Written by Price discrimination refers to the practice of charging different prices for the same product or service to different customers or groups of customers.
It occurs when a firm charges different prices to different buyers of identical goods due to reasons not related to differences in cost.
The goal of price discrimination is to increase the profit of the business by capturing more consumer surplus and converting it into producer surplus.
Examples of price discrimination are as follows:
- Airlines charge different prices for the same flight depending on the time of booking, the class of service, and the destination.
- Movie theatres charge different prices for the same movie depending on the age of the customer, the time of the day, and the format of the screening.
- Pharmacies charge different prices for prescription drugs depending on the insurance coverage and the bargaining power of buyers.
Conditions Necessary for Price Discrimination
The following conditions must be met for price discrimination to be successful:
1. Possession of market power: The first condition necessary for price discrimination is the presence of market power.
Market power refers to the ability of a firm to influence prices and control the supply of goods or services in the market.
In order to practice price discrimination, a firm must have some level of market power so that it can raise prices above marginal costs without facing significant competition.
Without market power, the firm would be unable to charge different prices to different customer segments, as competitors would quickly undercut it.
However, in a perfectly competitive market, where there are numerous firms selling identical goods or services at the same price, market power is non-existent.
In such cases, price discrimination is not possible, as any firm that tries to charge a price above the market price, will lose all of its customers to competitors.
2. Market segmentation: Price discrimination relies on the ability to identify and distinguish different customer segments with varying levels of willingness to pay.
So, a firm that wants to price discriminate must have the capacity to divide its customers into different segments based on their willingness to pay or their price elasticity of demand.
The firm may divide its market demand into an elastic segment (buyers who are price-sensitive) and an inelastic segment (buyers relatively insensitive to price).
It might charge less to elastic customers since they are very sensitive to price change and more to inelastic customers since they are less sensitive to price change
3. Prevention of arbitration or resale of the product: Even after segmenting its market, the firm should be able to stop product resale to successfully practice price discrimination.
That is, the firm should be able to prevent customers from the lower-priced market from reselling to customers from the higher-priced market.
If this is possible, then price discrimination cannot be successfully done.
Types of Price Discrimination
There are three types of price discrimination, namely; first-degree price discrimination, second-degree price discrimination, and third-degree price discrimination.
1. First-degree price discrimination
First-degree price discrimination, also known as perfect price discrimination, occurs when a firm charges each customer the maximum price they are willing to pay for a product or service.
To practice this kind of price discrimination, the seller of the good or service must have perfect knowledge of the maximum price that each consumer is willing to pay and charges them accordingly.
This results in consumers paying the exact amount they are willing to pay, eliminating any consumer surplus.
First-degree price discrimination is rare in practice, but elements of it can be observed in negotiation processes, such as when haggling the price of a car or negotiating the price of a house.
With first-degree price discrimination, the firm’s marginal revenue curve will equal its demand curve since it is able to capture the maximum revenue from each customer.
2. Second-degree price discrimination
This is also known as quantity price discrimination.
It occurs when the business offers different versions or packages of the product or service at different prices, and lets the customers choose which one they prefer.
Second-degree price discrimination may also be defined as a type of price discrimination where the price of goods and services varies according to the quantity demanded.
A good example is where progressive discounts are given as purchases increase.
This is common with season tickets to watch a Premier League football team in the UK.
Consumers generally gain from quantity price discrimination, and the firm’s output, total revenue, and profits all rise.
3. Third-degree Price discrimination
Third-degree price discrimination, also known as multi-market price discrimination or market segmentation pricing, occurs when a business divides the customers into different groups based on observable characteristics( such as age, gender, location, and income) correlated with willingness to pay or elasticity of demand.
So, in third-degree price discrimination, the firm discriminates between different categories of customers based on differences in price elasticity of demand or other characteristics.
For example, a movie theatre may charge lower prices to students and seniors than adults, a magazine may charge lower subscription rates to foreign readers than domestic readers or an airline may charge lower fares to leisure travellers than business travellers.
The downside of practicing third-degree price discrimination is that some consumers benefit while others do not benefits because they have to pay higher prices.
