Price Discrimination

Price discrimination
Price discrimination is the practice of charging a different price for the

same good or service. There are three types of price discrimination – first-
degree, second-degree, and third-degree price discrimination.
First degree
First-degree price discrimination, alternatively known as perfect price

discrimination, occurs when a firm charges a different price for every unit
consumed.
The firm is able to charge the maximum possible price for each unit which
enables the firm to capture all available consumer surplus for itself. In
practice, first-degree discrimination is rare.
Second degree
Second-degree price discrimination means charging a different price for

different quantities, such as quantity discounts for bulk purchases.
Third degree
Third-degree price discrimination means charging a different price to

different consumer groups. For example, rail and tube travellers can be
subdivided into commuter and casual travellers, and cinema goers can
subdivide into adults and children. Splitting the market into peak and off-
peak use is very common and occurs with gas, electricity, and telephone
supply, as well as gym membership and parking charges. Third-degree
discrimination is the commonest type.
Necessary conditions for successful discrimination
Price discrimination can only occur if certain conditions are met.
1. The firm must be able to identify different market segments, such as

domestic users and industrial users.
2. Different segments must have different price elasticities (PEDs).
3. Markets must be kept separate, either by time, physical distance

and nature of use, such as Microsoft Office ‘Schools’ edition which is
only available to educational institutions, at a lower price. Time
based pricing – also called dynamic pricing – is increasingly common
in goods and services sold online. In this case, prices can vary by
the second, based on real-time demand related to consumers’
online activity.
4. There must be no seepage between the two markets, which means

that a consumer cannot purchase at the low price in the elastic sub-
market, and then re-sell to other consumers in the inelastic sub-
market, at a higher price.
5. The firm must have some degree of monopoly power.
Diagram for price discrimination
If we assume marginal cost (MC) is constant across all markets, whether

the market is divided, it will equal average total cost (ATC). Profit
maximisation will occur at the price and output where MC = MR. If the
market can be separated, the price and output in the relatively inelastic
sub-market will be P and Q and P1 and Q1 in the relatively elastic sub-
market.
When the markets are separated, profits will be the area MC, P,X,Y +
MC1,P1,X1,Y1. If the market cannot be separated, and the two submarkets
are combined, profits will be the area MC2,P2,X2,Y2.
If the profit from separating the sub-markets is greater than for combining
the sub-markets, then the rational profit maximizing monopolist will price
discriminate.
Market separation and elasticity
Discrimination is only worth undertaking if the profit from separating the

markets is greater than from keeping the markets combined, and this will
depend upon the relative elasticities of demand in the sub-markets.
Consumers in the relatively inelastic sub-market will be charged the
higher price, and those in the relatively elastic sub-market will be charged
the lower price.
Costs of separation
The effectiveness of price discrimination will be weakened if the costs of

preventing seepage are significant, and reduce the profits accruing from
discrimination. For example, it might be necessary to introduce costly
monitoring and enforcement systems to ensure that consumers do not
break any conditions of sale which exist to keep markets separate.
Employing ticket inspectors or other security systems adds to the cost of
preventing seepage in public transport.
Note
In the above example we are assuming that the price at which consumers
in the relatively elastic sub-market (students, for example, looking to
travel into a major city) are prepared to enter the market is lower than
those in the relatively inelastic sub-market (commuters, for example). This
gives the combined demand (AR) curve an outward kink, and the
combined MR curve a discontinuous portion (indicated by the vertical
dotted line.) If, however, both types of consumers are prepared to enter
the market at the higher price than the combined demand (AR) curve is
simply shifted further to the right, and will not have the kink. This is
illustrated in the diagram below:
In all cases it should be noted that that profit maximisation must occur
where MC = MR. This means that profit maximising equilibrium for the
discriminating monopolist must occur where MR is positive, which means
that, irrespective of the gradient of the demand curves in the submarkets,
the price will always be set in the elastic portion of the demand curve
(individually, and when combined).
Evaluation of price discrimination
Advantages
From the firm’s perspective
From a firm’s perspective price discrimination can offer many advantages,

making it one of the commonest pricing strategies used by local, national
and global companies. Benefits to firms include:
Profit maximisation
Firstly, matching prices to the specific characteristics of the market, and

its various segments, is a profit maximising strategy (see above), where
the firm can extract some (or even all) of the consumer surplus available
in the market, and turn it into producer surplus (i.e. profits).
Economies of scale
Given that charging different prices can increase sales volume, especially
as a result of new consumers entering the market, attracted in by the
discounted prices, firms can benefit from the economies of scale which
arise from increased output and production.
Efficient use of infrastructure
Price discrimination can benefit firms with high fixed costs associated with
the building of infrastructure, and its maintenance. This includes natural
monopolies such as gas, electricity supply, and transport services. For
example, having more passengers on a train that is going to run anyway
provides additional revenue to the train operators. This revenue may be
used to add to profits (given that the marginal cost of one extra passenger
is virtually zero) or to cover new fixed costs, such as track or safety
improvements.
Better use of space
Similarly, price discrimination may also enable manufacturing and retail

firms to clear their existing stocks quickly when required – hence making
better use of their shop or factory space.
Managing the flow customers

Price discrimination according to the time of day means that the flow of
customers into retail stores can be managed more effectively, which
might provide a better experience for shoppers and spread out the work
for staff. For example, having a ‘happy hour’ or ‘early bird’ prices may
encourage shoppers to adjust their shopping times so that queues are
shortened at more peak times, as well as ensuring that staff are better
employed throughout the day.
Understanding the market
Firms may wish to trial new products in different locations, and may match
their prices to the specific demand conditions found in those local
markets. Also, firms can offer discounts in order to get consumer feedback
on these trialled products, and on existing ones.
Similarly, price discrimination may enable firms sell to export markets,

basing their prices on what consumers are prepared to pay in each
territory – which can vary considerably from country to country. From a
macro-economic perspective, international trade is likely to be created by
price discrimination.
Enables survival
As a result of generating additional revenue, price discrimination can

enable firms to survive. For example, small cinemas might be better able
to survive if they can offer low priced off-peak cinema tickets to the over-
65s for day-time screenings.
From the consumer’s perspective
Possibility of lower prices
From the consumer’s point of view, some, especially those in the highly
elastic sub-market, may gain consumer surplus as a result of lower prices.
Lower prices could also result from the application of scale economies (as
above).
Benefits to groups of consumers
If we look specifically at goods and services consumed by children, but

where adults are needed to accompany them, it can be argued that
charging children a much lower price enables families as a whole to
benefit, and gain increased group utility. For example, if cinemas or theme
parks set low prices for children (or even zero price for those under a
certain age), or offer with family discounts, more parents will be able to
attend, and accompany their children. This means that, in the longer term,
cinema chains and theme parks will increase their revenue and profits.
The same logic can be applied to travel and holidays, with child and family
discounts encouraging demand and helping generate revenue.
Enables flexibility
Having different prices may enable consumers to match their purchasing

and shopping to their own free time. For example, ‘early bird’ prices can
benefit individuals who are retired, or who work flexible hours.
Generating positive externalities
We can extend the analysis to consider the role of price discrimination in

reducing market failure, such as enabling wider consumption of merit
goods. For example, if ‘private’ schools charge relatively high tuition fees
for those who can afford them, and where demand is inelastic, the
revenue generated allows them to cover their costs and run classes. With
fixed costs covered, they can then offer places at discounted fees (to
cover the variable costs only) to those who cannot afford them. Given that
the demand for private education by less well-off parents is likely to be
price (fee) elastic, the lower price will encourage greater demand. The
benefit to ‘society’ is that more education is ‘consumed’ and more positive
externalities generated.
Survival
Consumers can also gain from the fact that firms can more easily survive,
so that future generations can derived continued benefit.
Disadvantages
Exploitation of captive markets
However, it could be argued that consumers in a captive sub-market are

being unduly exploited due to their inelasticity. This is especially relevant
when we look at transport, and the high ticket prices charged for peak
travel, compared with off-peak. The same could be said for energy prices,
where existing and loyal customers often pay higher prices, which
subsidises the discounts available to ‘new’ customers.
Limitations
Ultimately, the ability to price discriminate may be limited because the

conditions necessary are not fully met. In other words, there are limits on
the extent to which different prices can be applied.
Conclusion
Clearly, with global commodities, world markets tend to settle on one

price at any one time, given the process of arbitrage.
The growth of new trading and selling technologies, apps, online auction
bidding, and price comparison websites mean that consumers have
increasing information, which may reduce the possibility of price
discrimination. However, the widespread use of dynamic pricing
models by online sellers means that time-based pricing in increasingly
common.
So, at one extreme, price discrimination is still highly possible with locally
provided services, and where technology can provide flexible pricing,
while at the other, globally traded commodities are subject to the ‘law of
one price’, where price differences are very quickly eroded away.
Manufactured and branded goods fall somewhere between these two
extremes, with price discrimination possible – especially in terms of new
online pricing models – but where price differences may also be eroded
through technology, trade and arbitrage.
The effects of arbitrage
Arbitrage is a process where traders, acting as either buyers or sellers,

can exploit price differences for identical products – buying where the
price is lower and selling where it is higher.
The effect of this is to make prices converge, given the different effects of
buying and selling in the market.

Price Discrimination

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Price discrimination

Price discrimination is the practice of charging a different price for the

First-degree price discrimination, alternatively known as perfect price

Second-degree price discrimination means charging a different price for

Third-degree price discrimination means charging a different price to

Necessary conditions for successful discrimination

Price discrimination can only occur if certain conditions are met.

1. The firm must be able to identify different market segments, such as

2. Different segments must have different price elasticities (PEDs).

3. Markets must be kept separate, either by time, physical distance

4. There must be no seepage between the two markets, which means

5. The firm must have some degree of monopoly power.

Diagram for price discrimination

If we assume marginal cost (MC) is constant across all markets, whether

Market separation and elasticity

Discrimination is only worth undertaking if the profit from separating the

The effectiveness of price discrimination will be weakened if the costs of

Evaluation of price discrimination

From the firm’s perspective

From a firm’s perspective price discrimination can offer many advantages,

Firstly, matching prices to the specific characteristics of the market, and

Efficient use of infrastructure

Better use of space

Similarly, price discrimination may also enable manufacturing and retail

Managing the flow customers

Understanding the market

Similarly, price discrimination may enable firms sell to export markets,

As a result of generating additional revenue, price discrimination can

From the consumer’s perspective

Possibility of lower prices

Benefits to groups of consumers

If we look specifically at goods and services consumed by children, but

Having different prices may enable consumers to match their purchasing

Generating positive externalities

We can extend the analysis to consider the role of price discrimination in

Exploitation of captive markets

However, it could be argued that consumers in a captive sub-market are

Ultimately, the ability to price discriminate may be limited because the

Clearly, with global commodities, world markets tend to settle on one

The effects of arbitrage

Arbitrage is a process where traders, acting as either buyers or sellers,

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