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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.

The most striking example of price discrimination most of us encounter regularly involves airline tickets. Although there are a number of airlines, most routes in the United States 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 happen to purchase the ticket on Tuesday or Wednesday evening, the round trip may cost only $150—or less if you are a senior citizen or a student. 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 traveler and the visiting grandparent receive the same product—that same cramped seat.

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 oligopoly and monopolistic competition, too.

To get a preliminary view of why price discrimination might be more profitable than charging all consumers the same price, imagine that Air Sunshine offers the only nonstop flights between Bismarck, North Dakota, and Ft. Lauderdale, Florida. 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 $125, however many passengers it carries.

Further assume that the airline knows there are two kinds of potential passengers. First, there are business travelers, 2,000 of whom want to travel between the destinations each week. Second, there are students, 2,000 of whom also want to travel each week.

Will potential passengers take the flight? It depends on the price. The business travelers, 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 $150, they will take the bus. The implied demand curve is shown in Figure 8-10.

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 travelers but lose the student market. Or it could charge only $150; that way it would get both types of travelers but would make significantly less money from sales to business travelers.

We can quickly calculate the profits from each of these alternatives. If the airline charged $550, it would sell 2,000 tickets to the business travelers, earning total revenue of 2,000 × $550 = $1.1 million and incurring costs of 2,000 × $125 = $250,000; so its profit would be $850,000, illustrated by the shaded area B in Figure 8-10.

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If the airline charged only $150, it would sell 4,000 tickets, receiving revenue of 4,000 × $150 = $600,000 and incurring costs of 4,000 × $125 = $500,000; 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 travelers the full $550 but offer $150 tickets to the students. That’s a lot less than the price paid by business travelers, but it’s still above marginal cost; so if the airline could sell those extra 2,000 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 8-10.

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 $150, 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 travelers. 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.

Price Discrimination and Elasticity A more realistic description of the demand that airlines face would not specify particular prices at which different types of travelers 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 travelers and students. It just so happens that business travelers 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 travelers, with their low price elasticity of demand, a higher price than it charges students, with their high price elasticity of demand.

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What would happen if the airline could distinguish between students and business travelers 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. As 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.

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 8-11 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 8-11 can be used to make another point: a monopolist that can engage in perfect price discrimination doesn’t cause any inefficiency! Because 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.

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 losses, 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.

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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.