Price Discrimination

A-level Economics

Fair or unfair?

Definition: when firms charge different prices to different customers for the same product.

[It must be the SAME product]

The conditions:

1. First must have price making power, therefore barriers to entry likely to exist

2. Firms should be able to identify and separate different groups of customers by understanding their PEDs.

3. No seepage – when customers can buy at a lower price from the firm and re-sell it themselves

Examples of price discrimination

• Train tickets: same train service at different time of the day attracts easily over 3x the price (rush hour)

• Student discounts: e.g. clothes shopping or Maccies. 10% discount on exactly the same clothes. Free cheeseburger with a meal if an NUS card is shown

What does price discrimination mean for the seller?

Price discrimination allows the seller to charge different prices for the same product to different consumers.

Therefore, it allows the seller to charge higher prices to people who are more likely to pay them, and at the same time, charge lower prices for those who are more sensitive to price.

So, in the example of a train ticket to London, somebody commuting to London is likely to be travelling out of necessity in order to get to work. Train companies know this, and what they do is increase the price for those who are travelling to work at certain times of the day.

However, during the off-peak hours, where people are travelling for leisure, train companies are more relaxed and competitive with their pricing, as customers around that time are likely to be more sensitive to price.

Price discrimination transfers surplus from consumer to the producer

Surplus is a measure of welfare. Consumer surplus is a measure of consumer welfare and producer surplus is a measure of producer welfare.

Consumer surplus: defined as the difference between the current market price and the maximum price consumers are willing to pay

Producer surplus: defined as the difference between the market price and the minimum price the producer is able to sell at.

Therefore, when prices are increased by the seller, consumer surplus falls and producer surplus rises.

In fact, the surplus is transferred from the consumer to the producer.

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The 3 different kinds of price discrimination

First Degree (Perfect price discrimination)

This is when the firm knows the maximum price that each individual consumer can pay. The firm is able to charge a different price to each consumer, thereby maximising its potential to extract profit/revenue from the market.

There is no consumer surplus in the market, because everybody in the market is paying their maximum possible price.

In reality, it can’t really be done because the seller would need perfect information to achieve this.

Information can be gathered, but gathering information is very costly, which would eat into the firm’s profits – therefore, it is unlikely a firm will benefit from first degree price discrimination in reality.

Second Degree
This is often the case in wholesale markets. Discounts are provided to those who buy large quantities of a good. The more you buy, the less you pay per unit.

The price charged is based on the quantity you buy.

This encourages larger orders to be made.

Those who do not want to bulk buy, will instead pay the market price.

Third Degree

When a firm charges different prices for the same product across different segments of the market. We could segment the market by differentiating the different types of customers:

1.       Peak vs Off-peak travellers

2.       Children vs Adult pricing

3.       Adult vs Pensioner pricing

4.       Discounts for government workers

5.       Discount for Armed Forces

6.       Different prices charged in different locations (e.g. different countries)

This enables the firm to make more profit. It allows the firm to raise the price for groups with inelastic PED, and in turn reduce the price for groups with elastic PED.

Profit maximisation occurs at the point MC=MR (like always).

The supernormal profit made by each group is different – more profit is made by charging higher prices to the inelastic group.

By segmenting the market, the firm should be able to make more profit than by just charging one price.

Don’t forget, that for this all to work, the seller has to be able to prevent seepage – people who buy the product at low prices can’t sell it on to others and undercut the seller!

Good or Bad?

As mentioned earlier, profits and revenue are increased for the seller who price discriminates.

Is it good for society that the firm is making more profit?

In general, the answer would be no…

The firm makes supernormal profits at a point where price is greater than marginal cost (P>MC), therefore, allocative efficiency is not achieved.

However, let’s turn our attention to dynamic efficiency.

The argument for firms making supernormal profit is that they’re able to invest into R&D and make better products. They’re also able to invest into the production process and make production more efficient, thereby making better use of resources.

The other thing is that the firm is able to charge higher prices to people with higher incomes. For those who are less fortunate, a lower price is charged.

So, it’s a matter of perspective really – a student benefits a great deal from student discounts – it just makes life a little easier doesn’t it?

Therefore, price discrimination can redistribute income, which is good if there is income inequality in the economy.

Therefore, for these reasons, price discrimination could be a good thing (in theory).

So, in summary we have learned:

1. Price discrimination - definition and conditions

2. Different types of discrimination and diagrams

3. Efficiency arguments - is it good or bad for society?