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Price Discrimination

When you were young, did you ever order from the children's menu in a restaurant? When a family with small children goes to a restaurant, they are often given a children's menu in addition to the regular menu. If they order two similar items, one from each menu, they will find that the item ordered from the children's menu will be a bit smaller, but its price will be much smaller. In fact, it would often be worthwhile for the entire family to order from the children's menu, but they cannot. Restaurants usually only allow children to order from it.1

Why do restaurants use children's menus? Economists doubt that restaurant owners have a special love for children; they suspect that the owners find offering children's menus to be profitable. It can be profitable if adults who come to restaurants with children are, on the average, more sensitive to prices on menus than adults who come to restaurants without children. Children often do not appreciate restaurant food and service, and often waste a large part of their food. Parents know this and do not want to pay a lot for their child's meal. If restaurants treat children like adults, the restaurants may lose customers as families switch to fast-food restaurants. If this explanation is correct, then restaurants price discriminate.2

A seller price discriminates when it charges different prices to different buyers. The ideal form of price discrimination, from the seller's point of view, is to charge each buyer the maximum that the buyer is willing to pay. If the seller in our monopoly example could do this, it could charge the first buyer $7.01, the second buyer $6.51, etc. In this case the marginal revenue curve becomes identical with the demand curve. The seller will sell the economically efficient amount, it would capture the entire consumers' surplus, and it would substantially increase profits.

The Simple Analytics of Monopoly-Repeated
Marginal Cost
Marginal Benefit
to Buyers
Marginal Benefit
to Sellers

Every seller would price discriminate if there were not two major obstacles standing in the way. First, the seller must be able to distinguish between those buyers who are willing to pay a high price from those who are not. Second, there must be substantial difficulty for a low-price buyer to resell to those willing to buy at a high price.3

Because price discrimination is potentially profitable, businesses have found many ways to do it. Theaters often charge younger customers less than adults. Doctors sometimes charge the rich or insured patient more for services than they charge the poor or uninsured. Grocery stores have a lower price for people who bother to check the newspaper and clip coupons. Some companies, such as firms selling alcoholic beverages, produce similar products but try to promote one as a prestige brand with a much higher price. Electric utilities usually charge lower rates to people who use a lot of electricity (and thus probably have electric stoves and water heaters) than they do to those who use only a little electricity (and who probably have gas stoves and water heaters). Banks offer special interest rates on Certificates of Deposit (CDs) that will not be obtained when one lets a CD roll over. People who are more sensitive to interest rates will take the time and effort to personally renew each maturing CD.

To the extent that businesses find ways to price discriminate, they eliminate the triangle of welfare loss and approach the economically efficient amount of production. Thus, the mere existence of monopoly does not prove there is economic inefficiency.

Next we look at antitrust policy, one government policy towards monopoly.

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1 The author has met a person who at one time regularly requested and ordered from the children's menu in a restaurant because she knew it was a bargain. One day, the restaurant told her she could no longer do that. Her solution was to order carry out from the children's menu, which for some reason the restaurant allowed.

2 The word "discrimination" has come to have a very negative connotation that it did not have when the term "price discrimination" came into use. At one time it was a compliment to say that someone had "discriminating tastes." To discriminate is to make choices based on some characteristics or attributes of the situation. Our society has decided that some forms of discrimination or making decisions, such as those based on race, are improper, and the word "discrimination" has taken on a much narrower meaning than it had early in the century.

3 A third obstacle standing in the way in the United States has been legal. Several laws restrict the ways in which businesses can price discriminate. Although the stated purpose of these laws is to preserve competition, the sponsors clearly wanted to prevent competition from eliminating small sellers with high costs. A fourth obstacle is public opinion. Many people do not accept a change in demand as a legitimate reason to change price. For them only a change in costs justifies a change in price. As a result of public opinion, firms disguise price discrimination. The children's menu case mentioned at the start is an example of disguised price discrimination.

Copyright Robert Schenk