Solution:

First-degree price discrimination:

• In first-degree price discrimination, price varies by customer's willingness or ability to pay. This arises from the fact that the value of goods is subjective. A customer with low price elasticity is less deterred by a higher price than a customer with high price elasticity of demand.

• As long as the price elasticity (in absolute value) for a customer is less than one, it is very advantageous to increase the price: the seller gets more money for fewer goods. With an increase in the price, elasticity tends to rise above one.

• One can show that optimum price, as it varies from customer to customer is inversely proportional to one minus the reciprocal of the price elasticity of that a customer at that price.

• This assumes that the consumer passively reacts to the price set by the seller and that the seller knows the demand curve of the customer. In practice, however, there is a bargaining situation,

• which is more complex: the customer may try to influence the price, such as by pretending to like the product less than he or she does or by threatening not to buy it.

• An alternative way to understand the first Degree of Price Discrimination is as follows:

• This type of price discrimination is primarily theoretical because it requires the seller of goods or services to know the the absolute maximum price that every consumer is willing to pay. As above, consumers indeed have different price elasticities, but the seller is not concerned with this.

• The seller is concerned with the maximum willingness to pay (or reservation price) of each customer. By knowing the reservation price, the seller can absorb the entire market surplus, thus taking all of the consumer's surplus from the consumer and transforming it into revenues.

• From a social welfare perspective though, first-degree price discrimination is not necessarily undesirable. That is, the market is still entirely efficient and there is no deadweight loss to society. In a market with first-degree price discrimination, the seller simply captures all surplus.

• Efficiency is unchanged but the wealth is transferred. This type of market does not exist much in reality, hence it is primarily theoretical.

• Examples of where this might be observed are in markets where consumers bid for tenders, though still, in this case, the practice of collusive tendering undermines efficiency. It is a classic part of price competition between firms seeking a market advantage or protecting an established market position.

Perfect Price Discrimination - charging whatever the market will bear:

• Sometimes known as optimal pricing, with perfect price discrimination, the firm separates the whole market into each consumer and charges them the price they are willing and can pay. If successful, the firm can extract all consumer surplus that lies beneath the demand curve and turn it into extra producer revenue (or producer surplus).

• This is impossible to achieve unless the firm knows every consumer's preferences and, as a result, is unlikely to occur in the real world. The transaction costs involved in finding out through market research what each buyer is prepared to pay are the main block or barrier to businesses engaged in this form of price discrimination.

• If the monopolist can perfectly segment the market, then the average revenue curve effectively becomes the marginal revenue curve for the firm. The monopolist will continue to see extra units as long as the extra revenue exceeds the marginal cost of production.

• The reality is that, although optimal pricing can and does take place in the real world, most suppliers and consumers prefer to work with price lists and price menus from which trade can take place rather than having to negotiate a price for each unit of a product bought and sold.

• Diagram shows the demand curve faced by a monopolist. The curve indicates the the maximum price that can be obtained for successive units of output.

• For example, the first unit Q1 could command a maximum price of P1, the second could be sold for a maximum of P2, and so on.

• To simplify the discussion, it is assumed that marginal cost is constant and equal to average cost. First-degree discrimination involves charging the maximum price possible for each unit of output. Thus, the consumer who attaches the greatest value to the product is identified and charged a price of P1.

• Similarly, the consumers are willing to pay P2 for the second unit and P3 for the third are identified and required to pay P2 and P3, respectively.

• With first-degree price discrimination, the profit-maximizing output rate is where the marginal cost and demand curves intersect. In Figure, it occurs at QD. At this point, the maximum price that can be obtained for the product is just equal to the marginal cost of production.

• Any attempt to sell more than QD units would reduce profits because the price would have to be less than the marginal cost. Conversely, any rate of output less than QD would not maximize profits because the additional units could be sold (as shown by the demand curve) at prices greater than the marginal cost.

• First-degree discrimination is the most extreme form of price discrimination and the most profitable pricing scheme for the firm. Because buyers are charged the maximum price for each unit of output, no consumer surplus remains.

• Consumer surplus is the difference between the price a consumer is willing to pay and the actual price charged for the good or service. The maximum consumer surplus results when there is no price discrimination and the price is set equal to marginal cost.

• In Fig, this maximum consumer surplus is shown as the area of the triangle APB. In contrast with first-degree price discrimination, there is no consumer surplus because APB is captured by the firm as economic profit.