consequences of price discrimination

Consequences of Price Discrimination – Cambridge IGCSE/A‑Level (9708) – Topic 7.8

1. Syllabus Alignment

This note covers every sub‑point of 7.8 in the Cambridge syllabus:

• Definition and the three degrees of price discrimination.
• Conditions required for price discrimination.
• Link to marginal‑revenue (MR) analysis for each degree.
• Welfare consequences (consumer surplus CS, producer surplus PS, dead‑weight loss DWL).
• Distributional / equity implications.
• Real‑world examples.
• Evaluation of when price discrimination is welfare‑improving.
• Diagram requirements for the exam.

Cross‑reference notes: price discrimination presupposes market power (monopoly or oligopoly) and therefore links directly to the “market structures” and “government intervention” sections of the syllabus. Where relevant, mention possible regulation (anti‑trust, price‑cap, consumer‑protection).

2. Definition & the Three Degrees

Price discrimination – a firm sells the same product to different consumers at different prices that are not justified by differences in marginal cost (MC). The objective is to capture a larger share of consumer surplus and raise profit.

3. Conditions Required for Price Discrimination

4. Link to Marginal‑Revenue Analysis

4.1 First‑degree (perfect) discrimination

• Because each consumer pays his/her exact willingness to pay, the MR curve coincides with the demand curve: MR = P.
• Profit‑maximisation:
  $$\text{MR}=P=MC.$$
• Result: the firm produces the socially efficient quantity \(Q^{*}\) where MC meets demand, capturing the whole area under the demand curve above MC.

4.2 Second‑degree discrimination

• Self‑selection creates separate “blocks” of output. For block \(i\) with price \(P_{i}\) and quantity \(Q_{i}\) the marginal revenue is $$\text{MR}_{i}=P_{i}+\frac{\Delta P_{i}}{\Delta Q_{i}}\,Q_{i} \;=\; P_{i}\Bigl(1+\frac{1}{\varepsilon_{i}}\Bigr),$$ where \(\varepsilon_{i}\) is the elasticity of the demand faced by that block.
• Graphically the MR for each block is a stepped curve that lies **above** the uniform‑price MR curve.
• Profit‑maximising condition for each block: $$\text{MR}_{i}=MC.$$
• Because some units are sold at a lower price, output can increase beyond the uniform‑monopoly level, reducing DWL.

4.3 Third‑degree discrimination

• Separate demand curves \(D_{A}\) and \(D_{B}\) generate separate MR curves \(MR_{A}\) and \(MR_{B}\).
• From the general MR formula \(MR=P\bigl(1+\frac{1}{\varepsilon}\bigr)\) and the condition \(MR=MC\) we obtain the familiar markup rule: $$\frac{P_{A}-MC}{P_{A}}=\frac{1}{|\varepsilon_{A}|},\qquad \frac{P_{B}-MC}{P_{B}}=\frac{1}{|\varepsilon_{B}|}.$$
• The firm charges the higher price to the less elastic (inelastic) group and the lower price to the more elastic group.

5. Welfare Consequences (CS, PS, DWL)

5.1 Summary Table

5.2 Detailed Welfare Discussion

• First‑degree: The firm captures the entire area under the demand curve above MC: $$\text{Total Surplus}= \int_{0}^{Q^{*}}\!\bigl(P_{D}(q)-MC(q)\bigr)\,dq.$$ CS = 0, PS = Total Surplus, DWL = 0.
• Second‑degree: With block pricing or versioning, CS after discrimination is: $$CS_{\text{after}}=\sum_{i}\int_{Q_{i-1}}^{Q_{i}}\!\bigl(P_{D}(q)-P_{i}\bigr)\,dq.$$ The firm extracts part of the original CS; if the lower price for larger blocks raises output, the monopoly DWL is partially or wholly eliminated.
• Third‑degree: Welfare hinges on the change in total output. \[ \begin{aligned} &\text{If } Q_{A}+Q_{B}>Q_{\text{uniform}} \;\Longrightarrow\; \text{DWL falls (net welfare gain)}\\ &\text{If } Q_{A}+Q_{B}=Q_{\text{uniform}} \;\Longrightarrow\; \text{Only a redistribution (net welfare loss).} \end{aligned} \]

6. Distributional (Equity) Implications

1. Targeted subsidies – discounts for students, seniors or low‑income households can increase access to essential goods.
2. Exploitation risk – charging higher prices to groups with inelastic demand for necessities (e.g. life‑saving drugs) raises equity concerns and may trigger regulation.
3. Perceived fairness – if consumers become aware of price differentials they may view the firm as “unfair”, harming reputation and possibly prompting consumer‑protection action.

7. Real‑World Examples

• Airlines – advance‑purchase discounts, fare classes, frequent‑flyer status (all three degrees).
• Utilities – separate tariffs for industrial, commercial and residential users (third‑degree).
• Software & digital services – student licences (third‑degree), “freemium” models with premium upgrades (second‑degree), volume licences for enterprises (second‑degree).
• Pharmaceuticals – tiered pricing for high‑income vs. low‑income countries (third‑degree).
• Movie theatres – different ticket prices for adults, children and seniors (third‑degree).

8. Evaluation – When Is Price Discrimination Welfare‑Improving?

Key points to include in an exam answer (use bullet points for clarity):

• Output effect – If discrimination raises the total quantity above the uniform‑monopoly quantity, DWL falls → possible net welfare gain.
• Pure redistribution – If total output is unchanged, the gain in PS exactly equals the loss in CS → total welfare falls.
• Equity considerations – Even when efficiency improves, higher prices on essential goods may be judged undesirable.
• Administrative & transaction costs – Monitoring groups and preventing arbitrage can be costly; if these costs exceed the surplus gain, welfare may decline.
• Regulatory environment – Competition authorities may intervene where price discrimination is deemed abusive, especially in essential services.
• Market‑structure link – Discrimination is only possible with market power; in perfectly competitive markets the condition “market power” fails, so no discrimination occurs.

9. Suggested Diagram for Exams

Draw two demand curves (Group A – relatively inelastic, Group B – relatively elastic) with their corresponding MR curves. Include a common MC curve. Shade the following areas:

• Consumer surplus for each group before and after discrimination.
• Producer surplus (total area between the price(s) and MC).
• Socially efficient quantity \(Q^{*}\) where MC meets the combined demand – use this to illustrate any change in DWL.

Label clearly: \(P_{A}, Q_{A}, P_{B}, Q_{B}\), the uniform‑price monopoly point \((P_{U}, Q_{U})\), and the efficient point \((P^{*}, Q^{*})\).

10. Key‑Concept Links (Exam Checklist)