The concept of consumer surplus is a very useful one.
It will help us answer questions such as: is price discrimination a good thing for consumers or not? So let’s get to it. Simply put, consumer surplus is the consumer’s gain from an exchange.
For an individual consumer, it is the difference between the maximum price that the consumer is willing to pay for a given quantity and the market price he pays. If we go back to the demand curve for beer, we can see that at a price of €2, many consumers would be willing to buy a glass of beer. For some consumers, it is the maximum price they are willing to pay, whereas others would be ready to pay more. Some would be ready to pay up to €5.
For one of those consumers, the consumer welfare is €3, that is, the difference between the maximum price he is willing to pay, €5, and the price he actually paid, €2. The consumer welfare is money that he keeps in his pocket.
We can represent this consumer’s surplus by a blue line: the person here values the glass of beer at €5, and is only paying €2, so his surplus is €3.
Now we can do the same for other persons, like this one, who values the glass at €3, and therefore has a surplus of €1.
If we add up all the individual consumers’ surpluses, that is, for all consumers and over all units, we see that the total consumer surplus is the area above the price paid and below the demand curve. We are simply adding up all individual surpluses over all units of the good. This represents the money that is left in people’s pockets and not spent in buying the good. So, this neat blue triangle is called total consumer
surplus: it is the sum of consumer surpluses across all buyers. Good! So now we know how economists measure consumer welfare – by the consumer surplus.
With this knowledge we are ready to look into the effect of price discrimination on consumer welfare.
Before looking at the curves, let’s start with a rule of thumb:
It goes like this: if by price discriminating the producer increases the quantity produced – that’s what economists call the ‘output’ – then it is likely beneficial to the consumers as a whole. On the other hand, if the producer does not increase output, then it will reduce consumer surplus. To illustrate this, consider the sales of a new Harry Potter book on the European market, at a given price. If the publisher tries to sell it for the same price on the Indian market, it is likely that it will not sell as many, because people there have a much lower willingness to pay. So, by price discriminating and offering a lower price on the Indian market, the firm can increase its profit.
Nothing changes on the European market, but now Indian consumers have access to the book too. Output is increased, so is profit and so is the welfare of the new consumers. This works as long as there are no possibilities of reselling the good between markets. Resale between markets is called arbitrage and it may become a real problem to firms using price discrimination. It is usually easier to prevent arbitrage in services. When you fly, for example, only you can use the ticket you bought, since it bears your name. What happens when airlines price discriminate? They offer high prices mostly to the business travellers, and lower prices to the leisure travellers.
By increasing their customer base, they provide more flights to more places and they increase their output.
So, price discrimination here has two favourable impacts: it enables price sensitive travellers to fly, and allows business travellers to benefit from a larger choice of destinations and schedules. In a way it is beneficial even for the travellers who pay the higher prices.
Now let’s use some graphs to look at what is going on: in the first graph, there is no price discrimination but a uniform price instead, and the surplus is the blue triangle we have seen before.
Now imagine that the company price discriminates without
changing its output: the new consumer surplus, represented by the two red triangles, is clearly smaller. We say that the company is extracting the surplus from the consumers. It has a negative impact on them.
Let’s go back to the uniform pricing. Now, if the company sets a higher price and a lower price, and increases its production, we have another surplus. This surplus can be higher or lower than the first one, depending on the increase in production and on the level and number of prices. If the company is very smart, and can come close to knowing the maximum willingness to pay of its customers, then it will extract most of the surplus of the consumers.
So in a way, the increase or reduction of the consumer surplus depends on the ability of the company to discriminate among its customers in an efficient way. Note that the consumer surplus can drop to zero in the case of a perfect discrimination, where everybody would pay their maximum price, but it cannot be negative, since nobody is forcing anyone to consume the product.
To sum up: the effect of price discrimination on consumer welfare depends both on the prices and on the increase in the quantity produced and offered on the market. It will often enable new consumers to benefit from the good or service. By increasing the quantity produced, it may even be beneficial to all consumers, like in the airline case, where price discrimination has led to more scheduled flights to more destinations, at prices affordable for everyone.