Price discrimination occurs when a business charges a different price to different groups of consumers for the same good or service, for reasons not associated with costs.
Examples of price discrimination
(a) Perfect Price Discrimination – or charging whatever the market will bear
Sometimes known as optimal pricing, with perfect price discrimination, the firm separates the market into each individual consumer and charges them the price they are willing and able to pay. If successful, the firm can extract the entire consumer surplus that lies underneath the demand curve and turn it into extra revenue or producer surplus. This is hard to achieve unless a business has full information on every consumer’s individual preferences and willingness to pay. The transactions costs involved in finding out through market research what each buyer is prepared to pay is the main barrier to a businesses engaging in this form of price discrimination.
If the monopolist can perfectly segment the market, then the average revenue curve becomes the marginal revenue curve for the firm. The monopolist will continue to sell extra units as long as the extra revenue exceeds the marginal cost of production.
In reality, most suppliers and consumers prefer to work with price lists and menus from which trade can take place rather than having to negotiate a price for each unit bought and sold.
Second Degree Price Discrimination
This involves businesses selling off packages or blocks of a product deemed to be surplus capacity at lower prices than the previously published or advertised price. Price tends to fall as the quantity bought increases.
Examples of this can be found in the hotel industry where spare rooms are sold on a last minute standby basis. In these types of industry, the fixed costs of production are high. At the same time the marginal or variable costs are small and predictable. If there are unsold rooms, it is often in the hotel’s best interest to offload any spare capacity at a discount prices, providing that the cheaper price that adds to revenue at least covers the marginal cost of each unit.
There is nearly always some supplementary profit to be made from this strategy. Firms may be quite happy to accept a smaller profit margin if it means that they manage to steal an advantage on their rival firms.
Early-bird discounts – extra cash flow
Customers booking early with carriers such as EasyJet or RyanAir will normally find lower prices if they are prepared to book early. This gives the airline the advantage of knowing how full their flights are likely to be and is a source of cash flow prior to the flight taking off. Closer to the time of the scheduled service the price rises, on the justification that consumer’s demand for a flight becomes inelastic. People who book late often regard travel to their intended destination as a necessity and they are likely to be willing and able to pay a much higher price.
Peak and Off-Peak Pricing
Peak and off-peak pricing and is common in the telecommunications industry, leisure retailing and in the travel sector. For example, telephone and electricity companies separate markets by time: There are three rates for telephone calls: a daytime peak rate, and an off peak evening rate and a cheaper weekend rate. Electricity suppliers also offer cheaper off-peak electricity during the night.
At off-peak times, there is plenty of spare capacity and marginal costs of production are low (the supply curve is elastic) whereas at peak times when demand is high, short run supply becomes relatively inelastic as the supplier reaches capacity constraints. A combination of higher demand and rising costs forces up the profit maximising price.
The internet and price discrimination
The rapid expansion of e-commerce using the internet is giving manufacturers unprecedented opportunities to experiment with different forms of price discrimination. Consumers on the net often provide suppliers with a huge amount of information about themselves and their buying habits that then give sellers scope for discriminatory pricing. For example Dell Computer charges different prices for the same computer on its web pages, depending on whether the buyer is a state or local government, or a small business.
Two Part Pricing Tariffs
Another pricing policy is to set a two-part tariff for consumers. A fixed fee is charged and then a supplementary “variable” charge based on the number of units consumed. There are plenty of examples of this including taxi fares, amusement park entrance charges and the fixed charges set by the utilities (gas, water and electricity). Price discrimination can come from varying the fixed charge to different segments of the market and in varying the charges on marginal units consumed (e.g. discrimination by time).
Product line pricing occurs when there are many closely connected complementary products that consumers may be enticed to buy. It is frequently observed that a producer may manufacture many related products. They may choose to charge one low price for the core product (accepting a lower mark-up or profit on cost) as a means of attracting customers to the components / accessories that have a much higher mark-up or profit margin.
Good examples include manufacturers of cars, cameras, razors and games consoles. Indeed discriminatory pricing techniques may take the form of offering the core product as a “loss-leader” (i.e. priced below average cost) to induce consumers to then buy the complementary products once they have been “captured”. Consider the cost of computer games consoles or Mach3 Razors contrasted with the prices of the games software and the replacement blades!