Author: Geoff Riley Last updated: Sunday 23 September, 2012
Introduction to price discrimination
In our study of the theory of the firm we have assumed so far that a business charges a single price for its products, naturally the reality is different!
Most businesses charge different prices to different groups of consumers for the same good or service! Businesses could make more money if they treated everyone as individuals and charged them the price they are willing to pay. But doing this involves a cost – so they have to find the right pricing strategy for each part of the market they serve – their revenues should rise, but marketing costs will also increase.
It is important that you understand what price discrimination is, the conditions required for it to happen and also some of the economic and social consequences of this type of pricing tactic.
What is price discrimination?
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.
It is important to stress that 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 because of actual or perceived differences in the quality or performance of a good or service.
Conditions necessary for price discrimination to work
Essentially there are two 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” – a process whereby 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 such as Microsoft often offer heavy price discounts for educational users. Office 2007 for example was made available at a 90% discount for students in the summer of 2009. But educational purchasers must provide evidence that they are students
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.
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. 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)
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.
Third Degree (Multi-Market) Price Discrimination
This is the most frequently found form of price discrimination and involves charging different prices for the same product in different segments of the market.
The key is that third degree discrimination is linked directly to consumers’ willingness and ability to pay for a good or service. It means that the prices charged may bear little or no relation to the cost of production.
The market is usually separated in two ways: by time or by geography. For example, exporters may charge a higher price in overseas markets if demand is estimated to be more inelastic than it is in home markets.
In the peak market the firm will produce where MRa = MC and charge price Pa, and in the off-peak market the firm will produce where MRb = MC and charge price Pb. Consumers with an inelastic demand will pay a higher price (Pa) than those with an elastic demand who will be charged Pb.
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.
A fixed fee is charged + a supplementary “variable” charge based on units consumed.
Examples: taxi fares, amusement park charges
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.
Examples: 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”.
Consequences of Price Discrimination
Who gains and who loses out from persistent and pervasive price targeting by businesses? To what extent does price discrimination help to achieve an efficient allocation of resources? There are many arguments on both sides of the coin – indeed the impact of price discrimination on welfare seems bound to be ambiguous.
Impact on consumer welfare
Consumer surplus is reduced in most cases - representing a loss of welfare.
For the majority of buyers, the price charged is well above the marginal cost of supply.
However some consumers who can now buy the product at a lower price may benefit. Lower-income consumers may be “priced into the market” if the supplier is willing and able to charge them less.
Examples might include legal and medical services where charges are dependent on income levels.
Greater access to these services may yield external benefits (positive externalities) improving social welfare and equity. Drugs companies might justify selling products at inflated prices in higher-income countries because they can then sell the same drugs to patients in poorer countries.
Producer surplus and the use of profit
Price discrimination benefits businesses through higher revenues and profits.
A discriminating monopoly is extracting consumer surplus and turning it into supernormal profit.
Price discrimination also might be used as a predatory pricing tactic to harm competition at the supplier’s level and increase a firm’s market power.
A counter argument is that price discrimination might be a way of making a market more contestable.
Low cost airlines have been hugely successful by using price discrimination to fill their planes.
Profits made in one market may allow firms to cross-subsidise loss-making activities/services that have important social benefits. For example money made on commuter rail or bus services may allow transport companies to support loss-making rural or night-time services. Without the ability to price discriminate, these services may have to be withdrawn and jobs might suffer.
In many cases, aggressive price discrimination is a means of business survival during a recession. An increase in total output resulting from selling extra units at a lower price might help a monopoly to exploit economies of scale thereby reducing long run average costs.