Fiveable
Fiveable
start studying now
start studying now
AP Microeconomics
Unit 4 Overview: Imperfect Competition
4.1 Introduction to Imperfectly Competitive Markets
4.2 Monopolies
4.3 Price Discrimination
4.4 Monopolistic Competition
4.5 Oligopoly and Game Theory

🤑ap microeconomics review

4.3 Price Discrimination

Verified for the 2025 AP Microeconomics exam•Last Updated on June 18, 2024

Refresher of a Uniformly Pricing Monopoly

Last section, we learn about a monopoly. A monopoly is a market structure in which the entire market is run by one firm who has complete control over the price and quantity produced. In a uniformly-pricing monopoly, the monopolist charges only one price - the demand price at the point where MR = MC. In a monopoly, MR is less than D because a monopoly must charge all consumers the same price, meaning they cannot take advantage of different willingnesses to pay. Even if the first consumer is willing to pay 50,ifthepriceis50, if the price is 5, they must charge $5. 

However, the monopolist doesn't have to uniformly-price (barring laws forcing them to). This section will discuss price-discrimination, the process by which a monopolist smashes consumer surplus and charges every consumer a different price - their exact willingness to pay. 

What is Price Discrimination?

Price discrimination is a practice used by monopolies in which specific products are sold to different buyers and each consumer is charged the highest price that they are willing and able to pay. The price they are charged is based on their purchasing power and their demand elasticity. If a customer is willing to pay a lot, they're charged a lot. If they're willing to pay a little (up to the price where MR = MC), they're charged a little.

There are three conditions that need to be present in order for a monopoly to practice price discrimination:

  1. The firm must have monopoly power - you can't price discriminate without power over prices

  2. The firm must be able to segregate the market - this means being able to find out what each consumer's willingness to pay is

  3. Consumers cannot easily re-sell the product in the market - If consumers are able to easily resell the product, they may be able to arbitrage the price difference and undermine the monopoly's ability to price discriminate

There are many differences between a regular monopoly and one that price discriminates. Take a look at the table below for more information.

CharacteristicsPure MonopolyPrice Discriminating Monopoly
Demand & MRD > MRD = MR
EfficiencyProductively and allocatively inefficientAllocatively efficient, productively inefficient
Economic ProfitsSmaller long-run economic proftsLarger long-run economic profits
Consumer SurplusSome consumer surplusZero consumer surplus

Graphing Perfect Price Discrimination

In perfect price discrimination (also called first degree price discrimination), demand exactly equals marginal revenue because we're able to earn exactly the additional willingness to pay for each additional unit, unlike before. Thus, we have three main curves on our graph: MC, which stays the same, D = MR, which is downward sloping, and ATC, which also doesn't change.

Total revenue looks like a trapezoid going down the demand curve, since we make different amounts of revenue per consumer.

Total cost is the same as always - the rectangle formed by ATC and the price.

The following graph shows profit in a price discriminating monopoly:

Take a look at all that profit! By price discriminating, the monopolist is able to convert all consumer surplus over to additional revenue, and as such, make tons more profit.

My face when I saw this graph for the first time - profits go WILD

Producer and Consumer Surplus in Price Discrimination

Let's observe what happens to producer and consumer surplus when we price discriminate. First, remember what surplus looked like in a uniformly-pricing monopoly:

We have consumer surplus, producer surplus, and deadweight loss from the non-socially optimal production.

In price discrimination, consumer surplus is wiped out to ZERO. This is because every consumer is charged exactly their willingness to pay, so they always make no surplus. Instead, this is converted to producer surplus, since the monopolist gets what would be their additional willingness to pay. However, we also have no deadweight loss, since we now are producing where P = MC.

Efficiency and Price Discrimination

When a monopoly price discriminates, it becomes allocatively efficient. A pure monopoly always produces less than a perfectly competitive market, meaning its level of output is not allocatively efficient. When a monopoly price discriminates, it earns a higher marginal revenue (MR), so it will increase its output and produce at the allocatively efficient level of output.

By price discriminating, a monopolistic firm will increase its economic profits. A pure monopoly charges a single price, where a price discriminator will charge each consumer at different prices. This eliminates consumer surplus and turns that into revenue, which in turn increases the economic profits that are earned by the firm.

Examples of various situations where monopolies are price discriminating include:

  • An airline charging different prices to customers for the same flight. Many times the cost varies based on how much in advance the flight is booked (i.e. more expensive the closer you get to the actual flight) or based on your past ticket purchases. This is also called intertemporal price discrimination.
  • A university charging different students different prices of admission
  • A sports team charging different prices for seats in the same section of a stadium.
  • A car dealership negotiating car prices with consumers on an individual basis.
  • A movie theater charging different prices for tickets based on a consumers age.

Key Terms to Review (17)

Allocatively Efficient Level of Output: The allocatively efficient level of output occurs when the quantity of a good produced is equal to the quantity demanded by consumers at a price that reflects the true cost of production. This means that resources are allocated in such a way that maximizes total welfare in society, balancing the marginal cost of production with the marginal benefit consumers receive from the good. In this context, it is crucial to consider how price discrimination can affect this equilibrium by allowing firms to charge different prices to different consumers based on their willingness to pay.
Allocative Efficiency: Allocative efficiency occurs when resources are distributed in such a way that maximizes the total benefit received by all members of society. It is achieved when the price of a good or service reflects the marginal cost of producing it, ensuring that consumer preferences align with producer costs.
Arbitrage: Arbitrage is the practice of taking advantage of price differences in different markets to make a profit without risk. This process typically involves buying a security or asset in one market at a lower price and simultaneously selling it in another market at a higher price. In the context of price discrimination, arbitrage plays a crucial role as it can limit the ability of firms to charge different prices to different customers.
Average Total Cost (ATC): Average Total Cost (ATC) is the total cost of production divided by the quantity of output produced, reflecting the per-unit cost of producing goods. It helps firms understand their cost structure and make decisions on pricing, output levels, and market entry or exit. ATC plays a crucial role in analyzing profitability, efficiency, and competitive behavior across different market conditions.
Consumer Surplus: Consumer surplus is the difference between what consumers are willing to pay for a good or service and what they actually pay. It represents the additional benefit or utility that consumers receive from purchasing products at lower prices than they were prepared to pay, illustrating the value consumers place on goods and services in relation to market prices.
Deadweight Loss: Deadweight loss is the loss of economic efficiency that occurs when the equilibrium outcome is not achieved or not achievable in a market. This inefficiency can arise from various factors such as government interventions, externalities, or monopolistic practices, resulting in missed opportunities for trade and welfare. It represents the value of trades that do not happen due to distortions in the market.
Economic Profits: Economic profits are the difference between total revenue and total costs, including both explicit and implicit costs. This concept helps distinguish between normal profit, which is the minimum level of profit needed for a company to remain competitive, and economic profit, which occurs when a firm earns more than this normal profit. Understanding economic profits is crucial as it influences business decisions, pricing strategies, and market entry or exit.
Inter-temporal Price Discrimination: Inter-temporal price discrimination is a pricing strategy where a firm charges different prices for the same product at different times, taking advantage of varying consumer willingness to pay over time. This approach allows companies to maximize profits by targeting different segments of the market based on their timing of purchase, often seen in industries like technology or travel where prices fluctuate significantly based on demand and timing.
Marginal Revenue (MR): Marginal Revenue is the additional income generated from the sale of one more unit of a good or service. It is a crucial concept in understanding how firms make pricing and production decisions, as it reflects how much revenue increases with each additional unit sold, connecting deeply to market structures like monopolies, monopolistic competition, and perfect competition.
Market Segregation: Market segregation refers to the practice of dividing consumers into distinct groups based on specific characteristics or preferences, enabling firms to tailor their products and pricing strategies accordingly. This segmentation allows businesses to maximize profits by charging different prices to different segments, thus enhancing their ability to implement price discrimination effectively. By understanding the diverse needs and willingness to pay among various consumer groups, firms can strategically position their offerings in a way that appeals to each segment.
Monopoly Power: Monopoly power refers to the ability of a firm or entity to set prices above marginal cost and maintain a higher profit margin due to a lack of competition in the market. This power allows monopolists to control supply, dictate market conditions, and influence consumer choices. Monopoly power is often associated with significant barriers to entry that prevent other firms from competing effectively.
Monopoly: A monopoly is a market structure where a single seller dominates the entire market for a good or service, leading to the absence of competition. This market power allows the monopolist to set prices higher than would be possible in competitive markets, often resulting in reduced consumer welfare and potential inefficiencies.
Perfect Price Discrimination (First Degree Price Discrimination): Perfect price discrimination, also known as first degree price discrimination, occurs when a seller charges each consumer the maximum price they are willing to pay for a good or service. This strategy allows the seller to capture the entire consumer surplus by tailoring prices based on individual willingness to pay, which can lead to higher overall profits compared to charging a single uniform price. It’s most effective in markets where sellers have complete information about their consumers' preferences and willingness to pay.
Producer Surplus: Producer surplus is the difference between what producers are willing to accept for a good or service versus what they actually receive in the market. This surplus reflects the benefit to producers for selling at a higher market price, and it is a crucial measure of producer welfare, linking directly to concepts such as market dynamics and pricing strategies.
Productive Inefficiency: Productive inefficiency occurs when a firm or economy does not produce goods or services at the lowest possible cost, leading to wasted resources and higher production costs. This inefficiency can arise from various factors such as improper resource allocation, lack of competition, or mismanagement, ultimately resulting in a loss of potential output and economic welfare.
Pure Monopoly: A pure monopoly exists when a single firm is the sole producer of a product or service with no close substitutes, allowing it to control the entire market. This market structure is characterized by high barriers to entry, enabling the monopolist to maintain its dominant position and dictate prices without competitive pressure. The absence of competition gives the monopolist the power to set prices above marginal cost, leading to potential price discrimination practices.
Total Revenue: Total Revenue is the total income a firm earns from the sale of its goods and services, calculated as the price per unit multiplied by the quantity sold. This concept plays a crucial role in understanding how firms make decisions about pricing, production levels, and market entry or exit, as it directly impacts profitability and resource allocation.
Back
Practice QuizGlossary
4.4 Monopolistic Competition