Today and tomorrow we will be wrapping up our look at Monopolies. Tomorrow we will look at regulating monopolies and at monopolies in the long run. Today we will look at price discrimination, which is the first part of this power point.
Monopolies Part 3
We originally learned about Price Discrimination in one of the early chapters in the Undercover Economist. The idea of price discrimination is that a business is trying to figure out a way to charge different people different prices.
There are three types of price discrimination.
1) Charge each person the most they are willing to pay. The idea here is that somehow the store is able to determine this info and adjust the price accordingly. When Bob walks into the store the store somehow knows that he is willing to pay $5 and charges him $5. When Susan walks in, they know she will only pay $4 and they charge her $4. This type of price discrimination is very hard to achieve.
2) Charge everyone the same price for the first unit and then a different price for additional units. This works in one of two ways.
The more typical version is to charge a higher price for the first unit and then a lower price for additional units. A great example of this is Subway. Subway charges you a particular price for a 6" sandwich. If you want to make it 12", they charge you substantially less for the second 6". They are able to do this because the money you paid for the first half of the sandwich covers most of their costs: the food, wages for employees, electricity, maintenance, etc. If you are willing to buy the second half of the footlong sandwich, they really only need to charge you for the food. All of the other costs were already covered in the first half. Thus, they can charge you less and still make a profit on the second half.
The other way it works is when a business charges a lower price for the first unit and then higher prices for additional units. This only works if they get you "locked in" to their product. A good example of this is razor blades for shaving. The store sells you the handle for the razor and one or two blades at a relatively low cost per blade. If you want to keep using the handle you bought, you have to buy more of their blades. (The competitors blades won't work on their handle.) Thus, they can now charge more money per blade for the extra blades.
3) Charge one group one price and another group a different price. An example of this is charging different prices at a movie theater. For instance senior citizens, military personnel, or students get a different (usually lower) price.
In order for price discrimination to work, the store must have three things:
a) Monopoly Power: this doesn't mean that they have to be a monopoly. It just means that the store has to have a significant control of the market. So it could be an oligopoly.
b) Market Segregation: you can easily divide people into groups. For example it is easy for a theater to identify senior citizens, military personnel or students, by simply looking at their ID.
c) No Resale: if the product can be bought and resold, price discrimination doesn't work. Because you could just go ask someone who can get the lower price to buy it for you. The theater can offer lower prices to senior citizens because their customers can't take the movie home for others to enjoy (without breaking the law anyway.) That's why a bookstore doesn't offer a senior discount.
The power point then looks at two of the price discrimination strategies in more detail. First let's look at the third strategy. Different prices for different groups.
Why does the theater offer a lower price to senior citizens? Aren't they losing money?
The idea here is that the theater looks at its normal situation and sees how much money they will make. But then the theater asks itself, "Is there some way we can increase sales? Is there someone out there who isn't coming to the movies that we can get to show up?"
Retired senior citizens have a lot of free time, so they could come to the movie. But they also don't have a lot of extra money. So there are probably people who would go to the movie but they can't really afford it. What if we offered those people a discount?
If that entices more people to come to the movie then the theater is making additional money that they otherwise wouldn't have gotten. It's like they suddenly create a new market (the second graph in the power point) and any revenue earned in that market is bonus money. In particular because it didn't cost them anything to provide those movies.
Let's say that if they didn't offer a senior discount 20 people would go see the movie. With the senior discount 30 people come to the movie. How much more cost to the theater did the additional 10 people create?
The answer is effectively none. The theater was already showing the movie. They didn't have to hire any new employees. So it was essentially bonus revenue.
It is possible that some of the people in the original 20 movie watchers were senior citizens. So those people paid less than they would have originally. However, as long as the discount brings in enough new customers, the revenue lost by old customers getting the discount won't matter. If the discount doesn't bring in enough new customers, then you should stop offering the discount.
Finally let's look at the first type of price discrimination, charging each person the most they are willing to pay. As I said earlier this is very hard to achieve. But what would happen if you could do it?
If I have a store and every time a customer comes in I somehow know what they are willing to pay how does that affect our graph?
Here is a chart with two different scenarios. The cost to produce the product is $5. The left side is under a normal monopoly in which I charge everyone the same price. The right side is with price discrimination and I am charging everyone the most they are willing to pay.
Note that each row represents just 1 sale to 1 customer. In other words, on the left if I set the price at $7 I will sell four units all for $7. On the right I would still sell four units, but will charge each customer a different price.
Normal Monopoly
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Monopoly With Price Discrimination
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Number of Customers
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Price Customer is Willing to Pay
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Price All Customers Pay
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Price Customer is Willing to Pay
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Price Each Single Customer Actually
Pays
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1
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$10
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$5
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$10
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$10
|
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2
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$9
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$5
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$9
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$9
|
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3
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$8
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$5
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$8
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$8
|
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4
|
$7
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$5
|
$7
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$7
|
|
5
|
$6
|
$5
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$6
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$6
|
|
6
|
$5
|
$5
|
$5
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$5
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7
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$4 or Less
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-
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$4 or Less
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-
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|
First off notice that on both sides of the chart no sales are made for a price below $5. If it costs $5 to make, I am not going to sell for less than $5.
Looking at the left side, what is the Marginal Revenue for each line. (Figure this out on a scratch piece of paper.) To get you started, if the price is $10, I will make one sale for a TR of $10. If I am willing to lower the price to $9, I will make two sales for a total of $18. So the MR is $8. Do this all the way down to the last sale at $5.
Hopefully you saw that the MR goes down much faster than the price. Because in a monopoly MR is less than DARP.
Now think about the MR for the right side. The 1st customer comes in and is willing to pay $10. He gets charged $10.
Then a 2nd customer comes in. They are willing to pay $9. They get charged $9. But the key difference is that the first customer was still charged $10. So the marginal revenue for the first person was $10. The MR for the second was $9. The MR for the third will be $8. And so on.
In other words, the MR is now THE SAME as the Price. In other other words, the MR line has rejoined the DARP line. We now have a downward sloping MRDARP line.
Now lets think about the idea of Consumer Surplus. Here's another chart. It's similar to the first chart, but this time on the left the price doesn't change. We are looking at what happens when the price is $5 without price discrimination. On the right we still have price discrimination.
Normal Monopoly
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Monopoly With Price Discrimination
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Price Customer is Willing to Pay
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Price Customer Actually Pays
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Price Customer is Willing to Pay
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Price Customer Actually Pays
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$10
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$5
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$10
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$10
|
|
$9
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$5
|
$9
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$9
|
|
$8
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$5
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$8
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$8
|
|
$7
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$5
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$7
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$7
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$6
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$5
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$6
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$6
|
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$5
|
$5
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$5
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$5
|
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$4 or Less
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-
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$4 or Less
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-
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|
Remember that CS is the difference between what a person is willing to pay and what they actually paid.
On the left how much CS is there?
(10-5) + (9-5) + (8-5) + (7-5) + (6-5) + (5-5) = $15 of CS
On the right side how much CS is there?
(10-10) + (9-9) + (8-8) + (7-7) + (6-6) + (5-5) = $0
If we have this form of Price Discrimination. The CS disappears.
Worksheets:
This link will take you to an online copy of all the Monopoly Work Sheets. You need to scroll down and do the pages for Price Discrimination (Activity 3-13)
Monopoly Work Sheets
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