AP® Microeconomics review sheet from Aim for Five (aimforfive.com/micro/units/4/4-3)
Unit 4 · Topic 4.3
4.3 Price Discrimination
Price discrimination is charging different buyers different prices for the same product when the price difference isn't due to a cost difference. It lets a firm turn consumer surplus into profit. A perfectly price-discriminating firm produces the efficient quantity, but buyers keep none of the surplus.
Key terms
- price discrimination
- perfect price discrimination
- willingness to pay
- consumer surplus
- producer surplus
- allocative efficiency
What price discrimination is
Movie theaters charge less for students and seniors. Airlines charge more for a ticket bought the day before than one bought months ahead. The seat or the movie costs the same to provide, but buyers pay different prices. That's price discrimination.
It works because buyers differ in willingness to pay (the most a buyer would pay for something). If a firm charges one price, buyers who'd have paid more keep the difference as consumer surplus. Charging each group closer to its willingness to pay lets the firm capture some of that surplus as profit.
The three conditions
If any condition fails, the plan falls apart. Without the third, low-price buyers would simply resell to everyone else.
- Market power: the firm faces a downward-sloping demand curve. A price taker can't charge anyone more than the market price.
- Telling buyers apart: the firm can identify groups with different willingness to pay, for example by age, by how early they book, or by where they live.
- No resale: buyers who get the low price can't resell to buyers charged the high price. That's why discounts often need a student ID, and why tickets are tied to a name.
Perfect price discrimination
The extreme case is perfect price discrimination: the firm charges every single buyer exactly their maximum willingness to pay. Real firms can't do this perfectly, but it's the model you need for the exam.
Since the firm doesn't have to cut the price on earlier units to sell one more, each extra unit adds its full price to revenue. So the firm's marginal revenue curve is the same as its demand curve.
The firm still produces where MR = MC, which is now where demand meets MC. That's the allocatively efficient quantity, the same quantity a competitive market would produce. So there's no deadweight loss.
But every buyer pays exactly what the product is worth to them, so consumer surplus is zero. All of the surplus (the whole triangle between demand and MC) goes to the firm as producer surplus.
Describing the graph
Price on the vertical axis, quantity on the horizontal. Draw a downward-sloping demand curve and label it 'D = MR'. Draw MC. The firm produces where D = MR crosses MC. There is no single price; each unit sells at the height of the demand curve above it.
Producer surplus is the whole area between demand and MC, from zero to that quantity. Consumer surplus and deadweight loss are both zero.
Compare with a single-price monopoly (4.2): the single-price monopolist makes less, leaves buyers some consumer surplus, and creates deadweight loss. Perfect price discrimination raises output and total surplus, but shifts surplus from buyers to the firm.
Worked examples
Try each one yourself first, then open the solution.
- Example 1
Single price versus perfect price discrimination
Five buyers each want one concert poster. Their willingness to pay is $50, $40, $30, $20 and $10. Each poster costs the seller $15 to make (constant MC, no fixed cost). (a) If the seller charges one price, which price maximizes profit, and what are profit and consumer surplus? (b) If the seller can perfectly price discriminate, what are profit, consumer surplus and deadweight loss?
Show the solutionHide the solution
- Step 1: (a) Try each possible single price. At $50, 1 sells: profit (50 − 15) × 1 = $35. At $40, 2 sell: (40 − 15) × 2 = $50. At $30, 3 sell: (30 − 15) × 3 = $45. At $20, 4 sell: (20 − 15) × 4 = $20. At $10 the seller loses money on each poster.
- Step 2: The best single price is $40: 2 posters, $50 profit. The $50 buyer pays $40, so consumer surplus is $10.
- Step 3: The $30 and $20 buyers each value a poster above its $15 cost but don't buy. That's lost surplus: (30 − 15) + (20 − 15) = $20 of deadweight loss.
- Step 4: (b) With perfect price discrimination, the seller charges each buyer their full willingness to pay and sells to everyone whose value is at least $15: the first four buyers. The $10 buyer isn't served, since $10 < $15.
- Step 5: Profit = (50 − 15) + (40 − 15) + (30 − 15) + (20 − 15) = 35 + 25 + 15 + 5 = $80. Consumer surplus = $0. Deadweight loss = $0, because every poster worth more than its cost gets made.
Answer: (a) $40 each, 2 posters, profit $50, consumer surplus $10 (and $20 of deadweight loss). (b) 4 posters, profit $80, consumer surplus $0, deadweight loss $0.
- Example 2
Is price discrimination efficient? (classic trap)
A student writes: 'Perfect price discrimination is the worst outcome for society, because the firm takes all the surplus, so deadweight loss must be at its largest.' Explain what's wrong.
Show the solutionHide the solution
- Step 1: Deadweight loss is surplus that nobody gets, because trades worth making don't happen. It's about the size of total surplus, not who gets it.
- Step 2: A perfect price discriminator produces until the last buyer's willingness to pay equals marginal cost, the same quantity as a competitive market. Every trade worth making happens, so total surplus is as large as possible and deadweight loss is zero.
- Step 3: What changes is the split: consumer surplus is zero and producer surplus is all of total surplus. That's a question of fairness (equity), not efficiency.
Answer: The student mixes up efficiency and distribution. Perfect price discrimination is allocatively efficient with zero deadweight loss; it just gives all the surplus to the firm.
Common mistakes
- Calling any price difference price discrimination. If a price difference reflects a real cost difference, like higher shipping cost to a far-away buyer, it isn't price discrimination.
- Drawing MR below demand for a perfect price discriminator. For perfect price discrimination, MR is the demand curve.
- Saying price discrimination always hurts efficiency. Perfect price discrimination removes deadweight loss; it's consumers who lose surplus.
- Forgetting the no-resale condition when listing what a firm needs to price discriminate.
On the exam
- Questions often ask what happens to consumer surplus, producer surplus, output and deadweight loss when a single-price monopolist becomes a perfect price discriminator. Output rises to where demand meets MC, consumer surplus falls to zero, producer surplus rises, and deadweight loss disappears.
- Be ready to list or identify the conditions a firm needs to price discriminate.
Connected topics
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Check yourself
5 questions on 4.3 Price Discrimination. Pick an answer to see if you got it, and why.
A monopolist faces a straight-line demand curve that starts at a price of $100 and reaches a quantity of 100 units at a price of $0. Price in dollars is on the vertical axis and quantity is on the horizontal axis. The firm's marginal cost and average total cost are both constant at $20 per unit.
Case 1: The firm charges every buyer the same price. Its marginal revenue curve starts at $100 and reaches zero at 50 units.
Case 2: The firm can perfectly price discriminate, charging each buyer the most that buyer is willing to pay.
Hypothetical market described in words
In Case 1, what quantity and price maximize the firm's profit?
In Case 2, how many units does the firm produce?
How does consumer surplus change when the firm moves from Case 1 to Case 2?
What is the deadweight loss in each case?
By how much is the firm's profit higher in Case 2 than in Case 1?
0 of 5 answered