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PRICE DISCRIMINATION AND CONDITIONS UNDER WHICH IT CAN BE SUCCESSFULLY PRACTISED

Updated on March 9, 2011

Price discrimination is the practice of charging different people more than one price for the same commodity sellers sell to different customers, for reasons not associated with cost. For example Doctors in private practice, solicitors and business consultants vary their fees sometimes according to the income of their clients. We can therefore say that when a producer or seller charges different customers different prices, that producer price discriminates. Many of the best examples of price discrimination apply to services which must be consumed on the spot rather than goods that can be resold.

Price discrimination in a standardized commodity is not likely to work. This is because the group buying at a lower price may resell to the group paying the higher price, thereby preventing the monopolist from charging some customers a higher price. Effective price discrimination is possible only when the different markets within which the monopolist sells can be separated from one another to prevent resale of the product from one group to another. Certain conditions are necessary if price discrimination should be successful. These conditions are discussed below.

CONDITIONS UNDER WHICH PRICE DISCRIMINATION CAN BE SUCCESSFULLY PRACTICED

1. There Must be Monopoly Power

For price discrimination to be possible and successful the producer must control the supply and distribution of the commodity. This is to ensure that the commodity cannot possibly be obtained elsewhere in the same market. If consumers can get the commodity elsewhere, the discrimination cannot be successful.

2. No possibility of resale

It should not be possible for those buying at lower prices to resell to those buying at higher price. If this were the case, those group of buyers at which the discrimination is targeted would get the commodity from those buying at lower prices. This condition is particularly applicable to those services which must be consumed on the spot rather than goods that can be resold. Example medical services provided by doctors in private practice.

3. There must be no leakage of information between the markets

For price discrimination to be successful, information must not be leaked to those buying at higher prices that others are buying the same commodity at lower prices. If this should be the case, the consumer paying a higher price would buy the commodity through those paying lower prices or he may refuse to buy the commodity altogether.

4. The markets must be separated

The markets need to be separated mainly, by differences in income. This would enable the monopolist to sell the same commodity at different prices to consumers in the different markets. Markets can be possibly separated even in the same area so long as differences in income exist. For example expensive doctors in private practice frequently charge lower prices to less well-off patients but charge reasonably high prices to the very rich whose demand for the best medical care is very inelastic. Market separation is important because it avoids the situation where the commodity would be bought in the market with low prices and resold into the market with high price. A producer who has a domestic and foreign market can practice price discrimination by selling at different prices in the two markets, separated by distance.

5. There must be different price elasticity of demand in the different markets.

A very important condition for successful price discrimination is that price elasticity of demand in the markets into which the monopolist sells must be different. If the demand in one market is elastic, the demand in the other market could be comparatively less or more elastic, and not necessarily that, when the demand in one market is elastic that of the other market must be inelastic.

THE CONNECTION BETWEEN MARGINAL REVENUE (MR) AND PRICE ELASTICITY OF DEMAND (e)

The relationship between marginal revenue (MR) and price elasticity of demand (e) is that MR = P (1 – 1/e ), where P is the product price. With this relation, if we have different markets with each market having different price elasticity of demand, the marginal revenues in each market will be different at any given price. The market in which the demand is relatively more elastic will have marginal revenue greater than the market with a relatively less elastic demand.

Assuming there are two markets, market i and market j with price elasticity of demand values being 4 and 8 respectively. Then MRi = P (1- 1/ei ) where ei is price elasticity of demand in market i. Therefore MRi = P (1 – ΒΌ ) = 3/4P and MRj = P (1 – 1/8 ) = 7/8P. That is marginal revenue in market i (MRi) with price elasticity of demand value of 4 is 3/4P. That of market j (MRj) with elasticity value of 8 is 7/8P. The discriminating monopolist will sell more into market j because the marginal revenue in that market is higher; but less in to market i because there is lower marginal revenue in this market. The monopolist is however faced with a market demand curve that slopes downwards from left to right. The monopolist can therefore sell more by reducing price. As the monopolist reduces price in order to sell more into market j the MR in market j falls. To sell less in market i calls for an increase in price, and therefore by selling less and less into market i its marginal revenue increases because price in market i increases. By selling more and more into market j and less into market i, a time comes when the marginal revenue in the two market become equal. When this happens, the monopolist is said to be in equilibrium.

The fact that the monopolist will be in equilibrium by having the same marginal revenues in the different markets does not mean that he would have the same price in the different markets. There will be differences in prices due to differences in the slope of the demand curve that is differences in price elasticity of demand.

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