Let’s return to the example of business travelers and students traveling between Bismarck and Ft. Lauderdale, illustrated in Figure 63.1, 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, the maximum that each group is willing to pay. For business travelers, the willingness to pay is $550; for students, it is $150. As we have assumed, the marginal cost is $125 and does not depend on output, making the marginal cost curve a horizontal line. And as we noted earlier, we can easily determine the airline’s profit: it is the sum of the areas of rectangle B and 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 the monopolist achieves perfect price discrimination.

In general, the greater the number of different prices charged, the closer the monopolist is to perfect price discrimination. Figure 63.2 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, every consumer pays the most he or she is willing to pay, and the entire consumer surplus is extracted as profit.

Both our airline example and the example in Figure 63.2 can be used to make another point: a monopolist who can engage in perfect price discrimination doesn’t cause any allocative inefficiency! The reason is that the source of allocative 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” these consumers by offering some of them lower prices than others.

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. 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 traveler 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:

Our discussion also helps explain why government policies on monopoly typically focus on preventing deadweight loss, not preventing price discrimination—unless it causes serious issues of equity. Compared to a single-price monopolist, price discrimination—even when it is not perfect—can increase the efficiency of the market. When a single, medium-level price is replaced by a high price and a low price, some consumers who were formerly priced out of the market will be able to purchase the good. The price discrimination increases efficiency because more of the units for which the willingness to pay (as indicated by the height of the demand curve) exceeds the marginal cost are produced and sold. Consider 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 will serve more consumers and create more total surplus than 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.

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