Price Discrimination

What is price discrimination?

Price discrimination happens when a firm charges different prices from different
segments of the market for the same (an identical ) good or service, for reasons not
associated with costs of supply.

Conditions necessary for price discrimination

1. Firm is a price maker and monopoly power . The firm must operate in imperfect competition;
it must be a price maker with a downwardly sloping demand curve.
2. Separate markets. The firm must be able to separate markets and prevent resale. E.g. stopping
an adults using a child’s ticket. Prevent business travelers buying discount tickets.
3. Different elasticities of demand. Different consumer groups must have different elasticities of
demand. E.g. students with low income will be more price elastic and sensitive to price. Business
travellers will have more inelastic demand.
4. Low admin costs. It must be relatively cheap to separate markets and implement price
discrimination.

The degrees of price discrimination:

First-degree price discrimination, alternatively known as perfect price discrimination, occurs

when a firm charges a different price for every unit consumed.

The firm is able to charge the maximum possible price for each unit which enables the firm
to capture all available consumer surplus for itself. In practice, first-degree discrimination is
rare. First degree is practiced by lawyers and doctors.
Second Degree Price Discrimination

This involves charging different prices depending upon the choices of consumer. For example
quantity, time period, collecting coupons

• After 10 minutes phone calls become cheaper.

• Electricity is more expensive for the first number of units. For a higher quantity of
electricity consumed the marginal cost is lower.

• Loyalty cards reward frequent buyers with discounts on future products.

• If you collect coupons from a newspaper you can get a discount.

2nd-degree price discrimination is sometimes known as ‘indirect price discrimination’ because

the firm allows consumers to choose which price they will pay. Some choices are offered cheaper
because they impose costs on consumers (e.g. collecting coupons, buying in bulk or unsocial
hours.

Third-degree Price Discrimination:

Refers to a price discrimination in which the monopolist divides the entire market into
submarkets and different prices are charged in each submarket. Therefore, third-degree price
discrimination is also termed as market segmentation.

This involves charging different prices to different groups of people. For example:

• Student discounts,

• Senior citizen railcard

• Peak travel/ off-peak travel

• Cheaper prices by the time of the day (e.g. happy hour’s in pubs – usually earlier on in
evening where demand is lower.

In this type of price discrimination, the monopolist is required to segment market in a manner, so
that products sold in one market cannot be resold in another market. Moreover, he/she should
identify the price elasticity of demand of different submarkets. The groups are divided according
to age, sex, and location. For instance, railways charge lower fares from senior citizens. Students
get discount in cinemas, museums, and historical monuments.

In third degree price discrimination , market segmentation is done based on following

factors.
 Based on Personal factors such as income level of consumers , Age and Gender
Refers to price discrimination when different prices are charged from different
individuals. The different prices are charged according to the level of income of
consumers as well as their willingness to purchase a product. For example, a doctor
charges different fees from poor and rich patients.

Geographical:Charging different prices at different locations .

Refers to price discrimination when the monopolist charges different prices at different
places for the same product. Some multinational companies charge different prices in
different countries .( Dumping also can be considered as an example of price
discrimination.)

On the basis of time of usage and purpose :

Occurs when different prices are charged according to the use of a product. For instance,
an electricity supply board charges lower rates for domestic consumption of electricity
and higher rates for commercial consumption.

What is the difference between price discrimination and product differentiation?

● Charging different prices for similar goods is not pure price discrimination
● Product differentiation gives a supplier greater control over price and the potential to
charge consumers a premium price arising from differences in the quality or performance
of a product

Price discrimination diagram.

Profit is maximised where MR=MC. Without price discrimination, there would just be one price
set for the whole market (A+B). There would be a price of P3.
● However, price discrimination allows the firm to set different prices for segment A
(inelastic demand) and segment B (elastic demand)
 ● Because demand is price inelastic, segment (A) will have a higher profit maximising
price (P1)
● In segment (B) demand is price elastic, so the profit maximising price is lower.

Examples of Third Degree Price Discrimination

● Students frequently get a 10% discount in shops and restaurants
● Pensioners get discounted bus and train tickets. up to 33% cheaper
● Book in advance. If you book train tickets in advance, usually they are much cheaper
than buying on the day. This is because customers who buy in advance are usually more
price sensitive. They have time to look for alternatives. Businessmen who buy on the day,
probably have higher income, but also consider train journey more of a necessity –
therefore, their demand is price inelastic.
● A nightclub may offer a discount to female consumers on certain nights.

Advantages and Disadvantages of Price Discrimination

Advantages
From the firm’s perspective

From a firm’s perspective price discrimination can offer many advantages, making it one of the
commonest pricing strategies used by local, national and global companies. Benefits to firms
include:

● Profit maximisation

Firstly, matching prices to the specific characteristics of the market, and its various segments, is a
profit maximising strategy (see above), where the firm can extract some (or even all) of the
consumer surplus available in the market, and turn it into producer surplus (i.e. profits).

● Economies of scale

Given that charging different prices can increase sales volume, especially as a result of new
consumers entering the market, attracted in by the discounted prices, firms can benefit from
the economies of scale which arise from increased output and production.

● Efficient use of infrastructure

Price discrimination can benefit firms with high fixed costs associated with the building of
infrastructure, and its maintenance. This includes natural monopoliessuch as gas, electricity
supply, and transport services. For example, having more passengers on a train that is going to
run anyway provides additional revenue to the train operators. This revenue may be used to add
to profits (given that the marginal cost of one extra passenger is virtually zero) or to cover new
fixed costs, such as track or safety improvements.
 ● Better use of space

Similarly, price discrimination may also enable manufacturing and retail firms to clear their
existing stocks quickly when required - hence making better use of their shop or factory space.

● Managing the flow customers

Price discrimination according to the time of day means that the flow of customers into retail
stores can be managed more effectively, which might provide a better experience for shoppers
and spread out the work for staff. For example, having a ‘happy hour’ or ‘early bird’ prices may
encourage shoppers to adjust their shopping times so that queues are shortened at more peak
times, as well as ensuring that staff are better employed throughout the day.

● Understanding the market

Firms may wish to trial new products in different locations, and may match their prices to the
specific demand conditions found in those local markets. Also, firms can offer discounts in order
to get consumer feedback on these trialled products, and on existing ones.

Similarly, price discrimination may enable firms sell to export markets, basing their prices on
what consumers are prepared to pay in each territory – which can vary considerably from
country to country. From a macro-economic perspective, international trade is likely to be
created by price discrimination.

● Enables survival

As a result of generating additional revenue, price discrimination can enable firms to survive. For
example, small cinemas might be better able to survive if they can offer low priced off-peak
cinema tickets to the over-65s for day-time screenings.

● Manages demand.

Airlines can use price discrimination to encourage people to travel at unpopular times (early in
the morning) This helps avoid over-crowding and helps to spread out demand

From the consumer’s perspective

● Possibility of lower prices
From the consumer’s point of view, some, especially those in the highly elastic sub-market, may
gain consumer surplus as a result of lower prices. Lower prices could also result from the
application of scale economies (as above).

● Benefits to groups of consumers

If we look specifically at goods and services consumed by children, but where adults are needed
to accompany them, it can be argued that charging children a much lower price enables families
as a whole to benefit, and gain increased group utility. For example, if cinemas or theme parks
set low prices for children (or even zero price for those under a certain age), or offer with family
discounts, more parents will be able to attend, and accompany their children. This means that, in
the longer term, cinema chains and theme parks will increase their revenue and profits. The same
logic can be applied to travel and holidays, with child and family discounts encouraging demand
and helping generate revenue.

● Enables flexibility

Having different prices may enable consumers to match their purchasing and shopping to their
own free time. For example, ‘early bird’ prices can benefit individuals who are retired, or who
work flexible hours.

● Generating positive externalities

We can extend the analysis to consider the role of price discrimination in reducingmarket failure,
such as enabling wider consumption of merit goods. For example, if ‘private’ schools charge
relatively high tuition fees for those who can afford them, and where demand is inelastic, the
revenue generated allows them to cover their costs and run classes. With fixed costs covered,
they can then offer places at discounted fees (to cover the variable costs only) to those who
cannot afford them. Given that the demand for private education by less well-off parents is likely
to be price (fee) elastic, the lower price will encourage greater demand. The benefit to ‘society’
is that more education is ‘consumed’ and more positive externalities generated.

● Survival

Consumers can also gain from the fact that firms can more easily survive, so that future
generations can derived continued benefit.

● Increased investment.

These increased revenues can be used for research and development which benefit consumers

Disadvantages
● Exploitation of captive markets
However, it could be argued that consumers in a captive sub-market are being unduly exploited
due to their inelasticity. This is especially relevant when we look at transport, and the high ticket
prices charged for peak travel, compared with off-peak. The same could be said for energy
prices, where existing and loyal customers often pay higher prices, which subsidises the
discounts available to ‘new’ customers.

● Limitations

Ultimately, the ability to price discriminate may be limited because the conditions necessary are
not fully met. In other words, there are limits on the extent to which different prices can be
applied.

Clearly, with global commodities, world markets tend to settle on one price at any one time,
given the process of arbitrage.

The growth of new trading and selling technologies, apps, online auction bidding, and price
comparison websites mean that consumers have increasing information, which may reduce the
possibility of price discrimination. However, the widespread use of dynamic pricing models by
online sellers means that time-based pricing in increasingly common.

So, at one extreme, price discrimination is still highly possible with locally provided services,
and where technology can provide flexible pricing, while at the other, globally traded
commodities are subject to the ‘law of one price’, where price differences are very quickly
eroded away. Manufactured and branded goods fall somewhere between these two extremes,
with price discrimination possible - especially in terms of new online pricing models - but where
price differences may also be eroded through technology, trade and arbitrage.

Disadvantages of Price Discrimination

1. Higher prices for some. Under price discrimination, some consumers will end up paying
higher prices (e.g. people who have to travel at busy times). These higher prices are likely
to be allocatively inefficient because P > MC.
2. Decline in consumer surplus. Price discrimination enables a transfer of money from
consumers to firms – contributing to increased inequality.
3. Potentially unfair. Those who pay higher prices may not be the poorest. For example,
adults paying full price could be unemployed, senior citizens can be very well off.
4. Administration costs. There will be administration costs in separating the markets, which
could lead to higher prices.
5. Predatory pricing. Profits from price discrimination could be used to finance predatory
pricing.
The effects of arbitrage

Arbitrage is a process where traders, acting as either buyers or sellers, can exploit price
differences for identical products - buying where the price is lower and selling where it is higher.
The effect of this is to make prices converge, given the different effects of buying and selling in
the market.