402 PART • Market Structure and Competitive Strategy Pmax Consumer surplus when a single price P* is charged Variable profit when a single price P* is charged F IGURE 11.2 $/Q ADDITIONAL PROFIT FROM PERFECT FIRST-DEGREE PRICE DISCRIMINATION Additional profit from perfect price discrimination P* Because the firm charges each consumer her reservation price, it is profitable to expand output to Q** When only a single price, P*, is charged, the firm’s variable profit is the area between the marginal revenue and marginal cost curves With perfect price discrimination, this profit expands to the area between the demand curve and the marginal cost curve MC Pc D ϭ AR MR Q* Q** Quantity PERFECT PRICE DISCRIMINATION What happens if the firm can perfectly price discriminate? Because each consumer is charged exactly what he or she is willing to pay, the marginal revenue curve is no longer relevant to the firm’s output decision Instead, the incremental revenue earned from each additional unit sold is simply the price paid for that unit; it is therefore given by the demand curve Since price discrimination does not affect the firm’s cost structure, the cost of each additional unit is again given by the firm’s marginal cost curve Therefore, the additional profit from producing and selling an incremental unit is now the difference between demand and marginal cost As long as demand exceeds marginal cost, the firm can increase its profit by expanding production It will so until it produces a total output Q** At Q**, demand is equal to marginal cost, and producing any more reduces profit Variable profit is now given by the area between the demand and marginal cost curves.3 Observe from Figure 11.2 how the firm’s profit has increased (The additional profit resulting from price discrimination is shown by the purple-shaded area.) Note also that because every customer is being charged the maximum amount that he or she is willing to pay, all consumer surplus has been captured by the firm IMPERFECT PRICE DISCRIMINATION In practice, perfect first-degree price discrimination is almost never possible First, it is usually impractical to charge each and every customer a different price (unless there are only a few customers) Second, a firm usually does not know the reservation price of each customer Even if it could ask how much each customer would be willing to pay, Incremental profit is again ⌬p = ⌬R - ⌬C, but ⌬R is given by the price to each customer (i.e., the average revenue curve), so ⌬p = AR - MC Variable profit is the sum of these ⌬ps and is given by the area between the AR and MC curves