Electric utillities often practice second-degree price discrimination. Explain and show diagrammatically why the practice might improve consumer welfare.
Second-degree price discrimination refers to a pricing strategy in which a company charges different prices based on the quantity consumed or purchased by individual consumers. In the case of electric utilities, they may offer tiered pricing plans, where the price per unit of electricity decreases as the quantity consumed increases.
To understand why this practice might improve consumer welfare, let's consider the concept of consumer surplus. Consumer surplus refers to the difference between the maximum price a consumer is willing to pay for a product and the actual price they pay. It represents the benefit or value that consumers receive above and beyond what they had to pay.
By implementing second-degree price discrimination in the form of tiered pricing plans, electric utilities can optimize consumer welfare by capturing more of the consumer surplus. Here's how it works:
1. Different consumption levels: With tiered pricing, consumers who use larger quantities of electricity will fall into higher consumption tiers, where the price per unit is lower. This allows those who consume more energy to benefit from lower prices, as they are charged a lower average price for their overall consumption.
2. Fairness: By linking prices to consumption tiers, the price discrimination becomes more transparent and fairer. Consumers who use more electricity pay a higher total bill, reflecting the higher costs their consumption imposes on the electric utility.
3. Incentives for conservation: Tiered pricing plans can also incentivize consumers to reduce their electricity consumption. When consumers have the opportunity to save money through lower-tier pricing, they are motivated to become more energy-efficient, leading to reduced overall electricity consumption. This conservation helps to alleviate strain on the electric grid and reduce the environmental impact of energy production.
Now, let's consider a graphical representation to illustrate the potential consumer welfare improvement from second-degree price discrimination:
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Price | /
($) | /
| /
|/________________
| Tiered Pricing
|_________________
Quantity of Electricity Consumed
In the diagram above, the price (in dollars) is shown on the vertical axis, while the quantity of electricity consumed is shown on the horizontal axis. The line represents the tiered pricing structure. As the quantity of electricity consumed increases, the price per unit decreases due to the lower tier pricing.
The shaded area below the tiered pricing line and above the market price (which considers average cost) represents the increased consumer surplus resulting from tiered pricing. This additional consumer surplus indicates that consumers are benefiting from lower prices and increased access to electricity as consumption increases.
In conclusion, second-degree price discrimination, such as tiered pricing plans used by electric utilities, can improve consumer welfare by allowing consumers to benefit from lower prices, promoting fairness, and encouraging energy conservation.