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Profitability of Price Discrimination

Here, we understand when is price discrimination profitable in detailed.

Profitability of Price Discrimination
Before we start discussing about Profitability of Price Discrimination, first we understand the meaning of Price Discrimination that is
'Price Discrimination occurs when a monopolist charges different prices for different units of a commodity even though these units are in fact homogenous so far as their physical nature is concerned.'
Now we will discuss about Profitability of Price Discrimination in detailed-
Profitability of Price Discrimination:
The circumstances may all be favourable to a monopolist, that is, price discrimination may be possible and yet it would not be pursued, if it does not add to profits of the monopolist's firm.
For the price discrimination to be profitable, following two conditions must be fulfilled:
  1. Elasticity of demand for the product at a single price should be different in different markets.
  2. The cost of keeping markets separate should not be high relative to price differential.
  • Let us understand the first condition of profitability. As noted that when demand curve for a product is downward sloping marginal revenue is less than price. The difference between price and marginal revenue depends on the value of price elasticity of demand. The higher the price elasticity of demand, the smaller will be the difference between price and marginal revenue. When demand for a product is highly elastic, price would have to be reduced by a small amount to expand sale by one unit. Here, hence it is possible to find out marginal revenue on the basis of following formula, if price and the value of price elasticity of demand are given.
MR = P [e-1/e]
Where,
MR = Marginal revenue
P = Price
e = Price elasticity of demand.
With the help of this formula, it can be proved that when price elasticity of demand for a monopolist's product is same at a single price in different markets, price discrimination will not be profitable.
Suppose there are two markets A and B for monopolist's product and price elasticity of demand is 2 in both markets. If price of the product is Rs. 10 in both markets, marginal revenues will be Rs. 5 in both markets.
[10 x 2-1/2 = 5]
If monopolist transfers a unit of the product from market A to market B or from market B to market A, to charge different prices in them, the aggregate revenue from the two markets will remain same as before. Profit will not increase. If he transfers a unit of product from market A to market B, his revenue will decrease by Rs. 5 in market A and it will increase by Rs. 5 in market B. Here, the gain realized in market B is fully wiped out by loss in market A. The monopolist will not resort to price discrimination.
If price elasticity of demand for the product in two markets at a single price is different, it would be profitable to adopt price discrimination. When price elasticity of demand for a product differs in two markets at a given price, marginal revenue will be low in market where demand for the product is less elastic and it is high in the market where demand for the product is more elastic. Let us take eg- Suppose price is Rs. 10 per unit, price elasticity of demand is 2 in market A and 4 in market B. Hence, marginal revenue will be Rs. 5 in market A and Rs. 7.5 in market B.
In market A : MR = P [e-1/e] = 10 [2-1/2] = 5
In market B : MR = P [e-1/e] = 10 [4-1/4] = 7.5
It clearly indicates that, if a unit of product is transferred from market A to market B, aggregate total revenue of the monopolist will increase. His revenue will decrease by Rs. 5 in market A but it will increase by Rs. 7.5 in market B. Hence his aggregate total revenue will increase by 2.5 (Rs. 7.5 - Rs. 5).
Here, demand curve for the product is downward sloping in both markets. Therefore, price will have to be reduced to sell more in market B, while price will go up due to the contraction of supply in market A. It follows that price discrimination is profitable when, at the single price, the price elasticity of demand for the monopolist's product is different in different markets.
  • Now will discuss second condition, the cost of keeping different markets separate should not be too high relative to price differential.
For eg-
If the owner of a theatre has to spend a large amount of money in keeping various classes separate to provide better facilities to upper class cinegoers, maintenance of doorkeepers for different classes etc. then price discrimination may be possible but it will not pay him.
Meaning of Price Discrimination
Profitability of Price Discrimination
Elasticity of demand for product at a single should be different in different markets
The cost of keeping markets separate should not be high relative to price differential
Price Discrimination - Profitability of Price Discrimination.
Kinnari
Tech writer at NewsandStory
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