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 market price would be 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.
Price discrimination is selling a product at different prices for different classes of buyers. Generally, the monopolist strives to charge the highest prices were demand is inelastic and lower prices for more price sensitive buyers. 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 is mostly motivated by a desire to earn greater profits — it does not reflect the cost 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.
A common form of price discrimination is charging lower rates for children and for seniors at restaurants, movie theaters, and other forms of entertainment.
Only monopolies can practice price discrimination, because otherwise competition would prevent price discrimination. 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 that 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.
One commonly used technique to achieve market segregation is through the use of coupons. Generally, buyers, such as most businesses, 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.
Other examples of market segregation 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.
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.
To examine how price discrimination can increase a monopoly's profit, consider a monopoly that has perfect 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 enjoying no consumer surplus at all. Instead, total surplus consists entirely of producer surplus for the monopoly.