9.

1 Introduction of price discrimination

Price discrimination or price differentiation exists when sales of identical goods or

services are
transacted at different prices from the same provider. In a theoretical market with
perfect information,
perfect substitutes, and no transaction costs or prohibition on secondary exchange (or
re-selling) to
prevent arbitrage, price discrimination can only be a feature of monopolistic and
oligopolistic markets,
where market power can be exercised. Otherwise, the moment the seller tries to sell the
same goods at
different prices, the buyer at the lower price can arbitrage by selling to the consumer
buying at the higher
price but with a small discount. However, product heterogeneity, market frictions or high
fixed costs
(which make marginal-cost pricing unsustainable in the long run) can allow for some
degree of differential
pricing to different consumers, even in fully competitive retail or industrial markets. Price
discrimination
also occurs when the same price is charged from customers which have different supply
costs.

Difference between price discrimination and product differentiation

Product differentiation differentiation of the product gives the supplier greater control
over price
and the potential to charge consumers a premium price because of actual or perceived
differences in the
quality / performance of goods or services.
Price discrimination occurs when a firm charges a different price from different groups
of
consumers for an identical good or service, for reasons not associated with costs.

9.2 Objectives of Price Discrimination

There are several objectives of price discrimination. Some are as given below.
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Firms will be able to increase revenue. This will enable some firms to stay in business
which
otherwise would have made a loss. For example price discrimination is important for
train
companies which offer different prices for peak and off peak.
Increased revenues can be used for research and development which benefit
consumers
Some consumers will benefit from lower fares. Eg. old people benefit from lower train
companies,
old people are more likely to be poor
The other objective to the consumer of price discrimination are - price discrimination is
likely to
increase output and make the good or service available to more people and the
increased
competition in the market leads to lower prices and more choice

9.4 Types of Price Discrimination

There are many forms of price discrimination, but the standard method of classification
identifies
three types or degrees of discrimination. But there are other two types also named as
skimming and
combination. Their common characteristic is that they allow the firm to capture part of
the consumer
surplus that would have resulted from uniform pricing.
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
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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 of the price elasticity
tends to rise above
one. One can show that in optimum price, as it varies from customer to cuustomer, is
inversely
proportional to one minus the reciprocal of the price elasticity of that 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 really
does or by threatening not to buy it.
An alternative way to understand first Degree 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
absolute maximum price that every consumer is willing to pay.

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 individual consumer and charges them the price they are willing and
are able to 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
transactions costs
involved in finding out through market research what each buyer is prepared to pay is
the main block or
barrier to a businesses engaged in this form of price discrimination.
If the monopolist is able to 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 9.1 shows the demand curve faced by a monopolist. The curve indicates the
maximum
price that can be obtained for successive units of output

Second degree price discrimination

In second degree price discrimination, price varies according to quantity sold. Larger
quantities are
available at a lower unit price. This is particularly widespread in sales to industrial
customers, where bulk
buyers enjoy higher discounts.
Additionally to second degree price discrimination, sellers are not able to differentiate
between
different types of consumers. Thus, the suppliers will provide incentives for the
consumers to differentiate
themselves according to preference. As above, quantity "discounts", or non-linear
pricing, is a means by
which suppliers use consumer preference to distinguish classes of consumers. This
allows the supplier to
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set different prices to the different groups and capture a larger portion of the total
market surplus.
Second degree price discrimination is an imperfect form of first-degree discrimination.
Instead of
setting different prices for each unit, it involves pricing based on the quantities of output
purchases by
individual consumers. This is illustrated by Diagram 9.2. For each buyer, the first Q1
unit purchased are
priced at P1, the next Q2 - Q1 units are priced at P2, and all additional units are priced
at P3
Peak and Off-Peak Pricing
Peak and off-peak pricing are common in the telecommunications industry, leisure
retailing and in
the travel sector. Telephone and electricity companies separate markets by time: There
are three rates for
telephone calls: a daytime peak rate, and an off peak evening rate and a cheaper
weekend rate. Electricity
suppliers also offer cheaper off-peak electricity during the night.
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At off-peak times, there is plenty of spare capacity and marginal costs of production are
low (the
supply curve is elastic) whereas at peak times when demand is high, we expect that
short run supply
becomes relatively inelastic as the supplier reaches capacity constraints. A combination
of higher demand
and rising costs forces up the profit maximising price.

Third degree price discrimination

In third degree price discrimination, price varies by attributes such as location or by
customer
segment, or in the most extreme case, by the individual customer's identity; where the
attribute in question
is used as a proxy for ability/willingness to pay.
Additionally to third degree price discrimination, the suppliers of a market where this
type of
discrimination is exhibited are capable of differentiating between consumer classes.
Examples of this
differentiation are student or senior discounts. For example, a student or a senior
consumer will have a
different willingness to pay than an average consumer, where the reservation price is
presumably lower
because of budget constraints. Thus, the supplier sets a lower price for that consumer
because the student
or senior has a more elastic price elasticity of demand (see the discussion of price
elasticity of demand as
it applies to revenues from the first degree price discrimination, above). The supplier is
once again capable
of capturing more market surplus than would be possible without price discrimination.
Price Skimming
In price skimming, price varies over time. Typically a company starts selling a new
product at a
relatively high price then gradually reduces the price as the low price elasticity segment
gets satiated. Price
skimming is closely related to the concept of yield management. Price skimming is a
pricing strategy in
which a marketer sets a relatively high price for a product or service at first, then lowers
the price over
time. It is a temporal version of price discrimination/yield management. It allows the firm
to recover its
sunk costs quickly before competition steps in and lowers the market price
9.5 International Price Discrimination: Dumping
In economics, "dumping" can refer to any kind of predatory pricing. However, the word
is now
generally used only in the context of international trade law, where dumping is defined
as the act of a
manufacturer in one country exporting a product to another country at a price which is
either below the
price it charges in its home market or is below its costs of production. The term has a
negative
connotation, but advocates of free markets see "dumping" as beneficial for consumers
and believe that
protectionism to prevent it would have net negative consequences.

9.6 Disadvantages of Price Discrimination

1. Some consumers will end up paying higher prices. These higher prices are likely to
be allocatively
inefficient because P>MC.
2. Decline in consumer surplus.
3. Those who pay higher prices may not be the poorest.
4. There may be administration costs in separating the markets.
5. Profits from price discrimination could be used to finance predatory pricing.