Price discrimination certainly sounds bad, but we just showed that a perfectly price-discriminating monopolist produces more output than a single-price monopolist, and this is good so price discrimination can’t always be bad. What about if price discrimination is imperfect? Does a monopolist that sets two (or a handful of) prices raise or lower total surplus? The answer is subtle, but there is a similar intuition to the case of the perfectly price-discriminating monopolist. Price discrimination is bad if the total output with price discrimination falls or stays the same, but if output increases under price discrimination, then total surplus will usually increase.

To see this, let’s return to the case of Combivir in Europe and Africa. Suppose that GSK was forbidden from price discriminating so it had to set one world price. What world price would GSK set, and would this increase or decrease total surplus?

One possibility is that if forced to set a single price, GSK would lower the price enough so that some Africans could buy Combivir—for example, a price like P_World in Figure 14.1. A single price of P_World is better for Europeans since P_World < P_Europe, but it is worse for Africans since P_World > P_Africa. Thus, depending on exactly how much better off Europeans are and how much worse off Africans are at P_World, price discrimination could be better or worse than single pricing.

How likely is it, however, that GSK would lower the price to P_World? Two-thirds of the 630 million people living in Africa live on less than a dollar a day. Thus, even when GSK sells Combivir at close to its cost of 50 cents a pill, most Africans with AIDS cannot afford Combivir. GSK, therefore, cannot make up for a low price by selling large volumes of Combivir to Africans. Thus, if GSK cannot set two different prices, it will probably abandon the African market altogether and sell to the world at P_Europe. At P_Europe, only Europeans can afford to buy Combivir.

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At the single price of P_Europe, are Europeans better off than with price discrimination? No, the price to Europeans hasn’t changed and thus the quantity of Combivir consumed by Europeans is the same under both pricing systems. What about Africans? At the single price of P_Europe, Africans pay more for Combivir than with price discrimination and they consume less. Thus, in the most plausible case, forcing GSK to set a single price doesn’t help Europeans but does hurt Africans. Alternatively stated, price discrimination in this case increases total surplus because price discrimination increases output—with price discrimination, Europeans consume as much Combivir as with a single price, but Africans increase their consumption from what it would be with a high single price.

In industries with high fixed costs, price discrimination has another benefit. To explain why, we ask a strange question. Imagine that there are two diseases that if left untreated are equally deadly. One of the diseases is rare, the other is common. If you had to choose, would you rather be afflicted with the rare disease or the common disease? Take a moment to think about this question because there is a definite answer.

It’s much better to have the common disease because there are more drugs to treat common diseases than to treat rare diseases, and more drugs means greater life expectancy. Patients diagnosed with a rare disease are 45% more likely to die before the age of 55 than patients diagnosed with a more common disease.*

The reason there are more drugs to treat common diseases is because the market is larger. Simply put, it costs about the same to develop a drug for a rare or a common disease but the revenues are much greater for a drug that treats a common disease. Thus, the larger the market, the more profitable it is to develop a drug for that market.

The fact that profits increase with market size explains why price discrimination can benefit Europeans, as well as Africans. We have already shown that Africans benefit from price discrimination because of lower prices. Europeans benefit because price discrimination increases the profit from producing pharmaceuticals, and more profit means more research and development, more new drugs, and greater life expectancy.

Pharmaceuticals are not the only industry with high fixed costs—airlines, chemicals, universities, software, and movies all have a similar cost structure. Low prices for vacationers, for example, can benefit business travelers because the extra profit that airlines earn from selling to vacationers encourages airlines to offer more flights to more places at more times. The synthetic fabric Kevlar is five times stronger by weight than steel and is used to make bulletproof vests as well as auto tires. As a bulletproof vest, Kevlar has few substitutes, but as tire belting, it has many. As a result, DuPont charges more for Kevlar used in vests than for Kevlar used in belting. If DuPont had to charge the same price in all markets, Kevlar might not be used for belting at all, and Du Pont would have lower profits and less incentive to innovate.

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