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Frfce diseniminmtion

By the end of this chapter, you should be able to:

HL define and explain price discrimination
Ht- define, illustrate, give examples of, and distinguish between first
degree, second degree, and third degree price discrimination.

3.
1..{L Friee dlserimisxation
Pricc discrimination exists when a producer sells the exact same
product to different consumers at dillerent prices. For examplc, a
child's ticket to Ily lrom Vienna to Toronto may cost €500, while his
mother's ticket costs €700. The product, a seat on a plane, is exactly
thc same but the price is different.
In order for a producer to be able to price discriminate, three
conditions are necessary.
I The producer must have some price-setting ability, i.e. the marl<et
rrrust bc irnperfect. The more price-setting ability the producer has,
the easier iL is lor price discrimination to take place, which is why it
is most often found in monopoly and oligopoly rnarkets. Price
discrimination is not possible in pcrlcct compctition.
The consumers musL have different price elasticities of demand for
the product. If thcy do not, then they would not be prepared to
pay dilfcrent prices for the product. It lollows that a consumcr
with rclatively inelastic demand for a product will be prepared
to pay a hjgher price than a consumer with relatively claslic
demand, since elasticity tends to sis,ni[y the importance oi a
product to consumers.
The produccr must be able to separate the consumers, so that they
are not ablc to buy the product and then sell it to another
consumer. If this were not the case, then re consumers who buy
the product at a low price would simply sell to those who were
paying the higher price, at a price below that one. This would
destroy the ability of the producer to practise price discrimination.
Producers are able to separate markets in a number of di{ferent
ways. They can do so by:
E Time: Consumers are often prepared to pay higher prices at
certain times than at others. For example, commuters heading
to work in thc morning on the train are making a necessary
journey and so will be prepared to pay a higher fare than a
person who is Ircc all day and would like to go shopping. The
commuter's elasticity ol demand for travel is more inelastic
than that oI the shopper. Thus the train company charges
higher fares during peak times and lower fares during non-
peak times.
ti3
!!!! tt * prtce discrimination

. Age: Firms may charge different prices to consumers based

upon their ages. For example, children are often charged
lower prices than adults for visiting the cinema. The children
have a more elastic demand, because their incomes are lower.
c Gender: Firms may charge different prices to men than to
women. For example, a football club in Sweden charges lower
prices lor female supporters than for male supporters. It is
E
alleged that female supporters are not as keen on football as
s males, and so have a more elastic demand.
o
. Inclme: Firms may charge higher prices to people with high
e
incomes. For example, lawyers will often charge higher fees to
wealthy clients and lower fees to clients who do not have
high incomes. The wealthy clients will have a relatively
inelastic demand for legal services, since they can afford them
more easily.
o Geographical distance: Firnrs often sell products in dilferent
regions at different pdces. This is possible as long as the cost of
translering the product is greater than the difference in the
prices. If this is the case, then consumers in the low price
region cannot transfer the goods to the high price region,
without incurring transport costs that raise their total cost
above the price in the high pfice region. For example, CDs are
sold for a lower price in the USA than they are in the EU. This
is possible because there are different price elasticities in the
two countdes and the transportation costs between the
countries are greater than the price differential.
. T)rpes of mnsumer Firrrrs sometimes sell at different prices to
different users. For example, electdcity companies may charge
dilferent rates to industrial users and domestic users. The rates
will rellect their different elasticities of demand for power.
Museums may charge people who are registered as
unemployed a lower price than the standard rate. Market
traders may charge foreign tourists a higher price for a
product than they charge local consumers.
If the three conditions above do not exist, then price discrimination
will not be possible. we need to be carelul with price discrimination,
since there are often cases that seem to be price discrimination, but
are in fact simply examples of sales promotion. For example, students
often say that nightclubs letting girls in lor free while boys have to
pay is an example of price discrimination. Howeve! in reality this is
not the case. It is unlikely that there is any dilference in the price
elasticity of demand for nightclubs between girls and boys. The
motivation for the nightclubs is to ofler a promotion that will attract
girls to the nightclubs, so that lots of boys will then go, attracted by
the high number oI girls!
There are three degrees/levels of price discrimination to be considered:
I First-degree price discrimination is said to take place when
each consumer pays exactly the price that he/she is prepared to
pay. This is how it is assumed that traders in a bazaar or market
Quantity of Wo d Cup t-shirts
operate when they bargain to try to get the highest price that they
154 can. In Figure ll.I, we see the case of a trader selling World Cup FiSure I 1.1 First-deSree price
t-shirts to tourists in a market. discrimination
 tt .,price dtscnmination !!!!!
The trader attempts to bargain with the tourists to sell each shirt at
the highest price that the tourist is prepared to pay. If the trader is
successful then, as we can see, on that day the trader will sell one
shirt at $14, one at $13, one at $12, and so on. II the trader did
not price discriminate, then total revenue for the day would be
rhe shaded pale blue rectangle. Howeve! by discriminating, the
trader has eliminated the consumer surplus of the toudsts and so
the trader's total revenue is the shaded pale blue area plus the
shaded dark blue triangle. Also, since the extra revenue received d
from each shin (the marginal revenue) is equal to the price of the f
shirt, in this case, D = MR. o
b4u l.
tl
Second-degree price discrimination is said to take place when
a firm charges different prices to consumers depending upon how
much they purchase. This is often how utilities companies (e.9.
electricity and gas providers) operate. They may charge a high
price for the lirst number of units, the essential ones, and then a
lower price for any extra units consumed. Figure I1.2 shows the
situation for the pdcing of text messages by a mobile phone
Quantity of text messages (per month)
company. The first 50 messages per month are charged at a rate of
309 each. Any messages sent over this number are charged at the Figure I1.2 Second-degree price
reduced rate of 20e per message. discrimination

Third-degree price discrirnination is said to take place when

consumers are identified in different market segnents, and a
separate price is charged in each market segment that recognizes
the different price elasticities in each segment. This is the most
common form of price discrimination. Figure I 1.3 shows a tlpicai
example of price discrimination in a cinema.

Student hckets Aduh tickes

customeE per week (oos) Customers Per week (005) Customers Per week (oos)

Figure 11.3 Third degree price discrimination

The management of the cinema have identified two distinct

market segments in their audience, adults and students. The
students have a more elastic demand for going to films because
they have lower incomes. Thus the management know that they
will have to charge a lower price for students than for adults. They
can separate the market segments, because the students need to
show some proof of their status belore they are allowed into the
cinema with a lower price ticket.
Figure 11.3 shows the exact situation for a week at the cinema.
The demand curve for students, D(s), is relatively more elastic r35
than the demand curve for adults, D(A). The respective marginal
!!!! ll tirLce dlsc.m ratron

revenue cuwes are twice as steeply sloping as the demand curves.

we assume that the cinema is atlempting to maximize profits and
so we use the figure for total ticket sales on the right hand side.
The marginal cost curve is for the cinema as a whole and the
marginal revenue curve is a total oI MR(S) and MR(A). This is
why it is kinked. The cinema will maximize profits when MC=MR,
so it will serve 700 customers per week and the marginal cost will
.9 be $5.
E
o When the marginal cost is transferred to each market segment, we
o can find the profit-maximizing position in each. In the student
segment, when MC=MR=$5, profits are maximized by charging a
price of $7.50 and attracting 375 students. In the adult segment,
when MC=MR=$5, profits are maximized by charging a price of
$10.25 and attracting 325 adults.
In third-degree price discrimination, a market may be broken up
into more than two segments, but the principle will be the same.
In cinemas, there are many different prices offered, such as
normal adult, student, senior citizen, and under 12, but they all
take account of different elasticities and they are all examples of
third-degree price discrimination.
Whatever the degree, price discrimination can be both a good thing
and a bad thing; it really depends upon the situation and who the
stakeholder is.
There are clear advantages to the firm:
r Price discrimination enables the producer to gain a higher level of
revenue from a given amount of sales. This occurs because
consumer surplus is eroded.
r Price discrimination may enable the producer to produce more of
the product and thus gain from economies of scale. This could
benefit everyone, by lowering average costs and lowering prices in
all of the market segments.
r Price discrimination may enable a firm to drive competitors out of
the more elastic market. If the firm is able to price discriminate,
then it may use profits gained in the inelastic market segment to
Iower prices in the more elastic segment and thus undercut its
competitors in that segment. This especially occurs in international
trade, where a firm may have inelastic demand in the home
market and more elastic demand in foreign markets. Price
discrimination may allow the exporting firm to be aggressively
competitive in the foreign markets. According to global trading
rules set out by the World Trade Organization, firms may not sell
in foreign markets at prices below the costs of production. This is
known as dumping. and is illegal. However, firms are permitted to
sell at lower prices in foreign markets, prices that are below the
domestic market prices.
There are also some advantages to the consumer:
o Price discrimination may allow some consumeff to purchase a
product that they would not have been able to if other consumers
't36 were not paying a higher price and thus "subsidizing" the poorer
consumers. For example, in many countries, Iawyers charge high
 II Price discrlminalon !!!!!
prices to wealthy customers and this enables them to deal with
lower-income clients for little or no fee. Doctors often do the
same.
o Similarly, pdce discrimination allows some people to purchase a
product at a lower price than they would have had to pay if the
producer had not been able to secure higher prices from others.
For example, many universities charge foreign students higher
tuition fees than for domestic students. Studentworkpoint ll.l
5'
o Price discrimination usually increases total output in a market and Be inquisitive-investigate the
so the product is available to more consumers. following
. As stated above, price discrimination may lead to economies of Find three realworld examples of
l
scale, lower unit costs, and thus lower prices for consumers in all price discrimination. Provide details
market segments. of the different prices charged to
the different groups. Suggest why
The disadvantages to the consumer are that: the elasticities of demand might
be different between the market
. Any consumer surplus that existed before the price discrimination
segments, and explain how the
will be lost. producer/seller manaSes to keep
r Some consumers will pay more than the price that would have the markets separate (e.9. time,
been charged in a single, non-discriminated market. identity card).

The Twin City Liner

The TWin City Liner is a 75-minute boat journey
on the Danube, connecting Vienna and
16.30 €11 €19

Bratislava which are the capital cities ol Austria 18.30 €17 €19

and Slovakia. The boat makes live daily journeys Children - 500.6 discount
from Vienna to Bratislava and five from
Bratislava to Vienna.

r0.30 €r9

14.30 €28 €30

t6,00 €28 €30

18.30 €17 €30

22.30 €17 €19

Children - 500/0 discount

Here we have an excellent example of price

The prices for the journeys are as follows: discrimination. People who want to make the
journey might want to make a day of it. If they
are in Vienna then this means that they would
like to take the first or second boat of the day at
€30
8.30 or 9.00 and come back in time for dinnet
8.30 €28
leaving Bratislava at l6.OO or 18.30. This will
9.00 €28 €30 make the price of the round trip €56. Almost
12.30 €28 €19 any other combination of journeYs will be less
- 137
!!!!t rt Price dlscrimlnation

e expensive than this. It would seem that the Twin
City Liner company leels that this will be the
most desirable trip and are pricing to take
advantage of people's different elasticities of
demand. They must also be assuming that more
people will want to rnake the round trip journey
E they have two boats and have increased the
starting from Vienna rather than from Bratislava
o number of journeys. Furthermore, the price has
as combinations slarting from vienna and
returning the same day cost more than their
.9
equivalent from Bratislava.
The fact that they are charging a higher price on
Saturdays, Sundays, and holidays is also due to
differing elasticities of demand. These may be
the only days that certain people can travel, thus
their demand will be less elastic. The company
can "take advantage" of this by charging a
higher price.
The fact that children are offered a lower price
is also an example of price discrimination. They
will still occupy the "product" is
a seat, so
identical but they only pay 507o of the price.
It is worlh noting that up to two years ago the
company had one boat and ran three joumeys a
day lrorn Vienna and three from Bratislava. Now
increased. Look at this situation from the
perspective oI an economist. Clearly there has
been strong demand for the service. The extra
demand may have led to a price increase, and
also an increase in the supply. The decision by the
firm to increase the supply of boats (capital) was
an example of a change in a fixed factor of
production, and took the company to a new short
run average cost at a higher scale of production.
Perhaps the extra abnormal profits eamed by
price discdminating allowed the firm to increase
its capital and therefore increase its output?

EXAMINATION QUESTIONS
Paper l, part (a) question
I Explain the conditions necessary for a seller of a good to be able to
price discriminate. [10 norks]
Paper l, essay question
I a Explain the concept of price discrimination. [10 morks]
b Evaluate the effects of price discrimination on producers and consumers. [15 narks]

' lon'ori^,1o*'",.ti;ll
l-
II///I/II Asse ssm ent o dvice : u si n g
exomples
.' ' Always remember to include
Hoadlins: Governmeni anrtouncoi p\ans io ni6c tuiiion foes for examples in your written answers. For
example, in explaining the concept of
for?ign 6ludrnlB
price discrimination, you will be able
econonic6 Lonccpl: P riLe discriminalion to do so much more effectively if you
Diagram: Dillortnl o\arli(tiirs of dsmand for domcstic sludonto and give examples of situations where
{oreign siudenli price discrimination takes place. To
evaluate the effects, you need to be
Hinl: TrI i0 erplain wh1 the governmgnl might \,rant lo do lhib and
able to consider the effects on the
ronsider wh1 ths dcmand for univgrsiiies from forcign studc.nti mighi stakeholders in different examples,
be \ess o\attic than thc demand from dome6li. students.
+.- r l- J, J-r rJ .}*r!2 r dd!-r- J J .JF,F| r.r r
-., '+-]F ^}-.--F. -,

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