Price discrimination

MBA Managerial Economics

Price Discrimination

• What is Price Discrimination?

• What sort of organization practice such exercise? (

• Does it apply in Education Industry?

• What about (Banking?, Utility sector, Restaurants)
• Does it apply based on groups ?(students vs faculty); senior citizen
Price Discrimination
• Generally the firm must charge the same price for each unit that
consumers purchase in the market.
• however, firms can earn higher profits by charging different prices for
the same product or service
• The three basic types of price discrimination—first-, second-, and
third-degree price discrimination—are examined next.

• As we will see, each type requires that the manager have different
types of information about consumers.
Condition for price discrimination
• There are two fundamental conditions:
• 1 There must be different market segments (groups) with different
demand elasticities.
• 2 The market segments must be separated so that there is no
possibility of resale from one segment to another.
first-degree price discrimination
• Charge each consumer the maximum price he or she would be willing
to pay for each unit of the good purchased.

• By adopting this strategy, a firm extracts all surplus from consumers

and thus earns the highest possible profits.

• It is extremely difficult to implement because it requires the firm to

know precisely the maximum price each consumer is willing and able
to pay for alternative quantities of the firm’s product
 pricing and Value creation
• The Figure shows how first-degree price discrimination works. Each point on the market demand curve reflects the maximum price that
consumers would be willing to pay for each incremental unit of the output. Consumers start out with 0 units of the good, and the firm can
sell the first incremental unit for $10.

P
MC
10

N D
Second degree discrimination
• Second-degree price discrimination is the practice of posting a
discrete schedule of declining prices for different ranges of quantities.

• This practice is very common in the electric utility industry, where

firms typically charge a higher rate on the first hundred kilowatt hours
of electricity used than on subsequent units.

• The firm charges different prices to different consumers, but does not
need to know specific characteristics of individual consumers
Second degree discrimination
• Suppose the Acme Beverage Company charges consumers $7.60 per
case for the first two cases purchased and The second two cases are
priced at $5.20 each.
 Secondary Discrimination
so the shaded region between that price and the marginal cost
curve between 2 and 4 units of output reflects Acme’s profit
• Second degree discrimination contributions from selling the second two cases.

P
Mc
M
7.6

5.2

4 E

N D

2 4 5
Third degree price discrimination
• The final type of price discrimination is commonly practiced by firms
that recognize that the demand for their product differs systematically
across consumers in different demographic groups.
• In these instances firms can profit by charging different groups of
consumers different prices for the same product, a strategy referred
to as third-degree price discrimination.
3rd degree discrimination
• For example, it is common for stores to offer “student discounts” and
for hotels and restaurants to offer “senior citizen discounts.” These
practices effectively mean that students and senior citizens pay less
for some goods than do other consumers.

• One might think that these pricing strategies are instituted to benefit
students and senior citizens, but there is a more compelling reason: to
increase the firm’s profits.
Determing price under 3rd degree price
discrimination
• You are the manager of a pizzeria that produces at a marginal cost of $6
per pizza.
• During the day, only students eat at your restaurant. In the evening, while
students are studying, faculty members eat there. If students have an
elasticity of demand for pizzas of 4 and the faculty has an elasticity of
demand of 2, what should your pricing policy be to maximize profits?
• Assuming faculty would be unwilling to purchase cold pizzas from
students, the conditions for effective price discrimination hold. It will be
profitable to charge one price—say, PL—on the “lunch menu” (effectively
a student price) and another price, such as PD, on the “dinner menu”
(effectively a faculty price).
Determing price under 3rd degree price
discrimination
• To determine precisely what price to put on each menu, note that the
people buying pizza off the lunch menu have an elasticity of demand
of 4, while those buying off the dinner menu have an elasticity of
demand of 2.
• The conditions for profit maximization require that the marginal
revenue of selling a pizza to each group equal marginal cost. Using the
third-degree price discrimination rule, this means that
Determining price under 3rd degree price
discrimination
• PL

• PD

• Elasticity of demand for lunch (EL), and Elasticity of demand for Dinner (Ed)
• Setting ED= -2, EL =-4, and MC 6 yields
• PL

• PL = $8

• PD

• PD =$12
Determining price under 3rd degree price
discrimination
• Thus, to maximize profits, you should price a pizza on the lunch menu
at $8 and a pizza on the dinner menu at $12. Since students have a
more elastic demand for pizza than do faculty members, they should
be charged a lower price to maximize profits.
Segmentation for price discrimination
• Segmentation for price discrimination
• Firms can segment markets on different bases; the following are the most common.
• 1. Time. Many products that have seasonal demand have different prices at different
time periods; airlines, hotels, restaurants, cinemas, power providers and many other
industries have this feature. Demand is less elastic at peak season, so prices are
higher then.
• 2. Location. In some cases the price of a product may be higher in one location than
another because of a higher transportation or other cost.
• 3. Product form. Many firms offer a product line where the top-of-the-line model is
considerably more expensive than the other products in the line. This may be true
even when there is little difference in the cost of production of the different products.
Example of market segmentation and pricing
• * Airlines that charge different fares for the same journey at different
seasons of the year.
• * Universities that charge higher fees to overseas students than to home
students.
• * Restaurants that offer ‘early bird’ dinners.
• * Professional people, like doctors, accountants and consultants, who
charge richer clients higher fees than poorer clients for the same service.
• * Exporters who charge lower prices abroad than they charge
domestically. * Prestige outlets that charge higher prices than high street
or discount stores for the same products.
Application of the price discrimination for
airline industry:
• Valair is an airline flying a particular route that has seasonal demand.
The firm’s total demand is given by:

• where Q is the number of passengers per year, in thousands (‘000),

and P is the fare (in £).
• In the peak season the demand is given by:

• And in the off-season the demand is given by

Application of the price discrimination for
airline industry:
• Assume that fixed costs are £6 million per year and that marginal costs are
constant at £60 per passenger. Thus, the cost function is given by:

• where TC is total costs (in £’000).

• a. Calculate the profit-maximizing price and output without price
discrimination, and the size of the profit.
• b. Calculate the profit-maximizing price and output with price discrimination,
and the size of the profit.
• C. draw demand curve using demand function with or without price
discrimination
 Peak-season Off-peak-season

P=112
P=213.33

320 280

𝑄 𝐻 =320 − 1.5 𝑃 𝐻 𝑄 𝐿 =280 − 2.5 𝑃 𝐿

When P =0, Q=320, when Q=0, p=213.33 When P =0, Q=280, when Q=0, p=112
a. Calculate the profit-maximizing price and output without price discrimination,
and the size of the profit

• Total Demand Function

• TR = P*Q

• MR = chg in total revenue/ change quantity

• Total revenue with respect to quantity is the first derivative of total revenue
equation
• TR=
• MR =(600-2Q)/4
• Since marginal revenue = marginal cost when profit is maximum,
• Therefore MR=MC =60
• 60 = (600-2Q)/4
• Q=180; or 180;000 passengers per year
Profit without discrimination

• = £105 per ticket

• The profit is given by Revenue - Cost
• Total Revenue = P*Q

• 6000+60*(180)=2100
• 2100*1000
• = £ 2,100,000
PROFIT WITH PRICE DISCRIMINATION
• Demand function for Peak-season

• TR = P*Q
• MR = (320-2Q)/1.5
• MR =MC=60
• 60 = (320-2Q)/1.5
• (320-2Q)=90
• Q=115 OR 115,000 PASSENGER

• P= £ 136.67
Price with discrimination (off-peak)
• Demand Function

• TR = P*Q
• MR = (320-2Q)/2.5
• MR =MC=60
• 60 = (280-2Q)/2.5
• (280-2Q)=150
• Q=65 OR 65,000 PASSENGER

• P= £ 86.
Profit from price discrimination
• In order to obtain the size of the profit it is necessary to calculate total
revenue and subtract total costs.
• Note that it is incorrect to compute the profits in each segment
separately and then add them together.
• This would double-count the fixed costs.
Profit from price discrimination
• In order to obtain the size of the profit it is necessary to calculate total revenue and
subtract total costs.
• TC
=21307.05(‘000)
=21,307,050

• 6000+60*(115+65))=16800*1000=16,800,000

• = £ 4,507,050
• Spread between discrimination and without discrimination
• Profit = £ 4,507,050 - £ 2,100,000
Price discrimination and price elasticity of
demand
• Price strategies for different segments require understanding
sensitivity customers responding to price increase or decrease.
• One way to measure such sensitivity is price elasticity of demand
• There are various ways to measure price elasticity.
• PED is to derive from demand function and price and quantity at
which profit is maximum.

• Where i represent different segment of the markets.

Price discrimination and price elasticity of demand

• DEMAND CURVE

• PRICE ELASTICITY OF DEMAND FOR PEAK-PERIOD

• SLOPE = 1.5
• QUANTITY = 115, PRICE = 136.67
• =-1.783

• DEMAND CURVE FOR OFF-PEAK

• SS
• PRICE ELASTICITY OF DEMAND
• = =-3.303
Market-skimming pricing

• Setting a high price for a new product to skim maximum

revenues layer by layer from the segments willing to pay the
high price: the company makes fewer but more profitable sales.
The conditions:
1. A sufficient number of buyers have a high current demand;
2. The unit costs of producing a small volume are not so high that they cancel the
advantage of charging what the traffic will bear;
3. The high initial price does not attract more competitors to market;
4. The high price communicates the image of a superior product.