ECON 262
Notes on Price Discrimination
What is Price Discrimination? Two different ways to practice price discrimination:
1.
2.
Why do it? Because a firm can increase its profits (of course) - it broadens the market. Can pull in customers who otherwise would not be able to afford the good. But it also helps out consumers in the process (especially lower income consumers).
Necessary Conditions for Price Discrimination: In order to successfully price discriminate a firm must be able to:
1. Somewhat inelastic in at least one market segment:
2.
3.
Classifications of Price Discrimination:
We can classify price discrimination in two different ways: By degree or other?
Types of Price Discrimination:
First Degree Price Discrimination: Charging the maximum price that someone will pay (reservation price) for each unit of output. So those consumers that value the product more are charged more.
Reservation Price:
Graph:
Is this Practical? First degree price discrimination is not common because sellers can't have perfect knowledge about what each consumer would be willing and able to pay -- and even if they could, the cost would be prohibitive in getting the information. However, firms still attempt it - car dealerships for example
Example: An auction. Each buyer submits a sealed bid. There's a minimum bid set -- and all customers above that bid pay what they bid.
Second Degree Price Discrimination: (imperfect form of first degree) - Pricing based on the quantities of output purchased by individual consumers.
In most cases this involves goods and services whose consumption is metered.
Graph:
For each buyer, the first Q1 units purchased at P1, the next Q1 - Q2 units are priced at P2, and all additional units purchased are priced at P3.
Is it Practical? A lot more so than first degree.
Example: Quantity discounts. "Buy two get the third free."
Another Example: Suppose Best Buy sells a first CD for $15, and then additional CD’s for $10.
Suppose that the MC of selling the CD’s was $5 each. Suppose that the demand is such that consumers would pay up to $15 for a first CD and $10 for a second CD.
If they charged $10 each they would earn $10 ($10 x 2 = $20 - $10 cost = $10), and if they charged $15 each they would earn $10 ($15 - $5 cost = $10). By using second degree price discrimination they earn $15 ($15 + $10 = $25 - $10 cost = $15).
Example: Electricity
Block-book pricing is a form of second degree price discrimination:
First 100 kilowatt hours - $.10 per kwh
Second 300 kilowatt hours - $.08 kwh
All additional kilowatt hours - $.06 per kwh
Must make sure that block book pricing is price discrimination -- it could be due to different costs (start up costs, etc.)
Third Degree Price Discrimination: Involves separating consumers or markets in terms of their price elasticity of demand.
Can separate:
geographically
nature of use
personal characteristics of consumers.
Examples of each:
The Wall Street Journal charges different prices depending upon financial activity. Places such as New York City, Tokyo, etc. can be charged higher prices than other cities.
Telephone customers - residential or business. Business more inelastic.
Movie theatres and air fares.
Is it Practical? Yes, this is a widely used practice -- This is a very standard practice in entertainment goods (such as food, movies and sporting events): “Senior citizen’s discounts,” “Student discounts”, etc. appear to be a way for the firm to help out particular groups of people. In fact, it is also a way to increase profits. By separating low-value buyers from the high-value buyers, and charging different prices, the firm makes sales it would otherwise forego.
Remember - Successful third degree price discrimination requires that:
1. High and low value groups must be separable cost effectively. (This is often pretty easy. Senior citizens can be required to show a driver’s license, etc.)
2. There must be a way to prevent one group from reselling to the other. (If this is not prohibited, then arbitrage will eliminate sales in the high-value market).
3. Must be able to sell at a higher price to one group without losing too much demand.
Graphs:
Other Classifications of Price Discrimination (some of these overlap with 1st, 2nd or 3rd degree):
1. Personal discrimination.
Examples include:
a. Size up the customer's income - customers are charged what the market will bear, depending on how wealthy the customer is - medical and legal services (at least used to be that way).
b. Haggle every time - each exchange is a separately negotiated transaction. Examples - bazaars in the Middle East and markets in Latin America or at flea markets in the United States. And many private deals -- purchases of used items through the classifieds.
c. Measure the use - those buyers who use the good or service more intensively are charged more -- Xerox machine rentals based on number of copies made.
2. Group discrimination
Examples include:
a. Dump the surplus (dumping) - sales priced lower in foreign markets than in domestic markets in order not to depress the domestic price (drugs, TV's, steel)
b. Absorb the freight - freight is either absorbed or overcharged to customers who are located at varying distances from the production site.
c. Promote new customers - new customers are offered lower prices than old customers. Promote brand loyalty. (magazine subscriptions, rent)
d. Divide them by elasticity - when a group is classified by occupation, age, or sex. (children's vs. adult's haircuts or meals, student vs. non-student rates, senior citizen discounts, etc.)
3. Product Discrimination
Examples include:
a. Pay for the label - manufacturers distribute homogenous produces under various brands. Better known brands have higher prices. (clothing, food).
b. Appeal to the classes - price differences are greater than differences in marginal cost when quality is upgraded. (hardback vs. paperback books, first class vs. coach air fares)
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