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
Charging different prices for similar goods is not pure price discrimination
Product differentiation gives a supplier greater control over price and the potential to charge consumers a premium price arising from differences in the quality or performance of a product
Conditions necessary for price discrimination to work
Here are the
main conditions required for discriminatory pricing:
Differences in price elasticity of demand: There must be a different price elasticity of demand for each group of consumers. The firm is then able to charge a higher price to the group with a more price inelastic demand and a lower price to the group with a more elastic demand. By adopting such a strategy, the firm can increase total revenue and profits (i.e. achieve a higher level of producer surplus). To profit maximise, the firm will seek to set marginal revenue = to marginal cost in each separate (segmented) market.
Barriers to prevent consumers switching from one supplier to another: The firm must be able to prevent "consumer switching" – i.e. consumers who have purchased a product at a lower price are able to re-sell it to those consumers who would have otherwise paid the expensive price.
This can be done in a number of ways, – and is probably easier to achieve with the provision of a
unique service such as a haircut, dental treatment or a consultation with a doctor rather than with the exchange of tangible goods such as a meal in a restaurant.
Switching might be prevented by selling a product to consumers at unique moments in time – for example with the use of airline tickets for a specific flight that cannot be resold under any circumstances or cheaper rail tickets that are valid for a specific rail service.
Software businesses often offer heavy price discounts for educational users providing they give an academic email address
Students may be required to show proof of identification using secure ID cards
Price discrimination is easier when there are
separate and distinct markets for a firm's products and when price elasticity of demand varies from one group of consumers to another
Perfect price discrimination
Perfect Price Discrimination is 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 business's 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.
A 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 low and predictable.
If there are unsold rooms, it is in the hotel's best interest to offload spare capacity at a discount prices, providing that the extra evenue at least covers the marginal cost of each unit.
There is nearly always some supplementary profit to be made. 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.
Marginal Revolution video on an introduction to price discrimination
Early-bird discounts – generating extra cash flow for a business
booking early with airline 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)
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.
Geoff Riley FRSA has been teaching Economics for nearly thirty years. He has twenty years experience as Head of Economics at leading schools. He writes extensively and is a contributor and presenter on CPD conferences in the UK and overseas.