Deadweight Loss and Price Discrimination

Consumer Surplus
Consumer Surplus is the difference between what the consumer is

willing and able to pay and what he/she actually paid. Consumer
surplus will be more if person is ready to pay more as compared to
market price(market clearing price). It's a measure of the additional
benefit that consumers receive because they're paying less for something
than what they were willing to pay. Consumer surplus is derived from
the demand curve. Consumer surplus is the area above the market
clearing price and below the demand curve. For example, let's say that
you bought an airline ticket for a flight to Disney during school vacation
week for $100, but you were expecting and willing to pay $300 for one
ticket. The $200 represents your consumer surplus.
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Producer Surplus
The Producer surplus is defined as the difference between the amount the
producer is willing and able to supply the goods for and the actual amount
received by him. Producer surplus is a measure of producer welfare. It is
shown graphically as the area above the supply curve and below the
equilibrium price. As the price increases, the incentive for producing more
goods increases, thereby increasing the producer surplus.
PS= (Market clearing price- minimum price to sell)*quantity sold

Let’s assume that producer is producing N95 mask during 2020. The
manufacturing cost of the product is Rs. 150 per piece and so the producer is
willing to sell the product at Rs. 200. However, due to a sudden spike in the
demand for N95 mask, the market price is Rs. 240. Calculate the producer
surplus for the manufacturer if they sold 50,000 pieces during 2020.
PS=(240-200)*50,000=2,000000
Producer and consumer surplus
The Deadweight Loss
In a perfectly competitive market price is equal to marginal cost. But in a
monopoly price is not equal to marginal cost. Monopoly always charges
higher price compared to cost of production. Because of monopoly power,
monopoly charges higher price and produces lower quantity of goods and
the consumers are worse off as they are paying more. Because of monopoly,
society as a whole is worse off.
Because a monopoly sets its price above marginal cost, it places a wedge
between the consumer’s willingness to pay and the producer’s cost.
This wedge causes the quantity sold to fall short of the social optimum.
The Inefficiency of Monopoly...

Price A
Deadweight Marginal cost
loss
Monopoly L M
Price(Rs60)
X Y
PCM Price C
Z
( Rs. 50) B
N
Marginal
revenue Demand Curve or AR curve
D
0 Monopoly PCM Quantity

Quantity (5) Quantity(7)
The Deadweight Loss
Let’s examine why dead weight loss occurs. Is it because of Monopoly or
perfectly competitive market. Let’s assume that the competitive market and
monopoly have the same cost curve. AR and MR shows the average and
Marginal revenue curve for monopoly. AR curve is known as demand
curve(Industry demand curve in PCM). In PCM demand curve is downward
slopping. MC curve is the Monopoly marginal cost curve which is upward
slopping . It is also treated as supply curve of industry for PCM(supply curve
of industry is upward slopping). To maximize profit, a monopoly produces at a
point where MR=MC so that monopoly price is Rs 60 and output is 5. Now
let’s compare how much output perfectly competitive firm produces. Perfectly
competitive market(Industry) will be in equilibrium where demand is equal to
supply. Here, AR curve is treated as demand curve and MC curve is treated as
supply curve for an industry in PCM. Both intersect with each other at point C
and perfectly competitive market price is Rs 50 and output is 7.
The Deadweight Loss Continues…
Consumer surplus is the area below the demand curve and above the market
clearing price. In case of perfectly competitive market the consumer surplus area
is ABC. Producer surplus is the area above the supply curve and below the
market clearing price. Here, producer surplus area is BCD in PCM. You know
monopoly charges more price than the cost of production. Due to higher price
charged by monopoly, consumer will pay more and consumer surplus will come
down. Now, area of consumer surplus is ALM in Monopoly. Consumer surplus
has comedown because of higher price charged by the monopoly. There is loss
of consumer surplus X+Y. In a perfectly competitive market, producer surplus
was BCD. Because of higher price by monopoly the producer surplus has
changed(increased) to LMND. The gain of producer surplus is X-Z. The loss of
consumer surplus is X+Y Hence, the dead weight loss is the area Y+Z. Dead
weight loss the loss to the society. That loss arise because of producer and
consumer loss. TR in perfectly competitive market is 60*5= 300 in monopoly.
TR in PCM is 50 *7 =350. 350-300=50 is loss for the society.
Public Policy Toward Monopolies
Government responds to the problem

of monopoly in one of three ways.
 Making monopolized industries more
competitive.
 Regulating the behavior of monopolies.
 Turning some private monopolies into
public enterprises.
Price Discrimination
 What is Price Discrimination?
Price discrimination refers to the practice of selling
the same good at different prices to different buyers.
Types
 Personal: Air Travel and Movie Tickets
 Locality: Home vs. abroad
 Usability Example: Electric Charges
 Note: If price differences is based on cost
differences in supplying a product or services is not
treated as price discrimination.
 The price discrimination is said to be exist, if price
differences are not based on cost differences
Degrees of Price Discrimination
First degree price discrimination

 The seller charges maximum possible price for each unit of output
from the buyer. No Consumer Surplus.
 Requires complete knowledge of the market demand curve and
the willingness of individual consumers to pay
 Not a common form of discrimination.
 The first degree price discrimination is criticized in real world

because the firms needs to have precise knowledge of each
individual consumers demand curve and charge the highest
possible price for each separate units of the product sold.
Second Degree of price discrimination
 Instead of setting price for each buyer as in the 1st degree price
discrimination, the second degree price discrimination occurs
when a firm/company charges a different prices for different
quantities consumed, such as quantity discount on bulk
purchases. It involves setting prices subject to the amount
brought, in an attempt to capture part of the consumer surplus.
 By doing so, the firm will extract part, but not all consumer
surplus. The firm exercises second degree price discrimination
to get rid of excess inventories/stocks when demand is low.
Third degree of price discrimination

Most common form of discrimination
Divides markets into different sub markets and charges a
different price in each sub market.
Different prices according to respective price elasticity of
demand
Third degree Price Discrimination examples
 Electricity companies charges lower price to residential user than

the commercial user
 Companies charges lower price in abroad than home
 Entertainment companies chares lower price in afternoon than in
evening
 Service industries charges lower prices for children and older
people
 Airlines charges different prices for Economy and Business class
travel
 Milk man charges more money to residential user compared to
sweet shops
 Hospitals charges different amount money for the same disease to
different persons
Conditions for third degree
 Effect segregation: No reselling can take place from a low

price market to a high price market
 Different sub markets must have different elasticities.
Equilibrium condition for Third Degree:
Equilibrium of Discriminating monopolist
The First Problem

How much to produce?
 Solution: Aggregate MC = Aggregate MR
The Second Problem

How to share the produced output between
two sub markets
 Solution: MRA = MRB

Let’s assume that average total cost(ATC) in total market is Rs. 3 at the best
level of output. Then profit is (5-3)=Rs. 2 per unit and total profit is 2*90=Rs.
180.
While exercising price discrimination let’s see how much profit monopoly will
earn. In market 1, the price is Rs. 7 and ATC is Rs. 3. Then profit is 7-3=Rs. 4
per unit and total profit is 4*50=200.
Likewise in market 2 price is Rs. 4 and ATC is Rs. 3. Then Rs.1 is the profit
per unit and total profit is 1*40=40.
what is the total profits in market 1 and market 2 together. That is 200+40=Rs.
240. We can say, while exercising price discrimination the total profit is Rs.
240.
Let’s assume firm is not exercising price discrimination then what is the total
profit. Price is Rs. 5 and ATC is Rs. 3. Then profit is Rs. 2 per unit and total
profit is 2*90=180.
Rs. 240 total profit is better than Rs.180 total profit. Hence, we can say that
monopoly should exercise price discrimination. By exercising price
discrimination monopoly total revenue and profit will be more
Thank You

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Deadweight Loss and Price Discrimination

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Consumer Surplus

Consumer Surplus is the difference between what the consumer is

PS= (Market clearing price- minimum price to sell)*quantity sold

The Inefficiency of Monopoly...

0 Monopoly PCM Quantity

Government responds to the problem

 Locality: Home vs. abroad

 Usability Example: Electric Charges

First degree price discrimination

 The first degree price discrimination is criticized in real world

Third degree of price discrimination

 Electricity companies charges lower price to residential user than

 Effect segregation: No reselling can take place from a low

 Different sub markets must have different elasticities.

The First Problem

The Second Problem

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