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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- 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 they 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's required to set only one price? If

they can't price discriminate, GSK very
likely will simply abandon the African

market for 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

aloud 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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