Up to this point, we have considered only the case of a single-price monopolist, one that charges all consumers the same price. As the term suggests, not all monopolists do this. In fact, many if not most monopolists find that they can increase their profits by charging different customers different prices for the same good: they engage in price discrimination. There are three degrees of price discriminations: first-degree (also called perfect price discrimination), second-degree, and third-degree.

The most striking example of price discrimination many of us encounter regularly involves airline tickets. Although there are a number of Canadian airlines (with Air Canada being the dominant firm), most domestic routes are serviced by only one or two carriers, which, as a result, have market power and can set prices. So any regular airline passenger quickly becomes aware that the question “How much will it cost me to fly there?” rarely has a simple answer.

If you are willing to buy a nonrefundable ticket a month in advance and stay over a Saturday night, a round trip between Toronto and Montreal, for example, may only cost you $250 or less (including taxes, fees, and surcharges). But if you have to go on a business trip tomorrow, which happens to be Tuesday, and come back on Wednesday, the same round trip might cost $550. Yet the business traveller and the tourist receive the same product—the same cramped seat, the same awful food (if indeed any food is served).

You might object that airlines are not usually monopolists—that in most flight markets the airline industry is an oligopoly. In fact, price discrimination takes place under oligopoly and monopolistic competition as well as monopoly. But it doesn’t happen under perfect competition. And once we’ve seen why monopolists sometimes price-discriminate, we’ll be in a good position to understand why it happens in other cases, too.

To get a preliminary view of why price discrimination might be more profitable than charging all consumers the same price, imagine that Maple Sky offers the only nonstop flights between Toronto and Montreal. Assume that there are no capacity problems—the airline can fly as many planes as the number of passengers warrants. Also assume that there is no fixed cost. The marginal cost to the airline of providing a seat is $225, however many passengers it carries.

Further assume that the airline knows there are two kinds of potential passengers. First, there are business travellers, 2000 of whom want to travel between the destinations each week. Second, there are students, 2000 of whom also want to travel each week.

Will potential passengers take the flight? It depends on the price. The business travellers, it turns out, really need to fly; they will take the plane as long as the price is no more than $550. Since they are flying purely for business, we assume that cutting the price below $550 will not lead to any increase in business travel. The students, however, have less money and more time; if the price goes above $250, they will take the bus. The implied demand curve is shown in Figure 13-10.

So what should the airline do? If it has to charge everyone the same price, its options are limited. It could charge $550; that way it would get as much as possible out of the business travellers but lose the student market. Or it could charge only $250; that way it would get both types of travellers but would make significantly less money from sales to business travellers.

We can quickly calculate the profits from each of these alternatives. If the airline charged $550, it would sell 2000 tickets to the business travellers, earning total revenue of 2000 × $550 = $1.1 million and incurring costs of 2000 × $125 = $250 000; so its profit would be $850 000, illustrated by the shaded area B in Figure 13-10. If the airline charged only $250, it would sell 4000 tickets to the business travellers and students, receiving revenue of 4000 × $250 = $1 000 000 and incurring costs of 4000 × $225 = $900 000; so its profit would be $100 000. If the airline must charge everyone the same price, charging the higher price and forgoing sales to students is clearly more profitable.

What the airline would really like to do, however, is charge the business travellers the full $550 but offer $250 tickets to the students. That’s a lot less than the price paid by business travellers, but it’s still above marginal cost; so if the airline could sell those extra 2000 tickets to students, it would make an additional $50 000 in profit. That is, it would make a profit equal to the areas B plus S in Figure 13-10.

It would be more realistic to suppose that there is some “give” in the demand of each group: at a price below $550, there would be some increase in business travel; and at a price above $250, some students would still purchase tickets. But this, it turns out, does not do away with the argument for price discrimination. The important point is that the two groups of consumers differ in their sensitivity to price—that a high price has a larger effect in discouraging purchases by students than by business travellers. As long as different groups of customers respond differently to the price, a monopolist will find that it can capture more consumer surplus and increase its profit by charging them different prices. (Here we have assumed the monopolist can easily distinguish the two groups of customers and reselling from one group to the other is not possible.)

According to Figure 13-10, Maple Sky would maximize its profit by charging different airfares to different groups of travellers and in that figure the demand curve looks like a stepped function. The same logic applies when a firm faces downward sloping demand curves. Figure 13-11 shows how Maple Sky could maximize its profits for two groups of travellers with typical demand curves. When Maple Sky is able to charge different airfares, it will treat the market for student travellers separately from the market for business travellers. In each respective market, Maple Sky chooses the number of tickets sold such that marginal cost is equal to the marginal revenue (setting MC = MR in each market). This is considered third-degree price discrimination—monopolist charging different prices in different markets.

You may have noticed that, like the airline industry, attractions such as zoos, science centres, museums, and art galleries often offer different prices to different groups of customers, namely children, students, and seniors. How can these places offer admission discounts to these customers? Usually, seniors and children can be distinguished by their appearance. As for students, colleges and universities issue student ID cards, and student just need to show their valid ID to receive lower prices. Many Canadian schools take part in the International Student Identity Card (ISIC), which grants discounts on a range of activities from shopping at local retail stores to travelling abroad.

A more realistic description of the demand that airlines face would not specify particular prices at which different types of travellers would choose to fly. Instead, it would distinguish between the groups on the basis of their sensitivity to the price—their price elasticity of demand.

Suppose that a company sells its product to two easily identifiable groups of people—business travellers and students. It just so happens that business travellers are very insensitive to the price: there is a certain amount of the product they just have to have whatever the price, but they cannot be persuaded to buy much more than that no matter how cheap it is. Students, though, are more flexible: offer a good enough price and they will buy quite a lot, but raise the price too high and they will switch to something else. What should the company do?

The answer is the one already suggested by our simplified example: the company should charge business travellers, with their low price elasticity of demand, a higher price than it charges students, with their high price elasticity of demand. To achieve this price difference, several airlines and travel agencies offer discounts to students with valid identification, such as the ISIC card.

The actual situation of the airlines is very much like this hypothetical example. Business travellers typically place a high priority on being at the right place at the right time and are not very sensitive to the price. But nonbusiness travellers are fairly sensitive to the price: faced with a high price, they might take the bus, drive to another airport to get a lower fare, or skip the trip altogether.

So why doesn’t an airline simply announce different prices for business and nonbusiness customers? First, this would probably be illegal (the Competition Act places limits on the ability of companies to practise open price discrimination). Second, even if it were legal, it would be a hard policy to enforce: business travellers might be willing to wear casual clothing and claim they were visiting family in Montreal in order to save $300.

So what the airlines do—quite successfully—is impose rules that indirectly charge business and nonbusiness travellers different fares. Business travellers usually travel during the week and want to be home on the weekend; so the round-trip fare is much higher if you don’t stay over a Saturday night. The requirement of a weekend stay for a cheap ticket effectively separates business from nonbusiness travellers. Similarly, business travellers often visit several cities in succession rather than make a simple round trip; so round-trip fares are much lower than two one-way fares. Many business trips are scheduled on short notice; so fares are much lower if you book far in advance. Fares are also lower if you purchase a last-minute ticket, taking your chances on whether you actually get a seat—business travellers have to make it to that meeting; people visiting their relatives don’t.

Because customers must show their ID at check-in, airlines make sure there are no resales of tickets between the two groups that would undermine their ability to price-discriminate—students can’t buy cheap tickets and resell them to business travellers. Look at the rules that govern ticket-pricing, and you will see an ingenious implementation of profit-maximizing price discrimination.

Let’s return to the example of business travellers and students travelling between Toronto and Montreal, illustrated in Figure 13-10, and ask what would happen if the airline could distinguish between the two groups of customers in order to charge each a different price.

Clearly, the airline would charge each group its willingness to pay—that is, as we learned in Chapter 4, the maximum that each group is willing to pay. For business travellers, the willingness to pay is $550; for students, it is $250. As we have assumed, the marginal cost is $225 and does not depend on output, making the marginal cost curve a horizontal line. As we noted earlier, we can easily determine the airline’s profit: it is the sum of the areas of the rectangle B and the rectangle S.

In this case, the consumers do not get any consumer surplus! The entire surplus is captured by the monopolist in the form of profit. When a monopolist is able to capture the entire surplus in this way, we say that it achieves perfect price discrimination (also called first-degree price discrimination).

In general, the greater the number of different prices a monopolist is able to charge, the closer it can get to perfect price discrimination. Figure 13-12 shows a monopolist facing a downward-sloping demand curve, a monopolist who we assume is able to charge different prices to different groups of consumers, with the consumers who are willing to pay the most being charged the most. In panel (a) the monopolist charges two different prices; in panel (b) the monopolist charges three different prices. Two things are apparent:

With a very large number of different prices, the picture would look like panel (c), a case of perfect price discrimination. Here, consumers least willing to buy the good pay marginal cost, and the entire consumer surplus is extracted as profit.

Both our airline example and the example in Figure 13-12 can be used to make another point: a monopolist that can engage in perfect price discrimination doesn’t cause any inefficiency! The reason is that the source of inefficiency is eliminated: all potential consumers who are willing to purchase the good at a price equal to or above marginal cost are able to do so. The perfectly price-discriminating monopolist manages to “scoop up” all consumers by offering some of them lower prices than it charges others. The entire surplus is captured by producer surplus, and the deadweight loss is zero.

Perfect price discrimination is almost never possible in practice. At a fundamental level, the inability to achieve perfect price discrimination is a problem of prices as economic signals, a phenomenon we noted in Chapter 4. When prices work as economic signals, they convey the information needed to ensure that all mutually beneficial transactions will indeed occur: the market price signals the seller’s cost, and a consumer signals willingness to pay by purchasing the good whenever that willingness to pay is at least as high as the market price.

The problem in reality, however, is that prices are often not perfect signals: a consumer’s true willingness to pay can be disguised, as by a business traveller who claims to be a student when buying a ticket in order to obtain a lower fare. When such disguises work, a monopolist cannot achieve perfect price discrimination.

However, monopolists do try to move in the direction of perfect price discrimination through a variety of pricing strategies. Common techniques for price discrimination include the following:

Volume discounts and two-part tariffs are second-degree price discriminations. In these cases, the monopolist charges different prices based on the quantity purchased by its customers because the monopolist knows it has different groups of customers but is unable to differentiate them easily. By charging different prices based on the quantity purchased the monopolist is making its customers reveal their own preference by choosing the packages offered.

Our discussion also helps explain why government policies on monopoly typically focus on preventing deadweight losses, rather than preventing price discrimination—unless it causes serious issues of equity. The Competition Bureau, the federal agency responsible for Canada’s competition policy, focuses on price discrimination for sales in input or wholesale markets rather than in retail markets. Doing so ensures that firms are charged the same input prices, so no supplier can affect competition at the retail level. Compared to a single-price monopolist, price discrimination—even when it is not perfect—can increase the efficiency of the market. If sales to consumers formerly priced out of the market but now able to purchase the good at a lower price generate enough surplus to offset the loss in surplus to those now facing a higher price and no longer buying the good, then total surplus increases when price discrimination is introduced.

An example of this might be a drug that is disproportionately prescribed to senior citizens, who are often on fixed incomes and so are very sensitive to price. A policy that allows a drug company to charge senior citizens a low price and everyone else a high price may indeed increase total surplus compared to a situation in which everyone is charged the same price. But price discrimination that creates serious concerns about equity is likely to be prohibited—for example, an ambulance service that charges patients based on the severity of their emergency.