery stores give discounts for bulk purchases by customers who are price sensitive (think “buy one gallon of milk, get a second gallon free”… the family of six is price sensitive and is likely to pay less per gallon than the dual income couple with no kids who would never buy two gallons of milk).
  • Hotel room rates: Some hotels will charge less for customers who bother to ask about special room rates than to those who don’t even bother to ask.
  • Telephone plans: Some customers who ask their provider for special rates will find it incredibly easy to get better calling rates than if they don’t bother to ask.
  • Airline ticket prices: Weekend stayover discounts for leisure travelers mean business people, whose demand for flights is highly inelastic, but who will rarely stay over a weekend, pay far more for a round-trip ticket that departs and returns during the week.

Price discrimination occurs any time a firm with market power charges different prices to consumers based on their willingness to pay or their sensitivity to price changes.

The results of price discrimination are not all bad, either. In fact, such practices usually result in a higher level of output than would be achieved if a firm charged a single price to all consumers. As a result, more people can afford to buy the good in question and a greater level of allocative efficiency is achieved.

This lesson will define price discrimination, outline the conditions necessary for it to occur, and explain the different degrees of price discrimination. We will then illustrate the effect of perfect price discrimination and attempt to conclude whether or not it is good overall for society by looking at the effect it has on consumers and producers.


Natural Monopoly and the need for Government Regulation

In most cases, it can be argued that increased competition in a market will lead to an increase in efficiency, benefiting society and consumers. More competition, it can be argued, puts downward pressure on prices and forces firms to use their resources in a more efficient manner, encouraging firms to reduce their average total costs.

But what if the total demand for a good in a particular market is not high enough to necessitate more than one firm producing the good in question? In other words, what if having more than one firm means that each individual producer will have higher average total costs than a single firm would have? Such a scenario exists if the market demand curve intersects a monopolist’s average total cost curve in the range in which economies of scale are experienced, in other words where ATC it still decreasing. This is known as a natural monopoly.

Such industries exist, particularly in the case of large utilities such as water, electricity, natural gas, sewage and garbage collection. Think about the town you live in: how many firms can you choose to buy your electricity from? The answer is most likely ONE. Would you be better off if the answer were 100? Probably not. Here’s why: If 100 firms competed to provide electricity to your city, no single firm would achieve the economies of scale needed to lower its average total cost to a level that would allow it to provide electricity at the low, desirable rates that you currently pay. With 100 firms providing electricity, each firm would have much higher average costs and therefore would have to charge higher prices to their consumers! Competition would drive the price UP, instead of DOWN, like it is supposed to do, due to the significant economies of scale, namely the huge fixed costs of capital and infrastructure, needed to provide a utility such as electricity.

The problem with natural monopolies is that if they are left unregulated, they will produce much less and charge a price much higher than what is socially optimal (where marginal benefit equals marginal cost). Thus arises the need for regulation. This lesson will explain the theory of natural monopolies and examine the use of subsidies and price controls to promote a more socially optimal outcome in such industries.

After watching this lesson, read and respond to the discussion questions for the following blog post:  Monopoly prices – to regulate or not to regulate, that is the question!


Profit Maximization, Revenue Maximization and PED in Pure Monopoly

A monopolist, having total control over the level of output it produces and the price it charges, will generally be interested in maximizing its profits. But what if a firm decides that it is revenues that should be maximized instead?

This lesson will examine the profit maximization rule as it applies to a pure monopolist, and introduce the revenue maximization rule, which tells a monopolist the quantity it should produce at in order to earn the maximum level of revenues possible. We will examine the level of economic profits earned at one level compared to the other. Additionally, we will look at the price elasticity of demand for a monopolist’s product by revisiting the total revenue test of elasticity.

Introduction to Pure Monopoly

After studying the theories of perfect competition, we now transition into the opposite extreme in the spectrum of competition between firms. ‘Mono’ means ‘one’ and ‘poly’ means ‘seller’. A monopolistic market, therefore, is one in which only a single seller produces the output for the entire market. Examples of pure monopolies are rare, but they do exist; some examples include:

  • Utility companies, such as water and electricity, in particular towns,
  • Cell service providers in some countries
  • Professional sports teams (the Denver Broncos are the only professional football team in Denver)
  • Microsoft (a near monopolist in PC operating systems)

There have been many monopolies in various markets throughout history, but often such firms get broken up into smaller firms, sometimes due to government intervention aimed at increasing competition to lower prices for consumers.

That brings us to some of the characteristics of monopolistic markets: Besides there being just one seller, such firms are also price-makers, they face a downward sloping demand curve (compared to the PC firm’s perfectly elastic demand), and there are high barriers to entry, enabling monopolists to earn economic profits in the long-run. In addition, the marginal revenue a firm receives for additional units of output is always lower than the price it is selling the output for. This last characteristic may sound mundane, but in fact it is the reason monopolists will always charge higher prices and produce at lower quantities than perfectly competitive markets.

This lesson will introduce some of the characteristics of monopolies and use a demand schedule to derive the demand and marginal revenue curves for a hypothetical monopolistic airplane manufacturer. We will then place cost curves on the graph to determine the profit maximizing quantity a monopolist should produce at, and we’ll briefly examine the level of output and price as it would compare to a perfectly competitive market.