First-Degree Price Discrimination and Reservation Prices

First-Degree Price Discrimination Explained

We call the customer's reservation price the maximum price they are willing to pay for a good or service. First-degree price discrimination is the practice of charging each individual customer their exact reservation price.

Analyzing Profit with Graph 1

As the company charges each consumer their reservation price, it is profitable to increase production up to Q*. If the company only charges a single price, P*, the company's variable profits are represented by the area between the marginal revenue curve and the marginal cost curve.

With perfect price discrimination, these profits increase to the entire area between the demand curve and the marginal cost curve.

Calculating Single-Price Profits

First, we need to know how the company profits when it only charges a single price, P*, in this graph. To find out, we can add the profit generated by each additional unit produced up to the total quantity sold, Q*. This profit is the marginal revenue minus the marginal cost of each unit.

If we sum the profits generated by each additional unit produced, we get the variable profit of the company. In Graph 1, this variable profit is represented by the shaded area between the marginal revenue curve and the marginal cost curve. The consumer surplus is represented by the triangle above it.

The Impact on Cost Structure

Since price discrimination does not affect the cost structure of the enterprise, the cost of each additional unit is still given by the company's marginal cost curve. Therefore, the additional profit generated by producing and selling an additional unit is now the difference between the demand curve and the marginal cost.

Limitations in Real-World Practice

In practice, perfect first-degree price discrimination is rarely possible due to two main factors:

• First, it is usually impractical to charge every customer a different price.
• Second, the company normally does not know the reservation price of each customer.

Imperfect Price Discrimination

However, sometimes companies can discriminate imperfectly by charging a few different prices based on estimates of different reservation prices. This is a practice often used by medical professionals and lawyers. In these cases, it is possible to evaluate the customer's willingness to pay and set fees in agreement with that assessment.