Model Answer
0 min readIntroduction
A monopolist, unlike firms in competitive markets, possesses the power to influence prices. However, even a monopolist’s pricing power isn’t absolute. A crucial determinant of its pricing strategy, particularly when engaging in price discrimination, is the price elasticity of demand. Price discrimination refers to the practice of selling the same product to different customers at different prices, based on their willingness to pay. Understanding how a discriminating monopolist leverages elasticity information is key to maximizing profits. This answer will examine the role of price elasticity of demand in determining the price set by a discriminating monopolist.
Understanding Price Elasticity of Demand
Price elasticity of demand (PED) measures the responsiveness of quantity demanded to a change in price. It is calculated as: PED = (% change in quantity demanded) / (% change in price). Demand is considered:
- Elastic (PED > 1): Quantity demanded changes significantly with price changes.
- Inelastic (PED < 1): Quantity demanded changes little with price changes.
- Unit Elastic (PED = 1): Quantity demanded changes proportionally with price changes.
Price Discrimination and Market Segmentation
A discriminating monopolist identifies different groups of consumers with varying price elasticities of demand. This is possible when the monopolist can prevent resale between these groups – a key condition for successful price discrimination. Common market segments include geographic locations, age groups, or different uses for the product.
Pricing Strategy Based on Elasticity
The discriminating monopolist aims to maximize profits by charging different prices to each segment. The core principle is:
- More Elastic Demand: Lower prices are charged to segments with more elastic demand. This is because a small price increase would lead to a large decrease in quantity demanded, reducing total revenue.
- Less Elastic Demand: Higher prices are charged to segments with less elastic demand. Here, a price increase results in a smaller decrease in quantity demanded, increasing total revenue.
The monopolist will continue to adjust prices in each segment until marginal revenue (MR) equals marginal cost (MC) in each market. This ensures profit maximization across all segments.
Mathematical Representation
Profit maximization requires MR = MC in each segment. Since MR is related to PED, the monopolist implicitly considers PED when setting prices. For example, if a segment has a PED of -2, the MR curve will be steeper than if the PED is -0.5. The monopolist will set a lower price and higher quantity in the segment with PED = -2 to maximize profits.
Examples of Price Discrimination
- Airline Tickets: Airlines charge different prices for the same seat based on booking time, flexibility, and passenger type (e.g., business vs. economy). Passengers booking in advance (more inelastic demand) often pay higher prices.
- Movie Theaters: Matinee showings (lower demand, more price sensitive) are often cheaper than evening showings.
- Pharmaceuticals: Drug companies may charge different prices in different countries based on income levels and healthcare systems.
Third-Degree Price Discrimination
This is the most common type, where the monopolist charges different prices to different groups. For instance, a university might charge higher tuition fees to international students (less elastic demand due to limited alternatives) than to domestic students.
| Market Segment | Price Elasticity of Demand | Price Charged | Quantity Sold |
|---|---|---|---|
| Students | -1.5 (Elastic) | ₹500 | 1000 |
| Professionals | -0.8 (Inelastic) | ₹800 | 700 |
Conclusion
In conclusion, price elasticity of demand is fundamental to the pricing decisions of a discriminating monopolist. By identifying and segmenting markets based on varying elasticities, the monopolist can extract maximum consumer surplus and maximize profits. The ability to prevent resale is crucial for this strategy to succeed. However, price discrimination can raise concerns about fairness and equity, potentially leading to regulatory scrutiny. The effectiveness of this strategy depends on accurate assessment of elasticity and the ability to maintain market separation.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.