Boundless: "Price Discrimination"

Read this section to see how monopolists can potentially use their unique place in an industry to charge different prices to different consumers – in other words, how they indulge in price discrimination.

Although there are legal concerns around monopolistic practices, price discrimination is a popular tactic for capturing consumer surplus.

LEARNING OBJECTIVE

Construct the concept of price discrimination relative to legal concerns in pricing

KEY POINTS

  • In theoretical markets there exists perfect information, no transaction costs, and perfect substitutes, and in these cases price discrimination can only exist in monopolistic or oligopolistic markets.
  • For price discrimination to take place, companies must be able to identify market segments by their price elasticity of demand, and they must be able to enforce the scheme.
  • There are four degrees of price discrimination (including reverse price discrimination), that all occur under slightly different circumstances, depending on the market structure and the company's ability to discriminate.

TERMS

  • Consumer Surplus: The monetary gain obtained by consumers because they are able to purchase a product for a price that is less than the highest price that they would be willing to pay.
  • Price Discrimination: Occurs when sales of identical goods or services are transacted at different prices from the same provider.

EXAMPLE

Airlines use several different types of price discrimination, including: bulk discounts to tour operators, incentive discounts for higher sales volumes to corporate buyers, seasonal discounts, etc. The price of a flight from Singapore to Tokyo can vary widely if one buys the ticket in Singapore compared to Tokyo (or New York or elsewhere). First degree price discrimination based on customer also occurs: it is not accidental that hotel or car rental firms may quote higher prices to their loyalty program's top tier members than to the general public.

Price Discrimination

Price discrimination is the sale of identical goods or services at different prices from the same provider. Price discrimination also occurs when the same price is charged for goods with different supply costs.

Price discrimination's effects on social efficiency are unclear; typically this behavior leads to lower prices for some consumers and higher prices for others. Output can be expanded when price discrimination is efficient, but output can decline when discrimination is more effective at extracting surplus from high-valued users than expanding sales to low valued users. Even if output remains constant, price discrimination can reduce efficiency by misallocating output among consumers.

Legal Concerns

Although price discrimination is the producer's or seller's legal attempt to charge varying prices for the same product based on consumer demand, price discrimination can be illegal in some cases. For example, it is illegal for manufacturers to set different prices for anti-competitive purposes. Beer companies during the 1960s attempted to price discriminate based on location to price below competitors and run them out of business.

Economic Rationale

In theoretical markets there exists perfect information, no transaction costs, and perfect substitutes. In these cases price discrimination can only exist in monopolistic or oligopolistic markets: otherwise, a buyer can buy the good at a lower price and sell it immediately at a slightly higher place (but lower than the price discrimination level), making a profit. In the real world, product heterogeneity, market frictions and moderate fixed costs allow for a level of price description in many markets.

Two conditions are necessary for price discrimination:

  1. Companies must be able to identify market segments by their price elasticity of demand;
  2. They must be able to enforce the scheme.

For example, airlines routinely engage in price discrimination by charging high prices for customers with relatively inelastic demand—business travelers—and discount prices for tourists who have relatively elastic demand. The airlines enforce the scheme by making the tickets non-transferable thus preventing a tourist from buying a ticket at a discounted price and selling it to a business traveler (arbitrage). Airlines must also prevent business travelers from directly buying discount tickets. Airlines accomplish this by imposing advance ticketing requirements or minimum stay requirements conditions that would be difficult for average business traveler to meet .

Third Degree Price Discrimination

Third degree price discrimination: Instead of supplying one price and taking the profit (labelled "old profit"), the total market is broken down into two sub-markets, and these are priced separately to maximize profit. For example, tourist and business airline passengers.

Types of Price Discrimination

First degree

Here, the monopoly seller knows the maximum price each individual buyer is willing to pay, allowing them to absorb the entire consumer surplus. More is produced than the non-discriminating monopoly case, and there is no deadweight loss. This is mostly a theoretical outcome.

Second degree

Price varies according to demand: larger quantities are available at a lower unit price. Unlike first degree, sellers are unable to differentiate among individual consumers, and so they provide incentives for consumers to differentiate themselves. For example, airlines differentiate according to first, business and coach passengers.

Third degree

Price varies by attributes such as location or by customer segment, or in the most extreme case, by the individual customer's identity; where the attribute in question is used as a proxy for ability/willingness to pay. Sellers are able to differentiate between different types of consumers. An example is student discounts. In third degree discrimination, it is not always advantageous to discriminate.

Fourth degree/reverse price discrimination

Prices are the same for different customers, even if organizational costs may vary. For example, a coach class airplane passenger may order a vegetarian meal. Their ticket cost is the same, but it may cost more to the airline to obtain a vegetarian meal for them.

Examples of Price Discrimination

Price discrimination is common in services where resale is not possible; an example is student discounts at museums. Price discrimination in intellectual property is also enforced by law and by technology. In the market for DVDs, DVD players are designed—by law—with chips to prevent an inexpensive copy of the DVD (for example legally purchased in India) from being used in a higher price market (like the US).

Price discrimination can also be seen where the requirement that goods be identical is relaxed. For example, so-called "premium products" (including relatively simple products, such as cappuccino compared to regular coffee) have a price differential that is not explained by the cost of production. Some economists have argued that this is a form of price discrimination exercised by providing a means for consumers to reveal their willingness to pay. For instance, Starbucks will charge more for a coffee than, say, a local cafe, even if there is no discernable difference in quality.

Source: Boundless. “Price Discrimination.” Boundless Marketing. Boundless, July 21, 2015. Retrieved Oct. 23, 2015.

Last modified: Friday, October 18, 2019, 12:40 PM