Price discrimination
Price discrimination, known also by several other names, is a microeconomic pricing strategy whereby identical or largely similar goods or services are sold at different prices by the same provider to different buyers, based on which market segment they are perceived to be part of. Price discrimination is distinguished from product differentiation by the difference in production cost for the differently priced products involved in the latter strategy. Price discrimination essentially relies on the variation in customers' willingness to pay and in the elasticity of their demand. For price discrimination to succeed, a seller must have market power, such as a dominant market share, product uniqueness, sole pricing power, etc.
Some prices under price discrimination may be lower than the price charged by a single-price monopolist. Price discrimination can be utilized by a monopolist to recapture some deadweight loss. This pricing strategy enables sellers to capture additional consumer surplus and maximize their profits while offering some consumers lower prices.
Price discrimination can take many forms and is common in many industries, such as travel, education, telecommunications, and healthcare.
Terminology
Price discrimination is also referred to as differential pricing, equity pricing, preferential pricing, segmented pricing, dual pricing, and tiered pricing."Price fences" are the criteria which segment customers into groups to which differentiated prices can be charged.
Legality
Many forms of price discrimination are legal, but in some cases charging consumers different prices for the same goods is illegal. For example, in the United States, the Robinson–Patman Act makes price discrimination illegal in certain anti-competitive interstate sales of commodities.Types
Within the broader domain of price differentiation, a common classification dating to the 1920s, is:- "Personalized pricing" – selling to each customer at a different price; this is also called one-to-one marketing. The optimal incarnation of this is called "perfect price discrimination" and maximizes the price that each customer is willing to pay. As such, in "first degree" price differentiation the entire consumer surplus is captured for each individual.
- "Product versioning" or simply "versioning" – offering a product line by creating slightly differentiated products for the purpose of price differentiation, i.e. a vertical product line. Another name given to versioning is "menu pricing".
- "Group pricing" – dividing the market into segments and charging a different price to each segment. This is essentially a heuristic approximation that simplifies the problem in face of the difficulties with personalized pricing. Typical examples include student and senior discounts.
Theoretical basis
Price discrimination requires market segmentation and some means to discourage discount customers from becoming resellers and, by extension, competitors. This usually entails preventing any resale: keeping the different price groups separate, making price comparisons difficult, or restricting pricing information. The boundary set up by the marketer to keep segments separate is referred to as a rate fence. Price discrimination is thus very common in services where resale is not possible; an example is student discounts at museums: Students may get lower prices than others, but do not become resellers, because the service is consumed at point of sale. Another example of price discrimination is intellectual property, enforced by law and by technology. In the market for DVDs, laws require DVD players to be designed and produced with hardware or software that prevents inexpensive copying or playing of content purchased legally elsewhere in the world at a lower price. In the US the Digital Millennium Copyright Act has provisions to outlaw circumventing of such devices to protect the profits that copyright holders can obtain from price discrimination against higher price market segments.
Price discrimination attempts to capture as much consumer surplus as possible. By understanding the elasticity of demand in various segments, a business can price to maximize sales in each segment. When a seller identifies a consumer that has a lower willingness to pay, price discrimination maximizes profits.
There are two conditions which must be met if a price discrimination scheme is to work. First the seller must be able to identify market segments by their price elasticity of demand and second the sellers must be able to enforce the scheme. For example, airlines routinely engage in price discrimination by charging high prices for customers with relatively inelastic demand – business travelers – and discount prices for tourist who have relatively elastic demand. The airlines enforce the scheme by enforcing a no resale policy on the tickets preventing a tourist from buying a ticket at a discounted price and selling it to a business traveler. Airlines must also prevent business travelers from directly buying discount tickets. Airlines accomplish this by imposing advance ticketing requirements or minimum stay requirementsconditions that would be difficult for the average business traveler to meet.
Market power
Degrees
refers to the ability of a seller to increase price without losing share. Factors that affect market power include:- Number of competitors
- Product differentiation between suppliers
- Entry restrictions
| Type of Market | Features | Industry Examples |
| Perfect Competition |
| Farmers selling vegetables at a market |
| Monopolistic Competition | Fast food industry | |
| Oligopoly | Airline industry | |
| Monopoly | Utility servicing the region |
Oligopolies
When the dominant companies in an oligopoly compete on price, inter-temporal price discrimination may be adopted.Price discrimination can lower profits. For instance, when oligopolies offer a lower price to consumers with high price elasticity they compete with other sellers to capture the market until a lower profit is retained. Hence, oligopolies may opt to not use price discrimination.
Degrees
First degree: perfect price discrimination
Exercising first degree price discrimination requires the seller of a good or service to know the absolute maximum price that every consumer is willing to pay. By knowing the reservation price, the seller is able to sell the good or service to each consumer at the maximum price they are willing to pay, and thus fully capture consumer surplus. The resulting profit is equal to the sum of consumer surplus and seller surplus. This is the most profitable realm as each consumer buys the good at the highest price they are willing to pay. The marginal consumer is the one whose reservation price equals the seller's marginal cost. Sellers that engage in first degree price discrimination produce more product than they would otherwise. Hence first degree price discrimination can eliminate deadweight loss that occurs in monopolistic markets. Examples of first degree price discrimination can be observed in markets where consumers bid for tenders, though, in this case, the practice of collusive tendering could reduce the market efficiency.Second degree: quantity discount
In second-degree price discrimination, the price of the same good varies according to the quantity demanded. It usually comes in the form of a quantity discount that exploits the law of diminishing marginal utility. Diminishing marginal utility claims that consumer utility decreases with each successive unit consumed. By offering a quantity discount for a larger quantity the seller is able to capture some of the consumer surplus. This is because diminishing marginal utility may mean the consumer would not be willing to purchase an additional unit without a discount since the marginal utility received from the good or service is no longer greater than the price. However, by offering a discount the seller can capture some of consumers surplus by encouraging them to purchase an additional unit at a discounted price. This is particularly widespread in sales to industrial customers, where bulk buyers enjoy discounts.Mobile phone plans and subscriptions are instances of second-degree price discrimination. Consumers usually require a one-year subscription to be less expensive than a monthly one. Whether or not consumers need the longer subscription, they are more likely to accept one if the cost is less.