Monopoly - Price Discrimination

What is price discrimination?

Price discrimination happens when a firm charges a different price to different groups of consumers for an identical good or service, for reasons not associated with costs of supply.

Price discrimination takes us away from the standard assumption in that there is a single profit-maximising price for the same good or services.

Make sure you have at least one applied example of each type of price discrimination in your notes. Nearly all businesses make use of dynamic pricing methods where prices are heavily determined by the strength of demand and consumers’ willingness & ability to pay. Price discrimination is also known as yield management.

Test your understanding with this past exam multiple choice question!

What are the main types of price discrimination?

1st degree: Charging different prices for each individual unit purchased – where people pay their own individual willingness to pay

2nd degree: Prices varying by quantity sold such as bulk purchase discounts. Prices varying by time of purchase such as peak-time prices

3rd degree: Charging different prices to groups of consumers segmented by the coefficient of price elasticity of demand, income, age, sex

What are the main conditions required for a business to use price discrimination?

1. Firms must have sufficient monopoly power: Monopolists always have pricing power – they are price makers not takers
2. Identifying different market segments: There must be groups of consumers with different price elasticities of demand
3. Ability to separate different groups: Requires information on the purchasing behaviour of consumers – often achieved by accumulating data on previous buying patterns
4. Ability to prevent re-sale (arbitrage): No secondary markets where arbitrage can take place at intermediate prices - limiting sales might be done by using age-restrictions, ID cards and so on

Price discrimination does not happen in perfectly competitive markets. It is only a feature of imperfect competition where firms have some discretion / power over the prices they charge.

What are the main aims of price discrimination?

Providing that extra units can be sold for a price above the marginal cost of supply, price discrimination is an effective way to increase revenue and profits

1. To increase total revenue by extracting consumer surplus and turning it into producer surplus
2. To increase total profit providing the marginal profit from selling to customers is positive
3. To generate cash-flow especially during a recession
4. To increase market share and build customer loyalty
5. To make more efficient use of a firm’s spare capacity
6. To reduce waste and cut the cost of keeping products in stock / storage

What are the main advantages from price discrimination?

1. It makes fuller use of spare capacity leading to less waste and unsold stock. There are potential environmental benefits from this.
2. Helps generate extra cash flow for businesses which can ensure survival during a recession / tough economic times.
3. Can help fund the cross-subsidy of goods and services – for example premium prices for some can fund discounts for other groups perhaps living on lower incomes.
4. Higher monopoly profits can finance research and development spending which then drives improved dynamic efficiency.

What are some disadvantages from price discrimination?

1. Price discrimination operates mainly in the interests of producers as they extract consumer surplus and turn it into extra supernormal profit
2. Can be used as a pricing tactic to reduce competition and reinforce the market dominance of leading firms
3. May lead to manipulation of groups with a price inelastic demand, not all of whom are on high incomes
4. Can be viewed as unfair to certain groups, for example there is some evidence of businesses using gender pricing on selected products