11.7 - Price Discrimination - notes

The meaning and conditions for price discrimination

Price discrimination happens when a business charges varying prices to different buyers for an identical product or service. This strategy allows firms to maximise profits by tailoring prices to what different customers are willing to pay.

Key conditions required for price discrimination

• Price-making ability - The firm needs some control over pricing, often seen in markets with limited competition, such as monopolies or oligopolies.
• Separating customer groups - The business must identify distinct groups of buyers with varying price elasticities of demand (PED). Dividing the market into more groups can increase potential profits.
• Preventing resale - The firm has to stop 'seepage', where buyers who get a lower price resell the product to those who would pay more.

Examples of price discrimination in practice

• Cinemas and theatres providing reduced rates for students or older people.
• Cleaning services setting higher fees in wealthier areas compared to less affluent ones.
• Rail companies charging more for peak-time journeys than off-peak ones on the same route.
• Drug manufacturers offering medicines at lower prices in some countries than others.

Price discrimination does not apply if the products differ, such as premium versus economy airline seats, where extra features justify the cost difference.

How price discrimination transfers consumer surplus

Consumer surplus is the gap between what a buyer is prepared to pay for a product and its actual selling price. For instance, if a theatre ticket costs £12 but a customer would accept £15, the surplus is £3. Price discrimination aims to capture this surplus, turning it into extra income for the seller. There are varying levels of this practice, each converting different amounts of surplus into revenue.

First degree price discrimination

First degree price discrimination, also called perfect price discrimination, involves charging each buyer the absolute maximum they are willing to pay for the product. This approach captures the entire consumer surplus as revenue for the seller.

The diagram below shows this. The demand curve (D), which is also the firm's average revenue curve (AR), shows the maximum price each buyer would pay. If the firm charged a single price P, it would sell quantity Q, earning the revenue shown by the light grey rectangle and leaving buyers with the consumer surplus triangle above P. Under first degree price discrimination the firm captures this consumer surplus as well, so its total revenue becomes the whole area under the demand curve up to Q.

Features of first degree price discrimination:

• It fully eliminates consumer surplus, as every customer pays their personal maximum.
• Practical challenges include high costs of collecting individual data and difficulties in stopping resale, making it rare in real-world use.

Second degree price discrimination

Second degree price discrimination adjusts prices based on the quantity purchased, often seen in bulk buying scenarios where larger orders receive discounts. This method captures part of the consumer surplus by encouraging bigger purchases.

The diagram below shows this. The demand curve (D), which is also the firm's average revenue curve (AR), slopes downwards, so buyers taking larger quantities can be charged less. The firm charges the higher price P2 to buyers taking the smaller quantity Q2, and the lower price P1 to buyers taking the larger quantity Q1. Charging everyone the lower price P1 would give only the revenue at P1 shown by the light grey rectangle; charging the smaller-quantity buyers the higher price P2 turns the dark grey rectangle into additional revenue.

Features of second degree price discrimination:

• Prices decrease as quantity increases; for example, a supplier might charge £15 per unit for the first 40 items and £12 per unit for additional ones.
• It boosts seller income by converting some surplus into revenue and promotes larger sales volumes.

Third degree price discrimination and its impacts

Third degree price discrimination divides the market into segments and charges different prices based on factors like age, time, or location. Segments are chosen for their differing price elasticities of demand, allowing profit maximisation by setting prices where marginal cost equals marginal revenue in each group.

Features of third degree price discrimination:

• Market segments - Groups could include age categories (e.g., lower prices for children at a gym), timing (e.g., cheaper evening phone calls), or geography (e.g., varying medicine prices by country).
• Pricing strategy - Higher prices for groups with inelastic demand (less sensitive to price rises) and lower prices for those with elastic demand (more sensitive). This leads to greater overall supernormal profit than a single price for all.

The diagrams below show a firm setting a different price in two customer groups with different price elasticities of demand. In each diagram the demand curve (D) is also the firm's average revenue curve (AR_A for Group A, AR_B for Group B), and because there are no economies of scale, marginal cost and average cost are drawn as one horizontal line, MC (= AC). The firm maximises profit in each group where MC equals marginal revenue (MR_A and MR_B). Group A has an inelastic PED, so it is charged the higher price P_A for the quantity Q_A. Group B has an elastic PED, so it is charged the lower price P_B for the quantity Q_B. The shaded supernormal profit from the two groups combined is greater than the firm would earn by charging a single price to everyone.

Impacts of price discrimination on sellers and others

• Price discrimination boosts seller revenue by capturing consumer surplus, but its fairness depends on how the extra income is used.
• Benefits for sellers - Increases income, which could fund product improvements or efficiency gains, potentially leading to future price reductions.
• Drawbacks for efficiency - Average revenue exceeds marginal cost, preventing allocative efficiency (which requires price to equal marginal cost).
• Effects on consumers:
  • Some pay more, often those with higher incomes, which can seem fair if it subsidises lower prices for others (e.g., peak train fares supporting off-peak services).
  • However, it reduces overall consumer surplus and treats buyers unequally.