Price discrimination occurs when firms sell the same good to different groups of consumers at different prices. There are often different types of price discrimination offered. Often they are categorised in the following way:
- 1st-degree price discrimination – charging the maximum price consumers are willing to pay.
- 2nd-degree price discrimination – charging different prices depending on the quantity consumed.
- 3rd-degree price discrimination – charging different prices depending on a particular market segment, e.g. age profile, income group, time of use.
- 4th-degree price discrimination – when prices to consumers are same, but the producer faces different costs. Also known as reverse price discrimination.
- Premium pricing. In many examples of ‘price discrimination’ consumers are charged different prices for a similar good. In these examples, consumers pay a premium for a slightly more expensive option. For example, ‘premium unleaded petrol’ may cost the firm an extra 1p over standard unleaded, but the firm may sell this premium unleaded at 5p. This is not true price discrimination but uses the same principles – finding customers with more inelastic demand. Its use is widespread, such as first and standard class.
Examples of Price discrimination:
1. Time of Purchase
This petrol station is offering cut-price fuel for two days a week. The petrol station isn’t even telling you which days have cut-price fuel. The logic is that only the most price-sensitive consumers will take the trouble to find out which two days have cut-price fuel and then drive to the petrol station on those days. This takes planning and only the most price elastic consumers will buy on these cut-price days. Most consumers will not take the trouble to visit the petrol station on those two days. They will continue to buy when most convenient.
It is also a clever marketing strategy because from a distance, it is advertising ‘cut-price fuel’ you only notice the ‘2 days a week’ on closer inspection. This is a type of third-degree price discrimination.
2. Airline travel and time of departure
Airlines charge different prices depending on the season and day of the week. During the peak holiday season in August and Easter, the price will be higher because demand is greater and more inelastic. Flights which occur during the week e.g. Mon to Fri will be more expensive because these are typically taken by business travellers. If you stay for over the weekend, the price will be lower, as business travellers will not want to stay over the weekend, just to get a cheaper flight. I often go to New York for a week in October. For a flight from Mon to Fri, the price quoted is usually around £1,500. If I change dates to leaving or arriving on the weekend, the price falls to £450.
3. Quantity Purchased
For electricity, consumers get charged different tariffs depending on the quantity consumed. The first 100 units of electricity consumed are charged at a higher tariff, e.g. 25p kWh. After this first 100 units, consumers get charged a lower rate. The logic is that the first 100 units of electricity are essential, and therefore demand is more inelastic. However, after the first 100 units of electricity, your demand is less essential, so you become more price sensitive. Therefore, the electricity company charge a lower rate.
This graph shows that the average price of electricity falls, as firms get bigger and consume more electricity.
Firms often give coupons to selected consumers. For example, Tesco may send coupons to regular customers to get special offers, e.g. 20% off selected items. These coupons are often highly targeted to your spending habits. e.g. if you average weekly shopping bill is £50, Tesco may send you a £10 off voucher if you spend over £70. This is an indirect way of segmenting the market. Someone walking into the shop cannot benefit from the lower prices. It is also a clever marketing ploy to get people to come back.
5. Age Discounts
A popular way to segment the market is by age category, e.g. students and OAPs often get discounts, such as 10% off. For rail travel, people with railcards can get up to 33% off. The popularity of age discounts is that it is relatively easy to segment the market (you just need to prove your age). Also, different age groups generally have different elasticities of demand. Students and OAPs have lower income than working adults and so are more sensitive to changes in price.
See: Student discounts as price discrimination
6. Means-tested student fees
Means-tested student fees are a type of price discrimination. If you can prove you have low income, the university may offer lower tuition fees. This is a rare example, of pricing being determined by income; usually, it is considered too difficult.
7. Resident parking charges
In some tourist cities, residents get lower prices for public transport and parking. For example, in York, residents get lower parking charges. This is because tourists tend to have more inelastic demand. Also, residents use the facilities throughout the year and contribute more taxes. Tourists will have greater demand during the peak holiday season. The higher price for tourists is a way of taking consumer surplus from the inelastic demand of tourists.
8. Dutch auction for Car registration plates
Some popular car registration plates e.g. 007 Bond, are sold via Dutch auctions. You place a bid for the maximum price you would be willing to pay. The auction firm starts off at a certain price , e.g. £20,000 and every week reduces the price, until the person with the highest bid is reached. They then get the number plate. This is a type of first-degree price discrimination because, in theory, it takes all consumer surplus.
9. Loyalty cards
Some coffee shops offer a reward to regular consumers. If you buy nine coffees, you get the tenth free. This is a reward for buying a higher quantity. For one-off visitors to a coffee shop, people are likely to be less price sensitive.
10. Choosing your seat early
Airplanes offer numerous ways to charge different prices for variations on a plane ticket. For example, if you want to choose your seat, you can pay a premium of £30. This is not strictly price discrimination because it becomes a slightly different product. But, it is a way of extracting higher prices from those who want to pay for extras.
11. Three for Two offers
Lower prices for consumers who buy a higher quantity. Very common marketing technique in bookselling.
This involves charging a different price to different groups of people for the same good. For example – student discounts, off peak fares cheaper than peak fares.
Different Types of Price Discrimination
1. First Degree Price Discrimination
This involves charging consumers the maximum price that they are willing to pay. There will be no consumer surplus.
2. Second Degree Price Discrimination
This involves charging different prices depending upon the quantity consumed. For example:
- After 10 minutes phone calls become cheaper.
- Electricity is more expensive for the first number of units. For a higher quantity of electricity consumed the marginal cost is lower.
- Loyalty cards reward frequent buyers with discounts on future products.
3. Third Degree Price Discrimination – ‘Group price discrimination’
This involves charging different prices to different groups of people. For example:
- Student discounts,
- Senior citizen rail card
- Peak travel/ off-peak travel
- Cheaper prices by the time of the day (e.g. happy hour’s in pubs – usually earlier on in evening where demand is lower.
More on third-degree price discrimination
One way firms practise price discrimination is to offer slightly different products as a way to discriminate between consumers ability to pay. For example:
- Priority boarding tickets. Same flight but for a premium, you get a shorter queue.
- Organic coffee / fair trade coffee
- Extra leg room on airplanes
- First class/second class
This is a form of indirect segmentation. By offering slightly different choices, the firm is able to separate consumers who are willing to pay higher prices.
Conditions necessary for price discrimination
Firm a price maker. The firm must operate in imperfect competition; it must be a price maker with a downwardly sloping demand curve.
Separate markets. The firm must be able to separate markets and prevent resale. E.g. stopping an adults using a child’s ticket. Prevent business travellers buying discount tickets.
Different elasticities of demand. Different consumer groups must have elasticities of demand. E.g. students with low income will be more price elastic and sensitive to price. Business travellers will have more inelastic demand.
- Low admin costs. It must be relatively cheap to separate markets and implement price discrimination.
Simple diagram for Price Discrimination
Without price discrimination, the firm charges one price £7 * 100 = £700 revenue
WIth price discrimination, the firm can charge two different prices:
- £10 * 35 = £350
- £4 * 120 = £480
Total revenue = £830. Therefore, the firm makes more revenue under price discrimination.
Profit maximisation under Price Discrimination
To maximise profits a firm sets output and price where MR=MC. If there are two sub markets with different elasticities of demand. The firm will increase profits by setting different prices depending upon the slope of the demand curve.
- Therefore for a group, such as adults, PED is inelastic – the price will be higher
- For groups like students, prices will be lower because their demand is elastic
Diagram of Price Discrimination
Profit is maximised where MR=MC. WIthout price discrimination, there would just be one price set for the whole market (A+B). There would be a price of P3.
- However, price discrimination allows the firm to set different prices for segment A (inelastic demand) and segment B (elastic demand)
- Because demand is price inelastic, segment (A) will have a higher profit maximising price (P1)
- In segment (B) demand is price elastic, so the profit maximising price is lower.
Advantages of price discrimination
Firms will be able to increase revenue. Price discrimination will enable some firms to stay in business who otherwise would have made a loss. For example price discrimination is important for train companies who offer different prices for peak and off peak. Without price discrimination, they may go out of business or be unable to provide off-peak services.
Increased investment. These increased revenues can be used for research and development which benefit consumers
Lower prices for some. Some consumers will benefit from lower fares. For example, old people benefit from lower train companies; old people are more likely to be poor. Also, customers willing to spend time in researching ‘special offers’ and travelling at awkward times will be rewarded with lower prices.
- Manages demand. Airlines can use price discrimination to encourage people to travel at unpopular times (early in morning) This helps avoid over-crowding and helps to spread out demand.
Disadvantages of Price Discrimination
Higher prices for some. Under price discrimination, some consumers will end up paying higher prices (e.g. people who have to travel at busy times). These higher prices are likely to be allocatively inefficient because P > MC.
Decline in consumer surplus. Price discrimination enables a transfer of money from consumers to firms – contributing to increased inequality.
Potentially unfair. Those who pay higher prices may not be the poorest. For example, adults paying full price could be unemployed, senior citizens can be very well off.
Administration costs. There will be administration costs in separating the markets, which could lead to higher prices.
Predatory pricing. Profits from price discrimination could be used to finance predatory pricing.
Importance of marginal cost in price discrimination
In markets where the marginal cost of an extra passenger is very low, the firm has an incentive to use price discrimination to sell all the tickets. This is why sometimes prices for airlines can be very low just before their date. Once the company is due to fly the MC of an extra passenger will be very low. Therefore this justifies selling the remaining tickets at a low price.
Examples of price discrimination
- Student discounts on trains
- Discounts for buying train tickets in advance
- Discounts for travelling at off peak time
- Lower unit cost price for buying high quantity.
- Phone deals which give 100 texts free.