Monopoly Pricing Strategies and Price Discrimination
Monopoly Regulation Challenges
Regulating monopolies is often challenging in the real world. The main problem is that regulators do not have all the information necessary to determine the exact price point where the demand curve intersects the average total cost curve. Sometimes they set it too low, causing supply shortfalls; sometimes they set it too high. Moreover, regulated monopolies tend to overstate their costs to regulators and to provide consumers with inferior products.
In short, sometimes monopoly control is more harmful than beneficial. Some economists argue that the best solution, even in the case of natural monopolies, may be not to intervene. The reason for doing nothing is that trying to control a monopoly can have, in one way or another, more disadvantages than advantages. For example, the politicization of prices can cause market failures or create a breeding ground for political corruption.
Price Discrimination
A monopolist typically offers its products to all consumers at the same price (that is the situation we have considered so far). In reality, not all monopolies set one price. Many of them, as well as oligopolies and monopolistic competitors, pursue price discrimination in order to increase their profits.
Sellers engage in price discrimination when they charge different prices for the same good to different consumers. It is cost-effective to price discriminate when consumers differ in their sensitivity to price. The monopoly prefers charging high prices to consumers willing to pay more and charging lower prices to those who are only prepared to pay less.
To achieve this, different techniques are used to differentiate consumers based on their sensitivity to price (e.g., different prices for airline company executives and tourists, imposing rules that differentiate them such as requiring a Saturday stay at the destination, etc.).
Profit Maximization Through Price Discrimination
Charging higher prices to consumers with low price elasticity of demand and lower prices to consumers with high price elasticity of demand allows a monopoly to maximize profits. The greater the number of prices charged by the monopoly, the lower the lowest price, meaning some consumers pay prices very close to the marginal cost, and the monopoly extracts more money from consumers.
Perfect Price Discrimination
When a monopoly is able to charge each consumer a price equal to their willingness to pay, it is said to be successfully carrying out perfect price discrimination. Consumers who are willing to pay more than the value of the marginal cost buy the good, so all the consumer surplus becomes the monopoly’s profit. In this case, the monopoly does not cause any inefficiency because all mutually beneficial transactions are conducted.
It is unlikely that perfect discrimination is possible in the real world. In essence, the inability to achieve perfect price discrimination is because prices act as economic signals. When this happens, prices contain the information necessary to ensure that all mutually beneficial transactions are carried out: the market price indicates the seller’s cost, and the consumer indicates their willingness to pay to buy the property, provided it is at least as high as the market price.
However, in the real world, the problem is that often prices are not perfect indicators: a consumer can conceal their true willingness to pay. When this occurs, the monopolist cannot achieve perfect price discrimination. Nevertheless, monopolies try to approach perfect price discrimination using multiple strategies when setting prices.
Common Price Discrimination Strategies
- Restrictions on Advance Purchases: Prices are lower for those who buy in advance (or in some cases, by buying at the last minute). This allows separating those who are likely willing to pay higher prices from those who are not.