Economics: Price Discrimination
Key Terms
Monopoly: A situation, by legal privilege or other agreement, in which solely one party (firm) exclusively provides a particular product or service, dominating that market and generally exerting powerful control over it.
Price Maker: A firm that has the ability to choose its desired selling point of their good or services, as they face a downward-sloping demand curve.
Perfect/First-Degree Price Discrimination: A scenario that can be found in market dominated by a monopoly firm which is able to charge each consumer different prices based on certain characteristics, (e.g., kids price/adults’ price).
Third-Degree Price Discrimination: Third-degree price discrimination refers to a strategy a firm can use to be able to charge groups of consumers different price for the same goods/services.
Arbitrage: A market activity in which a security, commodity, currency, or other tradable item is bought in one market and sold simultaneously in another, in order to profit from price differences between the markets.
What is Price Discrimination?
As we have learned from covering market structures, we saw that all firms aim to maximise profit. Price discrimination refers to how some firms can segment the market and charge different consumers (or groups) varying prices, for an identical good with no differences in cost of production, in order to achieve this profit maximisation.
In order for firms to be able to do this, there needs to be 3 conditions that have to be met:
The firm must be a ‘Price Maker’ – The firm needs to have some market power, so it is able to change the price, perfect competition wouldn’t be able to do this as they are price takers.
The firm must have ‘Market Information’ – The firm should have market information, such as elasticities in order to understand consumers’ willingness to pay.
The good or services should not be able to be re-sold – The good or service bought should not be able to be re-sold as this would lead to people that buy it at a lower price selling it for more.
There are three types of price discrimination:
Perfect/First-Degree Price Discrimination: A scenario that can be found in market dominated by a monopoly firm which is able to charge each consumer different prices based on certain characteristics, (e.g., kids price/adults’ price).
Second Degree Price Discrimination: This occurs when firms charge different prices based on quantity, this could occur in cases such as bulk buying and when seats are nearly full on an airline.
Third-Degree Price Discrimination: Third-degree price discrimination refers to a strategy a firm can use to be able to charge groups of consumers different price for the same goods/services. This type of discrimination usually occurs in train transport fares, such as peak times.
First-Degree/Perfect Price Discrimination
Within first degree price discrimination firms are able to charge each individual different prices (usually what they can afford to pay), this means that initial consumer surplus now gets converted into producer surplus as it is all part of the profit.
As can be seen on the graph above, lets suppose the normal price for a good or service is P1, this resulting in the sale of Q1 quantity. This results in a consumer surplus of P1, A and Price, however, with first-degree price discrimination firms are able to charge down the entire D (AR curve) until they reach their costs turning all consumer surplus into profit.
The graph above shows monopoly and perfect competition, as you can notice with perfect competition, price is set at P* producing Q* however for monopoly price is at PM (due to profit maximisation MR=MC) leading to quantity QM being produced. However, with first degree competition firms can produce at point A as well since they will erode all consumer surplus.
Examples of this in real life are rare, as it is difficult to charge someone different price of the exact good or service. The nearest we come to this, is the world of art and fashion where items are unique, and the price is negotiated between the buyer and seller.
Second-Degree Price Discrimination
Second-degree price competition is based on quantity pricing. A great example to use in your exam is excess-quantity pricing. This is where firms have a fixed cost and a set capacity which has not yet been met. An example of this can be airlines, they have a set number of seats available with a fixed set of costs regardless of how many passengers get on the plane. What these firms can do is last, minute they can reduce prices in order to allow them to get closer to paying those costs.
The graph above demonstrates that scenario showing our constant marginal costs until we hit the set capacity we have (Qcap), since we are profit maximising out first price will be at P* however we only sell Q* quantity. We can then use second-degree price discrimination and put our price to match that of point A where we fill up the entire plane.
Examples of second-degree price competition include last minute tickets and are a lot more common than first-degree price discrimination.
Third-Degree Price Discrimination
Third-degree price discrimination involves charging different groups, different prices. This is common with age, for example kids tickets may be cheaper than adult ones. Firms may also target people based on elasticities; this is common with train travel at peak times where demand is more inelastic as people have to get to work hence rail companies can charge more.
In order for firms to be able to do this it is crucial that they have the correct market and consumer information or else they will lose revenue and potential market share.
The peak times scenario is demonstrated above, we can see that average costs are the same across all time however the elasticities of the demand curves differ depending on whether it is peak times of not. Firms are able to use these strategies to maximise profits.
Pros and Cons of Price Discrimination
Price discrimination has some pros; however, the severity of the cons greatly outweigh the pros as can be seen:
Cons:
Allocative Inefficiency – Price discrimination is not allocatively efficient, which reduces the welfare of society as not all resources are used as best as possible.
Anti-Competitive Pricing – This sort of pricing strategy may under cut other firms when price is more elastic giving the firm using price discrimination techniques an advantage which could lead to getting more market share.
Pros:
Dynamic Efficiency – It can be argued that since firms are generating greater profits, they can be dynamically efficient by re-investing that money to develop more cost-effective means of production or increasing their product range which could benefit consumers in the long-run.
Some Consumers Benefit – Some consumers benefit from the price decrease however not all!
Cross Subsidisation - Firms can use the extra profit to cross subside a good or service that may be making a loss.
References/ Further Reading:
Price Discrimination – Wikipedia - https://en.wikipedia.org/wiki/Price_discrimination