What is Price Discrimination?

Introduction

The concept of price discrimination is a well-defined notion in microeconomics. In fact, the term explains the pricing mechanism where one of the suppliers among different buyers transacts similar goods or services at differing prices. In essence, the model is applied depending on the willingness of the buyers to pay as well as their demand elasticity. Therefore, a firm sells a given quantity of goods or services at one price across the market while the suppliers offer different prices to various consumers. It is worth noting that certain conditions apply under the price discrimination theory. Firstly, the supplying firm must set the price of its commodities or services across the different market segments. Secondly, the firm must fragment the market into different groups depending on the respective demand elasticity and willingness to pay at the set prices. Finally, the supplier must ensure that the resale of the sold products in another market is prohibited. While the conditions would appear challenging to realize, price discrimination has been a common phenomenon in nearly all markets, including automobiles, movies, utilities, and airline tickets, among other areas. Therefore, it will be noted that monopolists employ the scheme of price discrimination as influenced by the price elasticity of demand and the concept of varying price discrimination as explained by first, second, and third-degree price theory and their differences in microeconomics.

First-Degree Price Discrimination

The first degree of price discrimination is also referred to as perfect price discrimination where the selling firm charges the maximum amount based on the buyer’s willingness to pay. Therefore, the supplier should determine with precision the maximum price a buyer would be willing and able to pay for the goods or the services (Escobari and Paan 4).

Therefore, as with all other kinds of price discrimination, the firm chooses an optimal point of production where marginal revenue equals the marginal cost (MR=MC). However, whenever the firm can have the buyer pay the maximum of the willingness, then the marginal revenue becomes the price as dictated by the demand curve. Accordingly, the point where the MC crosses the demand curve becomes the price at which the firm sells the product. At this point, the firm realizes no consumer surplus because all the consumers would be willing to buy the fixed price. (Bergemann and Stephen 922). Accordingly, the firm extracts all surpluses as the output amount is at the efficient level obtained at the perfect competition.

However, it is worth noting that the process would be very expensive for a firm to increase the maximum willingness to pay by all buyers. Therefore, obtaining first-degree price discrimination is challenging to realize or implement. The best example of first-degree price discrimination is witnessed through the efforts of auctioneers to establish the maximum price a consumer would be willing to pay for a product.

Second-Degree Price Discrimination

The second degree is also considered block pricing because the prices vary according to the quantities demanded. Accordingly, bulk buyers enjoy the advantage of relatively lower prices per unit bought. In essence, the second-degree pricing mechanism is often observed with industrial customers, where wholesale buyers realize higher discounts on their purchases (Weyl, Glen, and Michal 31). Another feature of second-degree price discrimination is that the sellers are not in a position to differentiate between the different consumers. Therefore, the sellers will set prices that will force the consumers to differentiate themselves according to their preferences, especially through non-linear pricing or quantity discounts (Bergemann and Stephen 922).

Accordingly, the supplier could capture a large section of the market surplus and different groups of buyers. The application of the second-degree pricing mechanism is often found in the service industry, where the quality and quantity would vary depending on consumer preferences. For example, the airline industries often apply the second-degree discrimination of prices with the different classes of travel seats (Nicholson and Christopher 23). For instance, first-class passengers enjoy more privileges such as wines and beers, while in economy class the passengers would only get juices or other cheap soft drinks.

In the second-degree price discrimination, the seller charges higher prices per unit for the fewer purchases and lower prices for the bulk purchases. In a similar manner to first-degree price discrimination, the firms adopting the second degree price discrimination concept have the production level at a point where the price charged covers all the marginal costs of the production (Bergemann and Stephen 922). The illustration below depicts a firm that charges different prices for one product (see figure 2). When the buyer decides to purchase Q₀ quantity of the product, then the price becomes P₀. Similarly, a higher quantity, such as in Q_1, would attract a much lower price than at P1, hence depicting the second-degree price discrimination.

The diagram shows the dimensions of the second-degree discrimination of prices as studied in microeconomics.

Fig.2: Second-degree Price Discrimination

Third-Degree Price Discrimination

The third type of price discrimination is unique in its ability to fragment the market into separate divisions with each market being defined by unique demand characteristics. Therefore, some of the markets would be least in the concept of price sensitivity (otherwise considered price inelastic) as compared to other markets where the quantity demanded depends more on the price changes (price elastic) (Cowan 334). At times, the firm could decide on setting the price at P₁ and selling Q₁ quantity in one market and then lowering prices at ‘P₂‘ for the sale of Q₂ in the second market; thus, the company would realize higher profits than selling at a single price P* (see Figure 3).

Fig. 3: Third-degree price discrimination

Firms are known to apply third-degree price discrimination to ensure that third parties do not interfere with the pricing mechanisms (O’Brien 92). Accordingly, the different markets would have to remain different and separate. Indeed, third-degree price discrimination is also known to be the most frequent pricing mechanism related to the consumer’s willingness and ability to pay for services and goods. However, the prices charged to the production units fail to relate to the costs incurred in the production process, as in the case of other kinds of price discrimination (Liu and Konstantinos 770). The market’s geographical location and time changes are often embedded in the third-degree discrimination of prices. For instance, when exporters sell products to overseas markets considered more inelastic, the prices charged may be higher than those in the local markets.

Another way in which third-degree price discrimination is illustrated is through setting a two-part tariff policy for the consumers (Cowan 334). As such, the firm defines a fixed price while a variable price is imposed on the units consumed. Particularly, practical examples of such two-part tariffs are noticeable in the amusement park charges and taxi fares. Similarly, discrimination would occur by varying the fixed charges set for the different market segments served and then varying the prices of the marginal units bought.

The Relationship Between Prices Set by the Monopolist and Price Elasticities of Demand

Among other conditions that are set to allow discrimination regarding prices are the differences in the demand’s price elasticity. Accordingly, every group of consumers would be expected to possess different demand price elasticity. Therefore, the monopolist sets the price at the highest level for the firm, which indicates a more inelastic demand while charging relatively lower prices to the groups possessing a more elastic demand (Zhelobodko et al. 2765). Price discrimination aims to allow the firm to realize the highest profit levels while increasing total revenues and lowering production costs. In fact, such an objective is realized when the firm achieves a higher level of surplus as a producer. Besides, the firm ensures that the marginal revenue is set at the same level as the marginal cost for every market segment to maximize profits.

By definition, “price elasticity of demand” (PED) is an economic measure that indicates the responsiveness of quantities of goods or services to changes in the respective prices at ceteris paribus (Fitzgerald and Stefanie 762). Therefore, the value gives the percentage change in the quantities demanded while responding to a percentage change in the prices. It is worth noting that negative signs denote price elasticity, although analysts might overlook the negative symbol. However, for the case of such commodities as the “Giffen” goods, the price elasticity recorded would be positive as the kinds of products do not conform to the law of demand (Fitzgerald and Stefanie 762). In essence, the price elasticity of demand is of great importance while determining the effects of changing prices on the quantities demanded in particular market segments. Furthermore, price elasticity determines the revenues collected by firms after applying price changes.

It is worth noting that the price elasticity of Demand (PED) can be classified as inelastic, elastic, perfectly inelastic, and perfectly elastic. For the elastic PED, the coefficient calculated is less than one. Indeed, when the coefficient is greater than one, the PED is said to be elastic. On the other hand, a zero coefficient indicates a perfectly inelastic PED, while an infinite coefficient indicates a perfectly elastic PED (Zhelobodko et al. 2765). Consequently, the importance of the PED measure in monopolistic markets is that it indicates the connection between prices and average revenues, marginal revenues, and total revenues, as well as the average revenue and marginal revenue. Moreover, the PED explains the reaction of the total revenue as output levels rise.

Monopolist Markets

In a monopolistic market structure, the firms utilize product differentiation as a strategy to gain control of the market by adjusting the market prices. Specifically, the behavior of the monopolistic market can be understood by comparing it with the operations in a perfectly competitive market. In fact, a monopolistic market structure resembles what would be considered a vertical adaptation of the perfect competition market (Tucker 15). The explanation indicates that while a perfectly competitive market depends on elastic demand, the monopolistic market relies much on a less elastic PED. However, a monopoly has the primary advantage of operating as the only controller on the market. Accordingly, the prices set by monopolists have a critical relation with the price elasticity of demand. While some market segments serve to indicate higher rates of responsiveness to changes in prices, there are other marketplaces that indicate minimal or no response at all (Tucker 15). However, one would appreciate that the levels of quantities demanded would be influenced by the respective changes in the corresponding prices. Therefore, when the monopolist applies third-degree price discrimination by segmenting the industry, one market structure will likely realize higher quantities in sales while another will realize higher revenues. In essence, the monopolist would be influenced by the rate of responsiveness indicated by the consumers to price changes in determining the willingness and ability to pay for the commodities. Under those premises, the third parties are not allowed to interfere with the determination of price elasticity of demand and therefore have no influence on the prices set.

Conclusion

Overall, macroeconomics highlights and clearly indicates the major elements distinguishing first, second, and third-degree price discrimination. Essentially, the common feature of the concept of price discrimination is the ability of the firm to charge different prices for similar goods and services to different buyers as influenced by the consumers’ willingness and ability to pay. However, the price feature in third-degree price discrimination depends on the price elasticity of demand. At times, the determined coefficient in PED would be termed elastic, inelastic, perfectly elastic, or perfectly inelastic. Ultimately, the choice of the degree of price discrimination rather depends on the specificity of market operations and consumer pool.

Works Cited

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Escobari, Diego, and Paan Jindapon. “Price Discrimination Through Refund Contracts in Airlines.” International Journal of Industrial Organization, no. 34, 2014, pp. 1-8.

Fitzgerald, Doireann, and Stefanie Haller. “Pricing-to-Market: Evidence from Plant-Level Prices.” The Review of Economic Studies, vol. 81, no. 2, 2014, pp. 761-786.

Liu, Qihong, and Konstantinos Serfes. “Price Discrimination in Two‐Sided Markets.” Journal of Economics & Management Strategy, vol. 22, no. 4, 2013, pp. 768-786.

Nicholson, Walter, and Christopher M. Snyder. Microeconomic Theory: Basic Principles and Extensions. New York, NY. Nelson Education, 2011.

O’Brien, Daniel P. “The Welfare Effects of Third‐Degree Price Discrimination in Intermediate Good Markets: the Case of Bargaining.” The RAND Journal of Economics, vol. 45, no. 1, 2014, pp. 92-115.

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Weyl, E. Glen, and Michal Fabinger. “Pass-Through as an Economic Tool: Principles of Incidence Under Imperfect Competition.” Journal of Political Economy, vol. 121, no. 3, 2013, pp. 528-583.

Zhelobodko, Evgeny, et al. “Monopolistic Competition: Beyond the Constant Elasticity of Substitution.” Econometrica, vol. 80, no. 6, 2012, pp. 2765-2784.