The Social Welfare of Price Discrimination

The Social Welfare of Price Discrimination

♪ [music] ♪ – [Tyler] In our last video, we saw that price discrimination
is good for the monopolist. It increases profits, but what about
for society as a whole, does price discrimination
increase social welfare? That’s the topic of today’s talk. It’s complicated, but here’s
a rule of thumb — if price discrimination
increases output then it’s very likely
to be beneficial, to increase social welfare. If output, however,
does not increase then welfare probably is reduced. Let’s give some intuition for when price discrimination
increases welfare. Think about our previous example of the pharmaceutical company GSK setting a high drug price in Europe and a lower drug price in Africa. Suppose that GSK were forced
to charge only one price. Do you think it would charge
closer to the European price of $12.50 per pill or closer to the African price
of 50 cents per pill? What’s more likely to happen if GSK is required
to set only one price? If they can’t price discriminate, GSK very likely will simply abandon
the African market where they weren’t making
that much profit anyway and set a single world price pretty close to the European level. People sometimes think that
if only everyone were allowed to import pharmaceuticals
to the United States from Canada, Mexico, or Africa
where they’re cheaper, then we would all enjoy
lower prices. Probably not. If smuggling or legal re-importation
of pharmaceuticals were to become more common, then pharmaceutical companies
would stop price discriminating and set higher prices for everyone. Who would be made better off
by the resulting single price? Well, Europeans are not better off because they’re still paying
a high price under the single price rule, but Africans are going
to be worse off, because they will no longer
have the option of buying important drugs
at the lower prices. In this case,
price discrimination is beneficial because it increases output. It gives some Africans
the chance to buy at a lower price when they otherwise would not
have had that chance under a no price discrimination rule. For industries
with high fixed costs, price discrimination
has another benefit — the extra profits generated
by price discrimination mean that it’s more profitable
for the company to engage in research
and development to produce more new drugs
for instance. For example, the extra profits
from selling in Africa mean that research
and development is more profitable, and that benefits Europeans too. When it comes to new drugs, you might say that misery
loves company. That is, the larger the market
for a potential drug, the more research
and development will be applied. Price discrimination similarly
means airlines can offer more flights to more places
at better times, and that also helps business people. Even though they’re paying
the higher prices, they have a better chance
at being able to get there at a good time in the first place. When it comes to software,
lower prices for the students also is going to help
support software R&D. If the students wouldn’t buy
the software at all at the higher price,
well then the price discrimination is a net benefit
to pretty much everyone. More generally, price discrimination
can help spread the fixed costs of research and development
over a larger population, and that means more innovation which is to virtually
everyone’s benefit. The ultimate form
of price discrimination is when each person is charged his or her maximum
willingness to pay. Economists call this
“perfect price discrimination.” Under perfect price discrimination, consumers end up
with zero consumer surplus. All of the gains from trade
go to the monopolist, but the efficient quantity
is produced. There’s no deadweight loss. Let’s look at this with a diagram. Think of the demand curve as showing
the maximum willingness to pay by different individuals to buy
a single unit of this good. Here, for example,
is Alex’s willingness to pay. Here’s Tyler’s willingness to pay,
Robin’s, and on, all the way down to Brian’s
willingness to pay for the good. If the monopolist could charge
each and every consumer his or her maximum
willingness to pay, the monopolist would walk
down the demand curve producing each unit such
that the willingness to pay just exceeded the marginal cost. In other words, the monopolist
would produce every unit up until the efficient
quantity of output, the same quantity as would be
produced by a competitive industry. The difference being that
in the competitive industry, the gains would go
to the consumers. In the case of
perfect price discrimination, all the gains go to the monopolist. This kind of price discrimination
requires that the monopolist have a lot of information
about each consumer. Are there examples
of this in practice? In fact there are some, and you may be very familiar
with one of them. Universities are fabulous
price discriminators. They’re even better than the airlines, especially because few people
realize what is actually going on. Universities give many students
financial aid, which is another way
of saying that they charge some of their students
more than others. Financial aid is a way
of doing well while doing good because it’s a form
of price discrimination. It increases profits
for universities. Moreover, to get the aid, students and their parents
must give the university an incredible amount
of financial information, including their tax forms,
their W2’s, information
about their bank accounts, the home they own and so on. All of this information means
the universities can create many, many different prices in a way that approaches
perfect price discrimination. At Williams College for instance, half the students pay full fare, which is about $32,000 a year. The other half gets some form
of financial aid, but the amount varies tremendously. Students whose parents have incomes
of about $91,000 a year or higher, they pay an average in tuition
of about $22,000 a year. While students
from very poor families may pay as little as $1,600 a year. That’s meaning
that one price can be about 20 times higher
than the other. That’s a lot of price discrimination. Price discrimination makes
a lot of sense for universities because their marginal costs are low while their fixed costs
are pretty high. If a professor is teaching
Economics 101 anyway, then the marginal cost of putting
an extra student in the classroom is pretty close to zero. Even a student who is paying
a smaller amount in tuition is probably adding more
to profits than to costs. That helps the university
cover its fixed costs such as the salaries
and the buildings necessary to support
the operations of the university. So again, price discrimination
by the universities increases profits, but it also probably increases
their output as well. More students attend university
than otherwise would be the case. And again, price discrimination
also helps to spread the fixed costs around a larger number
of customers. For these reasons,
price discrimination by universities probably increases social welfare. That’s it for the more obvious
forms of price discrimination. In the next talk we’ll be looking at some quite common
pricing strategies, such as tying and bundling, which also can be understood as more subtle forms
of price discrimination. – [Announcer] If you want
to test yourself, click “Practice Questions.” Or, if you’re ready to move on,
just click “Next Video.” ♪ [music] ♪

6 thoughts on “The Social Welfare of Price Discrimination

  1. What they said about University price discrimination is nonsense. I'm in California, in California we are only selling college education to students who are able to pay the highest prices. Students from within the state are no longer getting seats at California universitie. Out-of-state students, the ones who must pay the highest price, are taking up all the seats.

  2. In some cases price discrimination is legitimate. However if you produce a product that cost you 5 Dollars in production and selling why on earth should you be allowed to sell this product at a price of 10 Dollars in one place and for 20 dollars in another place? This is exactly what is happening here in Switzerland and the neigbouring countries. They sell the same products at a higher price here in switzerland just because we are wealthier the our neigbouring countries. This practice is even protected by laws.

  3. In short the bean counters objective is to take the most money from the have-nots as they possibly can without completely ruining their market.

  4. For the drug example we assumed drug companies could sell their drugs in a more expensive price in a pre hoc fashion. If they were able to sell their drugs for that price everywhere they would do that already. However, without monopolies, market prices tend to coalesce at the supply demand intersection. If drug companies fix their prices as exorbitantly high everywhere as in Usa, the local competition would just drive the price down. This is not possible for the novelty drugs, during which period companies recoup their r&d expenditures, but when a pill of daraprim sells for $750 (which is pyrimethamine, almost a 70 year old drug now) which can be bought for .25$ in other parts of the world, you gotta admit price discrimination in monopolistic markets is just a pseudonym for ripping off customers

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