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Essay Plan Number
Subject / Topic
13
Monopoly and Price Discrimination
PRICE DISCRIMINATION AND ECONOMIC EFFICIENCY
Q1: What are the conditions required for price discrimination to take place (5)
Basic definition required of price discrimination is required for full 5 marks in the first part
Concise identification + explanation of the main conditions for 4 marks (+ 1 for the definition)
1. Producer needs some price setting power (i.e. requires an imperfectly competitive market)
2. Seller must be able to prevent resale/arbitrage (or market seepage) from customers buying at the
lower price being able to re-sell at an intermediate price to other groups. Possible to do this
segmentation by time/ by distance or by other means (e.g. use of travel cards/identification) Easier
to prevent re-sale with a service.
3. Producer needs to be able to identify different sub-groups of consumers with a different price
elasticity of demand so that variations in price can be charged to extract the available consumer
surplus
Q2: Explanation how price discrimination might be practised by (a) Regional Water Company
and (b) Telecommunications businesses
TELECOMMUNICATIONS (5)
Marginal Cost
Price
Peak
Off-peak
AR peak
MR peak
AR off-peak
MR off-peak
Q1
Q2
Output
An example of second-degree discrimination where there are regular and predictable differences in
the level of demand at different times.
Credit relevant examples of such pricing - look for diagram showing peak and off-peak pricing
where prices are lowered when demand falls off at off-peak times. This encourages consumers to use
some of the excess capacity in the telecommunications system. Peak & off peak tariffs helps to
generate extra revenue to cover for the fixed costs of running the system. Peak demand might exceed
available capacity - leading to higher prices because of rising marginal costs. Peak users (perhaps
businesses) more willing to pay (higher incomes?) - prices reflect this.
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WATER INDUSTRY (5)
Look for identification & explanation of third degree discrimination and plausible illustration of which
consumers might have a relatively inelastic demand and which a more elastic demand schedule. The
marginal cost curve is important here - and must be derived. We assume that the marginal cost of
supply to both groups is constant. This must be shown using separate diagrams. Profit maximisation
occurs in each separate sub-market with the group with the inelastic demand facing the higher price.
Total profits are higher with setting two prices rather than setting one individual price for both sets of
consumers. See the relevant shaded areas in the diagram over leaf.
TOTAL MARKET
INDUSTRIAL USERS
Price
Price
DOMESTIC USERS
Price
P1
MC
MC
P2
MC
AR
AR2
AR1
MR
Output
PROFIT WITH ONE PRICE
MR1
MR2
Output
Q1
Q2
Output
COMBINED PROFIT WITH DIFFERENT PRICES
Q3: Does Price Discrimination lead to economic efficiency? (10)
Economic efficiency should be defined and explained:
• Allocative Efficiency where price = marginal cost and overall economic welfare is maximised
• Productive Efficiency - output is produced at minimum average total cost (either in the short or the
long-run)
In whose interests does price discrimination work? Clearly these pricing strategies are largely in the
interests of the producer by raising total revenue, adding to profits and using up spare productive
capacity. The producer is exploiting the monopoly power and in most (but not all) cases the consumer
does not benefit. 1st Degree discrimination might be used to illustrate this point
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Price
Pa
Pb
P1 & Q1: Normal profit maximising price and output
Q2: Output where the firm perfectly discriminates
P1
Marginal Cost
Average Revenue
MR
Q1
Q2
Output
Under perfect price discrimination we achieve the pareto optimal output (where price (AR) =
marginal cost) at Q2 although every consumer is paying a price > marginal cost (until the final
consumer) and all consumer surplus is extracted & turned into producer surplus (profit). In the other
forms of discrimination (i.e. second and third degree) we do not achieve allocative efficiency.
Clearly some consumers benefit from pricing strategies designed to price them into the market. They
can consume a good or service at a discounted price whereas before they might not have been able to
afford it. The consumption of the product adds to living standards & welfare.
Productive efficiency might be encouraged if the monopolist is selling more output through
discrimination and therefore moves further down the long-run average total cost curve,. There is though
the risk that diseconomies of scale might be experienced and price discrimination can also be used as a
barrier to the entry of new firms
Geoff Riley
www.tutor2u.com Economics
05 January 2000
Tutor2u Economics
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