Price discrimination

    A single-seller monopoly can profitably exploit its market power by practising

price discrimination. That is, different segments of the market can be charged different prices; hence their different price-sensitivities can be exploited. Wherever

price elasticity of demand differs, there is scope for price discrimination.

    To see why, suppose a market can be segmented into two parts: one representing

high-elasticity customers and the other consisting of customers with a low

price elasticity of demand. The respective demand curves are D_1 and D_2

,with the corresponding marginal revenue (MR) curves MR_1 and MR_2.

We assume, for simplicity, that the monopolist’s MC curve is constant and the

same for each market.

    In order to maximise profits, the monopolist must set price such that its MR in

each market equals its constant MC. The exercise will involve computing the MR

curve corresponding to each demand curve. A combined MR curve can be derived

as a lateral summation of the MR curve in each market. The combined marginal

revenue curve, CMR in Figure 6.4, is derived in this way. When CMR cuts MC,

the firm’s maximum profit point is attained.

    In Figure 6.4,the MC and the CMR curve intersect at E. Profits are maximised

when marginal revenue equals OC. In market 2, we see from Figure 6.4

that the level of output_sales corresponding to MR_2 # OC is OQ_2. At that sales

level, a price of OP_2 can be charged. In market 1, marginal revenue of OC is earned  on the OQ_1_th unit of sales. The price obtainable in this price-sensitive

market is only OP_1. The firm’s profits are therefore maximised by selling:

-OQ_1 at price OP_1 in market 1,

-OQ_2 at price OP_2 in market 2.

    Price discrimination is common practice wherever monopoly power exists. In

Chapter 4 we introduced the theory of market segmentation and the pricing decision

in the case of hotel rooms, football stadiums, theatres and suchlike. Utility

companies, such as gas, electricity and telecoms, also resort to elaborate forms of

price discrimination, and successful exporters are regularly accused of ‘dumping’

– i.e. selling cheaper in the (price-elastic) world market than in their domestic market. But a price-discriminating firm must be careful that the markets are truly segmented, i.e. it must not be possible to arbitrage between them. Otherwise, an intermediary could make money by buying the good in market 1 at OP_1 and selling it into market 2 at OP_2. Assuming zero impediments between markets, this arbitrage would continue until the prices in each market were equalised. The presence of impediments, or transaction costs, gives scope for divergence in price between one market and another. A firm obviously has an incentive to spend resources on creating market segmentation, through advertising campaigns and improved quality. Cosmetic changes to the product may be made in order to avert accusations of exploitation or unfairness.This would mean that the MC differs in each market and allowance would have to be made for this in deciding the optimal sales level in each market. But the principles guiding the decision would remain unchanged – it boils down to ascertaining the level of MR through careful demand analysis, supplementing it with reliable cost information and applying the appropriately adjusted marginal cost # marginal revenue rules.

   

    Price discrimination can also be incorporated into a monopolist’s pricing strategy

through charging two-part tariffs. Typical examples include telecom charges

involving a fixed rental per quarter plus a price per call, or professional associations

charging a membership fee allied to a concessionary members’ fee for conferences,

journal issues and other services. The net effect is that different users are

charged different amounts for the same service. The practices of ‘bundling’ or

‘full-line forcing’, whereby a firm requires the customer to stock a range of its

products or sells them on a ‘bundled’ as well as on a single-item basis, are other

 forms of price discrimination. These practices all presuppose the presence of some

monopoly power.

    Price discrimination is widely practised. This is because it can be important for

the bottom line. Dolan and Simon observe that, for given cost structures, a 1 per

cent boost in average price yields a net profit increase of 12 per cent to the average

US corporation._14 Readers can check this by taking 1 per cent of net sales of any

company and adding it to net profit. At the same time, price discrimination can

be hard to document. Fear of adverse consumer reaction and of attracting the

attention of the competition authorities makes firms cautious about publishing

details. They are more likely to try to explain price discrimination by claiming

that the dearer product is of superior quality or that the costs of supply and distribution vary between markets, or by offering complicated pricing structures and

elaborate bundling. Of course, if the products are not identical, prices could

diverge without this constituting price discrimination in the economist’s sense.