A company in a competitive market must accept the market price, but a monopoly can set a price that maximizes its own profit. Quantity and price are adjusted depending on the elasticity of demand for the product. If demand is inelastic, then the monopolist can increase profits by increasing prices, where the increase in price more than offsets the drop in quantity, but if demand is elastic, then the decrease in quantity sold will more than offset the increase in price, resulting in lower revenue for the monopoly. If the elasticity of demand were the same for the entire market, then the monopolist can maximize profit by setting a single price. However, for most products and services, the elasticity of demand varies according to market segment, so a monopolist can only maximize its profit by setting a profit-maximizing price for each market segment — this is what is called price discrimination.
Look at it this way. A monopoly seeks to maximize profits by restricting its quantity of output so that marginal revenue equals marginal cost. This output is less than what would occur in a competitive market because the marginal revenue of a monopolist selling at a single price is less than what the output would be at the market price anywhere on the demand curve. A monopolist can only increase the sale of its product by reducing its price. But in doing so, it also earns less revenue on all previous units. However, if a monopolist can price its products according to who the buyers are, then it can significantly increase its profits by setting the profit-maximizing price for each market segment.
Price discrimination is selling a product at different prices for different classes of buyers based on their differing elasticity of demand for the product or service; whether the product or service actually differs among the price groups is secondary, but in most cases, the different prices charged are not related to the differences in the cost of providing the underlying item. Generally, the monopolist strives to charge the highest prices where demand is inelastic — i.e., where higher prices lead to higher revenue in spite of the decreasing quantities sold at the higher prices — and lower prices for more price-sensitive buyers, where higher prices would decrease the quantity sold, leading to lower revenue in spite of the higher prices, because the drop in quantity more than offsets the rise in price. The products sold to different classes of buyers are sometimes different, but the differences have no significant relationship to the price differentials. The differences in prices are mostly motivated by a desire to earn greater profits — it does not reflect the cost-of-production differences among the products. For instance, Microsoft sells its Windows 7 operating system in several versions, including a Starter Edition, Windows 7 Home Premium for people who have more powerful computers, Windows 7 Professional for businesses, and its top edition, Windows 7 Ultimate, for enterprises. Microsoft Office is also sold in several editions with the consumer market being charged a lower price than the business or enterprise market. Businesses and enterprises have little concern for the price, which is why many items targeted for that market are more expensive than for the consumer market. Note, that the development of the Windows operating system is a sunk cost that covers the entire development. When Microsoft markets the less expensive operating systems to consumers, it simply takes features out of the original product or does not provide them in the 1st place. Since all of the features have been developed for the most expensive operating system, Microsoft could easily sell the same operating system to everyone at no additional cost to itself. Although this would benefit society, it does not allow Microsoft to maximize its profit because it prevents price discrimination. By contrast, Apple does sell the same operating system for their desktop computers to everyone.
Only monopolies can practice price discrimination; otherwise competition would prevent price discrimination by setting competitive prices. However, many companies that can differentiate their products to some extent in what is known as monopolistic competition can practice price discrimination to some degree. Additionally, several other requirements are necessary to effect price discrimination successfully:
- The monopolist must be able to identify segments of the market who are willing to pay different prices, then market its products accordingly. A common technique to achieve this is by making it harder to get the lower prices, since wealthier consumers value their time more than their money.
- The buyers of the lower-priced product should not be able to resell the product to the higher-priced market. Otherwise, the monopoly will not be able to maintain price differentials.
For instance, Microsoft prevents reselling by licensing the software rather than selling it. Also, the more expensive software has features that appeal more to businesses, so they would not be interested in the consumer software.
When the monopolist can readily identify discrete market segments with different demand elasticities, the monopolist charges the profit-maximizing price for each of the segments. This strategy is sometimes called third-degree price discrimination. Some examples of third-degree price discrimination include charging different prices according to age, or by charging the same price to everyone, but providing financial aid for lower income buyers, which is a universal method used by institutions of higher education. Another common form of price discrimination is charging lower rates for children and for seniors at restaurants, movie theaters, and other forms of entertainment.
When the monopolist knows that there are different market segments but cannot identify the segments or cannot charge different prices specifically to those segments, then the monopolist resorts to selling techniques that would appeal to the different groups — what is sometimes referred to as second-degree price discrimination. Examples of this type of market segregation is selling at different unit prices, depending on the amount bought, or through the use of coupons. Generally, buyers, such as most businesses and wealthy people, who are not price sensitive do not take the time to clip coupons. Buyers who are price sensitive often do clip coupons and, thus, get the discounted price. Some segments of the population, such as the unemployed, also have more time to clip coupons.
The benefit of price discrimination to the monopolist is greater profits, of course, but it also increases productive and allocative efficiency because more product is produced and is made available to a greater market than would otherwise be provided by the monopoly.
To examine how price discrimination can increase a monopoly's profit, consider a monopoly that has perfect price discrimination (aka first-degree price discrimination) — in other words, it can price its product so that it is exactly equal to each buyer's willingness to pay. Although no monopoly can practice perfect price discrimination, it does simplify the analysis, because its marginal revenue curve is exactly equal to the market demand curve. Therefore, like for a competitive firm, marginal revenue equals market price. A competitive firm will produce until marginal cost equals the market price — producing more or less than this will lower profits. Under perfect price discrimination, the marginal revenue curve coincides with the market demand curve, so the monopolist will also produce until marginal cost equals the price of the product. This increases profits shown by the shaded portion of the graph #2 below. Allocative efficiency is also maximized when price equals marginal cost. Note, however, that under perfect price discrimination, buyers enjoy no consumer surplus at all. Instead, total surplus consists entirely of producer surplus for the monopoly.
Are Auctions or Individual Sales Good Examples of Perfect Price Discrimination?
Some have argued that individual sales, where the price for the products or service is individually negotiated, such as when a car dealer sells cars, is an example of first-degree price discrimination. However, there are significant differences:
- the seller is negotiating a price, not setting a price — the buyer may be a better negotiator than the seller, in which case the seller earns less revenue, not more;
- the product or service being offered is not from a monopoly — the potential customer can, and often does, go elsewhere;
- the cost of negotiating will also be variable, because the sale may not be made or the time to sell may vary considerably, so costs do not necessarily go down, but may go up with increasing sales;
- the items being sold are usually different.
Even auctions cannot be considered examples of perfect price discrimination because they occur at a specific time and place, so not everyone who would be interested in the product will be there. Moreover, the ultimate buyer would probably still enjoy some consumer surplus since the price will probably still be less than what the buyer was willing to pay. The upshot of all of this is that both marginal revenue and marginal cost will be highly variable, so I would not describe these situations as good examples of perfect price discrimination.