Definition
  • Price Discrimination according to Barron's Educational Series is, "Charging a different price for a different product or to a different buyer without any true cost differential to justify the different price" (2000).
  • 1st Degree Price Discrimination follows the definition above but is charging a different price based on the customer.
  • 2nd Degree Price Discrimination is charging a different price based on quantity sold.
  • 3rd Degree Price Discrimination is charging a different price based on location of customer segment.

1st Degree Price Discrimination
This type of discrimination, also known as perfect price discrimination, essentially states the company charges the consumer the maximum price that individual is willing to pay for that product. This extracts all the consumer surplus and earns the firms the highest possible profits. This method of discrimintation is also one of the most difficult to adopt because it requires the company knows each of its customers perfectly at each level of consumption (Baye, 2006). This can best be seen in car dealers, where the price on the car is negotiable, and the dealers job is to get the most out of the consumer as possible, the consumer surplus will be 0. In some cultures, bargaining for goods and services, i.e., first degree price discrimination is the norm. In others, first degree discrimination is much less prevalent and consumers are more used to prices which are not negotiable. The aim of first degree price discrimination is for the firm to appropriate the entire consumer surplus (see fig. 1,2, and 3).

Figure 1
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Figure 2
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Figure 3
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Examples of 1st degree price discriminators:
Car dealerships mechanics, doctors, and lawyers (service related business).

2nd Degree Price Discrimination
In this type of discrimination the companies are actually not able to differentiate between the different types of consumers. This practice creates a schedule of declining prices for different quantities. Using this strategy the company can extract some of the consumer surplus without knowing much about the individual consumer. The consumer chooses the amount of product they wish to consume with the posted prices, and this allows consumers to differentiate themselves according to preference. This type of discrimination can easily be seen in the bulk purchases of large consumers like Walmart, who in turn pass the savings onto the eventual consumer. This can also be seen in quantity discounts, the more you purchase the more you save. A family pack of soap powder or biscuits tends to cost less per kg than smaller packs. This of course discriminates against people living alone, often pensioners and students. In some supermarkets the price per kg of product is listed, which helps the customer by providing information on which to base decisions on.

Figure 4

Figure_4.jpg

Examples of 2nd degree price discriminators:
Electric utilities, cable companies, water & sewage companies, trash collection.

3rd Degree Price Discrimination
This type of price discimination, is based around the idea that the firm sets prices that will accomodate the consumer. The firms know broad demographics about the particular types of consumers they will supply, and charge prices such that everyone will be able to consume the product. In order for this form of discrimination to work the firm must be able to predict the elasticity of demand in various consumers. This type of discrimination can be seen in the movie theater business. Student and senior discounts are given because these groups of consumers have more elastic price elasticity of demand. It is because of this discrimination that the firm is able to extract the consumer surplus of those who might not otherwise pay the standard rate. Third degree price discrimination relies on the firm being able to separate the segments. If separation of segments is not possible then the product can be transferred.

The example below shows the total market for public transport journeys before 9.00am. The total market demand (Dm) is the sum of the demand of two segments, adults (Da) and students (Ds). For adults the price of a bus ticket is only a small part of their income and this means that their demand (Da) is more inelastic than that of students for whom a bus ticket is a larger part of their income, (see the determinants of elasticity).

In fig. 3 the firm we once again decides on their output by equating MC with MR. However there is not just one price. By drawing a horizontal line through the MC=MR point until it intersects with the MR curves for adults and students and then reading the price off the respective demand curves Da and Dr the price in each segment is determined, Pa and Pr. Not surprisingly the price in the adult market is higher.

Figure 5
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This discrimination allows the firm to appropriate more, but not all, of the consumer surplus, fig. 6.

Figure 6
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Firms can often segment the market by charging different amounts for providing the product or service at different times, e.g. Weekend rail fares. The firm can also change the basic product in some way, for example offering faster check-in for flights, slightly more legroom and complimentary drinks. These firms can also segment markets by location, selling in different places at different prices, car sales are an example of this. Car prices tend to be different in different countries and these differences in prices cannot always be explained away.

Examples of 3rd degree price discriminators:
Wall street journal (student pricing), movie theaters (student & senior discounts), hotels (senior discounts).

Benefits and costs of price discrimination

These of course depend on whether you are the firm or the consumer. Price discrimination means that consumer surplus can be appropriated, and as long as the cost of the marketing scheme (adverts, identity cards, ticket inspectors etc.) is less than the extra revenue the scheme brings in then it is advantageous to the firm. At first sight it would seem the loser is the consumer. But a second examination reveals that students are gaining, they pay less than if there was a single market price. But an even deeper examination shows how adults might gain. If by price discriminating the firm can increase output substantially, the average costs may fall because of economies of scale. These economies may even outweigh the price difference between adults and students. In conclusion, it is necessary to look at price discrimination on a case-by-case basis.


Multiple Choice Questions:
1) Suppose a profit maximizing monopolist is able to engage in perfect price discrimination (meaning that each unit is sold at a price equal to it marginal value) and faces a demand curve for its products given by Q=20-0.05P. This monopolis has a total cost function of TC=24+4Q. How much will this monopolist's profits be?

a.) $138
b.) $106
c.) $276
d.) $300
e.) $324
Solution: A firm able to engage in perfect price discrimination will attempt to capture all available surplus, so it will set Q to where P=MC. The producer surplus is equal to the area between the demand curve and MC curve from Q=0 to 18, this area is 324. Profit is Producer surplus - FC (fixed costs are 24), so the profit is $300. Answer: d.

2) Perfect price discrimination means that a firm charge:
a) The maximum amount that buyers are willing to pay for each unit.
b) Different prices to people of different racial or ethnic backgrounds.
c) Different prices to different groups of buyers.
d) One single price—the maximum possible—to all of its buyers.
Solution: Perfect price discrimination occurs when a firm charges the maximum amount that buyers are willing to pay for each unit. (a)

3) If an economist says that firm practices price discrimination, that firm is:
a) Exploiting the poor.
b) Charging different prices for the same good or service.
c) Making great efforts to keep its costs as low as possible.
d) Producing two products, one with decreasing returns to scale and the other with increasing returns
Solution: b.

4) If a firm charges customers $ 200 per unit of the first unit purchased, and $160 per unit for each additional unit purchased in excess of one unit. Then, what is the economic term of this strategy?
a) First-degree price discrimination
b) Profit maximization pricing
c) Second-degree price discrimination
d) Third -degree price discrimination
Solution: Second degree price discrimination (c) because second-degree price discrimination involves charging different prices for different quantities.


References
  1. "price discrimination." Dictionary of Marketing Terms. Barron's Educational Series, Inc, 2000. Answers.com 20 Feb. 2007. http://www.answers.com/topic/price-discrimination.
  2. "price discrimination." Wikipedia. Wikipedia, 2007. Wikipedia 20 Feb. 2007. <http://en.wikipedia.org/wiki/Price_discrimination>
  3. Baye, Michael. Managerial Economics and Business Strategy. 2006.
  4. http://www.cr1.dircon.co.uk/TB/2/monopoly/pricediscrimination.htm
  5. http://www.econ.ucsb.edu/~xhu/quiz3_solutions.pdf
  6. http://grader.wps.prenhall.com/grader/grader