Question

Compare the welfare implications of perfect competition and a monopoly with first degree price discrimination.

Answer 1

The practice of charging each customer his or her reservation price is called perfect first degree price discrimination.

Under Perfect Competition, the price is set where the marginal cost equals average revenue.

According to the above graph, equilibrium occurs at B, with equilibrium price Pc and equilibrium output quantity Q*. When charging Pc, the consumer surplus adds up to the area under the triangle CBPc and producer surplus equal to area PcBA.

However, in case of first degree price discrimination, firms charge an amount exactly equal to their willingness to pay. Since every buyer pay equal to their willingness, no surplus is left for them. Rather the entire surplus goes to the producer. The producer surplus in this case is the area under the triangle CBA.

Hence, it can be concluded that the total surplus remains unchanged when compared between the perfect competition and a monopoly with first degree price discrimination. Therefore, no deadweight loss in this case (no welfare loss for the economy as a whole but producers benefit at the cost of decline in consumer welfare).

Note that here the monopolist does not produce the monopoly quantity which would occur at the intersection of MR and MC. It rather supplies the perfect competition level of output as perfect price discrimination is possible which would increase its total revenue.