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- In our last video, we saw that price
discrimination is good for the monopolist.
It increases profits, but what about for
society as a whole, this price
discrimination increase social welfare?
That's the topic of today's talk.
It's complicated but here's a rule of
thumb, if price discrimination increases
output then it's very likely to be
beneficial to increase social welfare, if
output however does not increase then
welfare probably is reduced. Let's give
some intuition for when price
discrimination increases welfare. Think
about our previous example of the
pharmaceutical company GSK setting a high
drug price in Europe and a lower drug
price in Africa. Suppose that GSK were
forced to charge only one price. Do you
think it would charge closer to the
European price of $12.50 per pill or
closer to the African price of 50 cents
per pill? What's more likely to happen if
GSK is required to set only one price? If
they can't price discriminate, GSK very
likely will simply abandon the African
market where they weren't making that much
profit anyway and set a single world price
pretty close to the European level. People
sometimes think that if only everyone were
allowed to import pharmaceuticals to the
United States from Canada, Mexico or
Africa where they're cheaper, then we would
all enjoy lower prices. Probably not.
Smuggling or illegal re-emportation of
pharmaceuticals were to become more common
than pharmaceutical companies would stop
price discriminating and set higher prices
for everyone. Who would be made better off
by the resulting single price? Well,
Europeans are not better off because
they're still paying a high price under
the single price rule, but Africans are
going to be worse off.
Because they will no longer have the
option of buying important drugs at the
lower prices. In this case, price
discrimination is beneficial because it
increases output. It gives some Africans
the chance to buy at a lower price when
they otherwise would not have had that
chance under a no price discrimination
rule. For industries with high fixed costs
price discrimination has another benefit,
the extra profits generated by price
discrimination mean that it's more
profitable for the company to engage in
research and development to produce more
new drugs for instance. For example the
extra profits from selling in Africa mean
that research and development is more
profitable, and that benefits Europeans
too. When it comes to new drugs, you might
say that misery loves company. That is the
larger the market for a potential drug the
more research and development will be
applied. Price discrimination similarly
means airlines can offer more flights to
more places at better times, and that also
helps business people. Even though they're
paying the higher prices, they have a
better chance at being able to get there
at a good time in the first place. When it
comes to software, lower price is for the
students also is going to help support
software R and D. If the students wouldn't
buy the software at all at the higher
price, well, then the price discrimination
is a net benefit to pretty much everyone.
More generally price discrimination can
help spread the fixed costs of research
and development over a larger population
and that means more innovation which is to
virtually everyone's benefit. The ultimate
form of price discrimination is when each
person is charged his or her maximum
willingness to pay. Economist call this
'perfect price discrimination,' under
perfect price discrimination consumers end
up with zero consumers surplus. All of the
gains from trade go to the monopolist, but
the efficient quantity is produced.
There's no dead weight loss. Let's look at
this with a diagram. Think of the demand
curve as showing the maximum willingness
to pay by different individuals to buy a
single unit of this good. Here for example
is Alex's willingness to pay, here's
Tyler's willingness to pay, Robin's and on
all the way down to Brian's willingness to
pay for the good. If the monopolist could
charge each and every consumer his or her
maximum willingness to pay, the monopolist
would walk down the demand curve producing
each unit such that the willingness to pay
just exceeded the marginal cost. In other
words the monopolist would produce every
unit up until the efficient quantity of
output, the same quantity as would be
produced by a competitive industry. The
difference being that in the competitive
industry the gains would go to the
consumers. In the case of perfect price
discrimination, all the gains go to the
monopolist. This kind of price
discrimination requires that the
monopolist have a lot of information about
each consumer. Are there examples of this
in practice? In fact there are some, and
you maybe very familiar with one of them.
Universities are fabulous price
discriminators. They're even better than
airlines, especially because few people
realize what is actually going on.
Universities give many students financial
aid, which is another way of saying that
they charge some of their students more
than others. Financial aid is a way of
doing well while doing good because it's a
form of price discrimination. It increases
profits for universities. Moreover to get
the aid, students and their parents must
give the university an incredible amount
to financial information, including their
tax forms, their W2's, information about
their bank accounts, the home they own and
so on. All of this information means the
universities can create many many
different prices in a way that approaches
perfect price discrimination.
At William's College for instance, half
the students pay full fare. Which is about
$32,000 a year, the other half gets some
form of financial aid but the amount
varies tremendously. Students whose
parents have incomes of about $91,000 a
year or higher, they pay an average
intuition of about $22,000 a year. While
students from very poor families may pay
as little as $1,600 a year. That's
meaning that one price can be about 20
times higher than the other, that's a lot
of price discrimination. Price
discrimination makes a lot of sense for
universities because their marginal costs
are low while their fixed costs are pretty
high. If a professor is teaching
economics 101 anyway, then the marginal
cost of putting an extra student in the
classroom is pretty close to zero. Even a
student who is paying a smaller amount in
tuition is probably adding more to profits
than to costs. That helps the university
cover its fixed costs such as the salaries
and the buildings necessary to support the
operations of the university. So again
price discrimination by the universities
increases profits but it also probably
increases their output as well. More
students attend university then otherwise
would be the case. And again, price
discrimination also helps to spread the
fixed costs around a larger number of
customers. For these reasons, price
discrimination by universities probably
increase the social welfare. That's it for
the more obvious forms of price
discrimination. In the next talk we'll be
looking at the some quite common pricing
strategies, such as tying and bundling,
which also can be understood as more
subtle forms of price discrimination.
- If you want to test yourself, click
practice questions.
Or, if you're ready to move on,
just click 'next video.'
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