Price discrimination

Price discrimination is the practice of charging a different price for the same good or service.
There are three types of price discrimination – first-degree, second-degree, and third-degree
price discrimination.

First degree

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.

See Diagram in Attached Page

Second degree

Second-degree price discrimination means charging block prices after selling the economic
equilibrium quantities at the equilibrium price where Durable Consumers buy the product.
Second degree continues until P >f ATC. Here Trendy Consumers buy. Bargain seekers are left
out ..

Third degree

Third-degree price discrimination means charging a different price to different consumer groups.
For example, rail and tube travelers can be subdivided into commuter and casual travellers, and
cinema goers can be subdivide into adults and children. Splitting the market into peak and off
peak use is very common and occurs with gas, electricity, and telephone supply, as well as gym
membership and parking charges. Third-degree discrimination is the commonest type.

Necessary conditions for successful discrimination

Price discrimination can only occur if certain conditions are met.

1. The firm must be able to identify different market segments, such as domestic users and
industrial users.
2. Different segments must have different price elasticities (PEDs).
 3. Markets must be kept separate, either by time, physical distance and nature of use, such
as Microsoft Office ‘Schools’ edition which is only available to educational institutions, at
a lower price. Time based pricing - also called dynamic pricing - is increasingly common
in goods and services sold online. In this case, prices can vary by the second, based on
real-time demand related to consumers' online activity.
4. There must be no seepage between the two markets, which means that a consumer
cannot purchase at the low price in the elastic sub-market, and then re-sell to other
consumers in the inelastic sub-market, at a higher price.
5. The firm must have some degree of monopoly power.

Diagram for price discrimination

If we assume marginal cost (MC) is constant across all markets, whether or not the market is
divided, it will equal average total cost (ATC). Profit maximisation will occur at the price and
output where MC = MR. If the market can be separated, the price and output in the relatively
inelastic sub-market will be P and Q and P1 and Q1 in the relatively elastic sub-market.

When the markets are separated, profits will be the area MC, P,X,Y + MC1,P1,X1,Y1. If the market
cannot be separated, and the two submarkets are combined, profits will be the area
MC2,P2,X2,Y2.
If the profit from separating the sub-markets is greater than for combining the sub-markets,
then the rational profit maximizing monopolist will price discriminate.

Market separation and elasticity

Discrimination is only worth undertaking if the profit from separating the markets is greater than
from keeping the markets combined, and this will depend upon the relative elasticities of
demand in the sub-markets. Consumers in the relatively inelastic sub-market will be charged the
higher price, and those in the relatively elastic sub-market will be charged the lower price.

Costs of separation

The effectiveness of price discrimination will be weakened if the costs of preventing seepage are
significant, and reduce the profits accruing from discrimination. For example, it might be
necessary to introduce costly monitoring and enforcement systems to ensure that consumers do
not break any conditions of sale which exist to keep markets separate. Employing ticket
inspectors or other security systems adds to the cost of preventing seepage in public transport.

Note

In the above example we are assuming that the price at which consumers in the relatively elastic
sub-market (students, for example, looking to travel into a major city) are prepared to enter the
market is lower than those in the relatively inelastic sub-market (commuters, for example). This
gives the combined demand (AR) curve an outward kink, and the combined MR curve a
discontinuous portion (indicated by the vertical dotted line.) If, however, both types of consumer
are prepared to enter the market at the higher price then the combined demand (AR) curve is
simply shifted further to the right, and will not have the kink. This is illustrated in the diagram
below:

In all cases it should be noted that that profit maximisation must occur where MC = MR. This
means that profit maximising equilibrium for the discriminating monopolist must occur where
MR is positive, which means that, irrespective of the gradient of the demand curves in the
submarkets, the price will always be set in the elastic portion of the demand curve (individually,
and when combined).

Evaluation 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 maximization
Firstly, matching prices to the specific characteristics of the market, and its various segments, is a
profit maximizing 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 monopolies such 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 trial 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.

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 reducing market
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.

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 subsidizes 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.

Third Degree Price Discrimination

Third Degree Price Discrimination involves charging a different price to different groups
of consumers for the same good. These groups of consumers can be identified by particular
characteristics such as age, sex, location, time of use.

In the real world, third-degree price discrimination is quite common. For a firm to practice
price discrimination it requires:
 Ability to set prices. Some market powers.
 Ability to segment different classes of consumers (e.g. rail card to prove you are a senior
citizen)
 Ability to prevent resale. E.g. stop adults using student tickets.

Price discrimination for train tickets

If you buy on the day, tickets are usually more expensive. If you book 7 days in advance and
stick to a specific time of the day, the price is lower.

On the same train, customers can be paying different prices for the same ticket.

Examples of Third Degree Price Discrimination

Price discrimination – local restaurant offering 10% discount to students and NHS workers

 Students frequently get 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.

Logic of Third Degree Price Discrimination

Why are students given 10% discount?

With lower income, students tend to be more sensitive to prices. Their demand is price
elastic. Therefore, by cutting prices for students, a firm is able to increase sales and
revenue, but still, keep relatively higher prices for other adults who have more inelastic
demand.

Different forms of price discrimination – product versioning

Note: A variance of price discrimination occurs when firms sell slightly different products.
For example, first-class tickets are more expensive because the firm can offer a better
service. However, first-class tickets also take advantage of different elasticities of demand.
Businessmen who pay first class will have a more inelastic demand and so willing to pay
higher prices to get a slightly better product.

Product versioning
One-way firms practice price discrimination is to offer slightly different products as a way
to discriminate between consumers ability to pay. For example:

 Priority boarding tickets. Same flight but for a premium, you get a shorter queue.
 Organic coffee / fair trade coffee
 Extra leg room on airplanes
 First class/second class

This is a form of indirect segmentation. By offering slightly different choices, the firm is
able to separate consumers who are willing to pay higher prices.

Conditions necessary for price discrimination

1. Firm a price maker. 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 travellers buying discount
tickets.

3. Different elasticities of demand. Different consumer groups must have 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.

Simple diagram for Price Discrimination

Without price discrimination, the firm charges one price £7 * 100 = £700 revenue

With price discrimination, the firm can charge two different prices:

 £10 * 35 = £350
 £4 * 120 = £480

Total revenue = £830. Therefore, the firm makes more revenue under price
discrimination.

Profit maximization under Price Discrimination

 To maximize profits a firm sets output and price where MR=MC. If there are two sub
markets with different elasticities of demand. The firm will increase profits by setting
different prices depending upon the slope of the demand curve.

 Therefore, for a group, such as adults, PED is inelastic – the price will be higher
 For groups like students, prices will be lower because their demand is elastic

Diagram of Third Price Discrimination

Profit is maximized 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 maximizing price
(P1)
 In segment (B) demand is price elastic, so the profit maximizing price is lower.
 Advantages of price discrimination
1. Firms will be able to increase revenue. Price discrimination will enable some firms to
stay in business who otherwise would have made a loss. For example price discrimination
is important for train companies who offer different prices for peak and off peak. Without
price discrimination, they may go out of business or be unable to provide off-peak services.

2. Increased investment. These increased revenues can be used for research and
development which benefit consumers

3. Lower prices for some. Some consumers will benefit from lower fares. For example, old
people benefit from lower train companies; old people are more likely to be poor. Also,
customers willing to spend time in researching ‘special offers’ and travelling at awkward
times will be rewarded with lower prices.

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

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.

Importance of marginal cost in price discrimination

In markets where the marginal cost of an extra passenger is very low, the firm has an
incentive to use price discrimination to sell all the tickets. This is why sometimes prices for
airlines can be very low just before their date. Once the company is due to fly the MC of an
extra passenger will be very low. Therefore this justifies selling the remaining tickets at a
low price.

Examples of price discrimination

1. Student discounts on trains
2. Discounts for buying train tickets in advance
3. Discounts for travelling at off peak time
4. Lower unit cost price for buying high quantity.
5. Phone deals which give 100 texts free.

Legality

The process of charging different amounts for the same item to different people or to different groups of
people is price discrimination. As long as you can justify why you are charging different prices, such as
implementing a "kid's meals" program to attract families and you avoid harm to a certain group, such as
charging higher prices to people of certain racial groups, this practice is legal. Similarly, wholesalers can
offer price breaks for quantity purchases and they can offer customized merchandise but they cannot
influence competition by limiting these offers to a few select retailers because doing so would harm
excluded retailers.