The Social Welfare of Price Discrimination

Now that we’ve learned a little about price discrimination, we can begin to think about whether or not price discrimination is bad for society. How does price discrimination affect output, and what is this effect on social welfare? If price discrimination increases output, it is likely beneficial for society. If output isn’t increased, social welfare is reduced. What are some examples of perfect price discrimination? Universities practice perfect price discrimination all the time. Students pay different amounts for their education based on many different factors surrounding each student’s ability to pay. This practice increases profits and also increases the number of students able to attend college. For this reason, price discrimination by universities likely increases social welfare.

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- [Tyler] 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,

does 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.

If smuggling or legal re-importation
of pharmaceuticals

were to become more common,

then 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 prices for the students

also is going to help
support software R&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.

Economists call this
“perfect price discrimination.”

Under perfect price discrimination,

consumers end up
with zero consumer surplus.

All of the gains from trade
go to the monopolist,

but the efficient quantity
is produced.

There's no deadweight 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 may be very familiar
with one of them.

Universities are fabulous
price discriminators.

They're even better than the 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
of 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 Williams 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 in tuition
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
than 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 increases social welfare.

That's it for the more obvious
forms of price discrimination.

In the next talk we'll be looking

at some quite common
pricing strategies,

such as tying and bundling,

which also can be understood

as more subtle forms
of price discrimination.

- [Announcer] 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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