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Price
Discrimination

Learn how firms charge different prices for the same product to maximize profit by capturing consumer surplus.

AP Microeconomics

What Is Price Discrimination?

Price discrimination occurs when a firm charges different prices to different consumers (or for different units) of the same good or service, where the price difference is not due to differences in cost.

Why Does It Matter?

Higher Profits
Firms earn more revenue than charging a single price by capturing surplus from each customer segment.
Efficiency Effects
Some forms can increase total output and reduce deadweight loss compared to single-price monopoly.
Equity Questions
Consumers with higher willingness to pay are charged more: is this fair or exploitative?

Three Conditions Required

1
Market Power: The firm must be a price maker (monopoly, monopolistic competition, or oligopoly) rather than a price taker.
2
Identifiable Groups: The firm must be able to distinguish consumers by their willingness to pay (age, location, purchase timing, etc.).
3
No Resale (Arbitrage Prevention): Consumers who buy at a low price cannot resell to those charged a higher price.

The Three Degrees

1st Degree
Perfect price discrimination: charge each consumer their exact willingness to pay. Captures all consumer surplus.
2nd Degree
Price varies by quantity or version purchased (bulk discounts, tiered pricing). Consumers self-select.
3rd Degree
Different prices for different groups (students, seniors, regions). Most common form in practice.

Single Price vs. Perfect Discrimination

Single Price Monopoly Price Quantity D MR MC Pm Qm CS PS DWL 1st Degree (Perfect) Price Quantity D MC All PS Q*
\( \text{DWL} = 0 \)

The Profit Maximization Rule

The firm allocates output so that the marginal revenue is equal across all segments and equal to marginal cost. If \( MR_1 > MR_2 \), the firm should sell more in market 1 and less in market 2.

1st vs 3rd Degree

1st Degree 3rd Degree
Price Charged Unique price per unit One price per group
Consumer Surplus Zero Reduced, not zero
Deadweight Loss Eliminated May increase or decrease
Output Level Efficient (\( Q^* \)) Between \( Q_m \) and \( Q^* \)
Practical? Nearly impossible Very common

How to Analyze Price Discrimination

1
Identify market power: Is the firm a price maker? A perfectly competitive firm cannot price discriminate.
2
Check for segmentation: Can the firm identify groups with different elasticities? Are there student, senior, or geographic segments?
3
Verify no arbitrage: Can low-price buyers resell to high-price buyers? If yes, discrimination fails.
4
Apply \( MR = MC \) per segment: Set marginal revenue equal to marginal cost in each market to find optimal \( Q \) and \( P \).
5
Evaluate welfare: Compare total surplus, consumer surplus, and deadweight loss to the single-price case.

Example: Movie Theater Pricing

A movie theater charges \( P_A = \$12 \) for adults and \( P_S = \$8 \) for students. The marginal cost of one seat is \( MC = \$3 \).

Adults
Less elastic demand: they value the experience highly and have fewer substitutes during peak hours.
Students
More elastic demand: tighter budgets, more substitutes (streaming), willing to wait for discounts.

Example: Two-Market Graph

Market 1 (Inelastic) P Q D1 MR1 MC P1 Q1 Market 2 (Elastic) P Q D2 MR2 MC P2 Q2

Example: Calculating Profit Gain

A monopolist faces two markets. Without discrimination, the single monopoly price is \( P_m = \$20 \) with \( Q_m = 100 \). With third-degree discrimination:

Market A
\( P_A = \$25 \), \( Q_A = 60 \)
Revenue: \( \$1{,}500 \)
Market B
\( P_B = \$15 \), \( Q_B = 55 \)
Revenue: \( \$825 \)

Real-World Examples

1st Degree
Car dealerships (haggling), college financial aid (tuition varies by family income), auction pricing.
2nd Degree
Bulk discounts (Costco), tiered phone plans, electricity rates that decrease per kWh for high usage.
3rd Degree
Student/senior discounts, airline pricing (business vs. economy), peak vs. off-peak pricing.

Welfare Effects

Single Price 3rd Degree Perfect (1st) CS PS DWL CS PS DWL
\( \text{CS} = 0 \)
 PS
\( \text{DWL} = 0 \)

Common Mistakes

✕ Any Price Difference
Price differences due to cost differences (shipping, size) are NOT price discrimination. The same good must cost the same to produce.
✕ Perfect Competition
Price takers cannot price discriminate. Market power is a prerequisite: the firm must face a downward-sloping demand curve.
✕ Elasticity Backwards
The less elastic group pays MORE, not less. Students often reverse this because "elastic" sounds like it stretches to a higher price.

Summary Comparison

1st Degree 2nd Degree 3rd Degree
Mechanism Individual WTP Self-selection Group identity
CS Captured All Some Some
DWL Zero Reduced Ambiguous
Output vs. \( Q_m \) Increases to \( Q^* \) Increases May increase
Info Required Each buyer's WTP Demand tiers Group elasticities
Example Auctions Bulk discounts Student tickets

Question 1 of 5

Which of the following is not a necessary condition for a firm to practice price discrimination?

Question 2 of 5

Under perfect (first-degree) price discrimination, what happens to consumer surplus and deadweight loss compared to a single-price monopoly?

Question 3 of 5

A monopolist practices third-degree price discrimination between two markets. In Market A, demand is relatively inelastic. In Market B, demand is relatively elastic. Which statement is correct?

Question 4 of 5

A software company offers a "basic" version for \( \$50 \) and a "premium" version with extra features for \( \$150 \). Both versions cost the same to produce. This is an example of:

Question 5 of 5

Why can't a perfectly competitive firm practice price discrimination?