Price Discrimination under Monopoly: Types, Degree and Equilibrium

The monopolist charges the same price for the product from all customers. But in several cases, monopolist sells the same product at different prices to different customers even though the cost of production is the same. This practice of charging the multi prices is known as price discrimination.

For example, if the producer of a camera of a given variety sells it to customer A for Rs 2500 and to customer B for Rs 3000, then he is practising price discrimination. It is also known as multi-part pricing.

Types of Price Discrimination:

Four types of price discrimination are:

1. Personal Price Discrimination:

Price Discrimination is said to be personal when a seller charges different prices from different persons.

2. Local Price Discrimination:

Price Discrimination is said to be local when a seller charges different prices from people from different places. For example, a seller may sell a commodity at one price at home and at a different price abroad.

3. Price Discrimination According to Use:

When a seller charges different prices for different uses of a product, then it is called price discrimination according to use.

4. Price Discrimination According to Time:

When a seller charges different prices for the same product at different times, then it is called price discrimination according to time.

Degree of Price Discrimination:

Prof. A. C. Pigou has distinguished between the following three types of price discrimination. These are:

1. First Degree Price Discrimination
2. Second Degree Price Discrimination
3. Third Degree Price Discrimination

First-Degree Price Discrimination:

Under first-degree price discrimination, a monopolist charges different prices from different customers. If a monopolist charges each customer the maximum price he or she is willing to pay, then this practice is known as first-degree price discrimination.

In this case, the consumer will not be able to have a surplus because the price he is willing to pay is equal to the price which he is actually paying. Under this, the monopolist can extract all the surplus from the buyer, which he is getting by threatening him with the alternative of getting none of the goods.

Thus consumer surplus is zero (i.e. maximum exploitation of consumers) under first-degree price discrimination.

Second-Degree Price Discrimination:

According to Professor Pigou, if a monopolist charges different prices per unit for different quantities of the same good, then this practice is known as second-degree price discrimination.

In second-degree price discrimination, buyers are divided into different groups, and from each group, a different price is charged, which is the lowest demand price of that group. This price discrimination would occur if each individual buyer had perfectly inelastic demand for the goods below and above a certain price.

For example, electric power companies charge lower rates for the initial units demanded by the customer and higher rates for subsequent consumption. In this case, consumer surplus is not zero.

Third-Degree Price Discrimination:

If a seller divides his buyers into two or more than two groups or submarkets and charges different prices in each submarket, then this practice is known as third-degree price discrimination.

When is Price Discrimination Possible?

In order to practice price discrimination, two necessary conditions need to be fulfilled are:

1. The market is to be divided into submarkets, and each submarket has a different price elasticity of demand. A monopolist can practice price discrimination only when he is selling in different markets in such a way that goods sold by him in the cheaper market cannot be resold in the dearer market.
2. The market is to be divided into submarkets so that no reselling can take place from a cheaper market to a dearer market.

Equilibrium under Price Discrimination:

We are starting with the simple case of a monopolist who sells his commodity in two submarkets at two different prices. Each of the submarkets has demand curves with different price elasticity.

The price-discriminating monopolist has to decide:

• (i) how much total output he must produce.
• (ii) How should the total output be allocated between the submarkets so as to maximise the total revenue and profits?

Suppose initially the seller is selling 100 units in each market. We also assume that with this allocation, marginal revenue in market 1 denoted by MR1 is Rs 10, and marginal revenue in market 2 denoted by MR2 is Rs 8. In this case, reallocation of units from cheaper markets to dearer markets is possible, and the monopolist could increase its total revenue by increasing the number of units sold in market 1 and reducing the number of units sold in market 2. By selling one more unit in market 1, the total revenue increases by Rs 10 and by selling one unit less in market 2, the total revenue reduces by Rs8. So by reallocating the monopolist is getting a net increase in total revenue of Rs 2 (Rs10-Rs 8). So:

1. The total output produced by the monopolist should be divided between the two sub-markets so that marginal revenue in each sub-market is equal i.e. MR1=MR2.
2. For a price-discriminating monopolist to be in equilibrium, the total output must be such that marginal revenue in each sub-market is equal to the marginal cost of production i.e. MR1=MR2=MC.

In Fig, Panel A shows submarket 1 where AR1 and MR1 are the corresponding average revenue and marginal revenue curves. Panel 2 shows submarket 2, where AR2 and MR2 are the corresponding average revenue and marginal revenue curves. Panel C shows the aggregate marginal revenue curve, which is derived by the horizontal summation of marginal revenue curves of sub-markets 1 and 2. MC is the marginal cost of production.

For a price-discriminatory monopolist to be in equilibrium, the total output is such that MC is equal to the aggregate MR curve. The equilibrium point shows that ∑MR is equal to MC, i.e. the addition to total revenue arising from an additional unit of output when allocated to the submarkets optimally is equal to MC, i.e. addition to total cost arising from an additional unit of output. The equilibrium output is OC, as shown in Panel C.

Now draw a line from point C towards MR1 and MR2. The point where this line crosses the marginal revenue curves determines the output sold in the two submarkets. So OQ1 units of output are sold in market 1 at OP1 price, and OQ2 units of output are sold in market 2 at OP2 price and OQ1+OQ2=OQ.

The profit is maximised in each market by equating MC to the corresponding MR. So,

In Market 1: MR1=MC

In Market 2: MR2=MC

The total profit is maximised when MC is equal to individual marginal revenues.

𝑀𝑅₁ = 𝑀𝑅₂ = 𝑀𝐶

The monopolist can profitably practice price discrimination if the market can be divided into submarkets and each submarket has different price elasticity.

Price Discrimination and Elasticity of Demand:

We have seen in Fig that demand is more elastic in market 2 than in market 1 at all the levels of output. And more (less) elastic the submarket demand, the lower (higher) the equilibrium price in the submarket. This can be shown with the help of the relationship between price and elasticity of demand. We have seen that

𝑀𝑅 = 𝑃 (1 − 1/e)

Where,

MR is Marginal Revenue

P is the Price, and

e is the elasticity of demand.

In the case of price discrimination in Submarket 1»

𝑀𝑅₁ = 𝑃₁ (1 − 1/e₁)

Where

𝑀𝑅₁ is the Marginal Revenue in submarket 1

P₁ is the Price in submarket 1

e₁ is the Price Elasticity of Demand in submarket 1.

Similarly, in Submarket 2,

𝑀𝑅₂ = 𝑃₂ (1 − 1/e₂)

Where,

𝑀𝑅₂ is the Marginal Revenue in submarket 2

P₂ is the Price in submarket 2

E₂ is the Price Elasticity of Demand in submarket 2.

And marginal revenue must be equal in both markets.

MR1= MR2, so we have

𝑀𝑅₁ = 𝑃₁ (1 − 1/e₁) = 𝑀𝑅₂ = 𝑃₂ (1 − 1/e₂)

Or

𝑃₁/𝑃₂ = (1 − 1/e₁)/(1 − 1/e₂) ……………….. (1)

(i) If e1=e2, i.e. the elasticity is the same in both submarkets, then price discrimination is not possible. If e1=e2, then equation (1) becomes

P₁/P₂ = 1 or P₁ = P₂

(ii) If price elasticity differs, i.e. e₁≠e_2, then the price will be lower (higher) in the market whose demand is more (less) elastic.

P₁ (1 – 1/e₁) = P₂ (1 – 1/e₂)

If e₁>e₂ then,

(1 – 1/e₁) > (1 – 1/e₂)

Thus the condition of equality of the marginal revenues to be fulfilled P1<P2.

OR

If e₁<e₂ then,

(1 – 1/e₁) < (1 – 1/e₂)

And for the condition of equality of the marginal revenues to be fulfilled, P1>P2.

The market with high elasticity of demand will have a lower price, and the market with low elasticity of demand will have a higher price.

Dumping: Price Discrimination

Dumping is a special case of price discrimination where a firm is a monopolist in a domestic country but sells a commodity at a lower price in a foreign country. Dumping is possible because:

1. The firm is protected from foreign competition by tariffs and other import restrictions.
2. There are no export restrictions. So firm cal also sell the good in the foreign market.
3. There exists a difference in the price elasticity of demand among the markets.

Here we are studying a special case where a firm is a monopolist in the domestic market and faces international competition in the foreign market. It is graphically shown in Fig. Panel A shows the firm domestic monopoly, which faces a downward-sloping average revenue curve AR1 and marginal revenue curve MR2.

Panel B shows the case of a firm in a foreign market where it faces perfect competition and a perfectly elastic horizontal demand curve. MR2 and AR2 are the marginal revenue and average revenue curves faced by a firm in the foreign market.

Panel C shows the aggregate marginal revenue, which is the horizontal summation of MR1 and MR2. MC is the marginal cost of production.

The equilibrium output will occur where aggregate marginal revenue is equal to MC at point E, and the equilibrium output is OQ. The total output OQ is to be distributed in the foreign and domestic markets in such a way that marginal revenue in each market is equal to each other and to the marginal cost, i.e. MR1=MR2=MC.

In fig, for any output OM or less than OM, all the output will be sold in the domestic market, and the firm has no leftover output to be sold in the foreign market. And for any output more than OM, the firm has output left over after completing domestic demand OM; it will sell in a foreign market at a perfectly competitive price Pc.

The equilibrium is determined at point E where aggregate MR is equal to MC and equilibrium output is OQ. The equilibrium output OQ is more than the output OM, i.e. seller is selling some output in the foreign market as well. Out of OQ units of output, OM is sold in the domestic market at a price PM, and MQ is sold in the foreign market at price Pc, i.e. OQ=OM+MQ.

If and price in the foreign market is less than the price in the domestic market, this is said to be dumping in the foreign market.

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