Economics-Price Discrimination

Yiyi Dong Tutor: Dr George Bitsakakis

11 November 2012 Game Theory

The Welfare Effects of Price Discrimination

I. First Degree Price Discrimination and Its Effect on Social Welfare

First degree price discrimination or perfect price discrimination describes when the monopoly has perfect information about all its consumers’ demand curves and extracts the entire consumer surplus by charging everyone their reservation prices, the highest price a consumer is willing to pay for a product. For each individual consumer, the firm would charge a different price for each additional unit the consumer purchases, since the firm knows the exact demand curve of that specific person. However, it is almost impossible for firms to practice perfect price discrimination in the real world for several reasons. First, it is impossible for firms to acquire perfect demand information about their consumers. The monopoly would have to hire marketing firms to carry out extensive consumer research. Even then, the marketing companies would have a hard time finding out the exact reservation prices, because the consumers have an incentive to lie about their demand. Second, first degree price discrimination would incur huge administrative cost on the firm to process and maintain the large amount of information they possess. Third, arbitrage between consumers can largely undermine the effectiveness of price discrimination. It is difficult for firms to prevent a lower demand consumer from selling products to higher demand consumer at a lower price.

First degree price discrimination is market efficient because all the consumer surplus is transferred to the producer. No dead weight loss is incurred in the process. However, the welfare redistribution from consumers to producers is not well received by the society because of the unfair treatment to the consumers. Some economists suggest government intervention to counter the redistribution even when the market is performing...