Price discrimination refers to a business practice which involves selling of similar or near similar products to consumers at different prices during a certain period (Stole and Lars 2221). There are two main motives why businesses engage in the practice. Firstly, the business may be aiming at becoming a monopoly in the said market segment. In this case, the business could sell certain highly priced goods at a low price to a certain market segment that the business wishes to control. The second and the main reason why businesses engage in price discrimination is to take advantage of consumer surplus. Through price discrimination, the seller is able to identify a section of buyers or an individual buyer who is willing to pay more for the good than its marked price in the market. The business thus overprices the product and the consumer ends up paying more than other consumers in other market segments. Put in other words, the business checks for the elasticity of demand in the respective market segments. Depending on the nature of a particular market segment ranging from availability of substitutes for the product, income levels and the consumers general sensitivity to pricing, the business may identify an area to be less or sharply responsive to price changes. For areas where the elasticity is high, raising a product price could lead to significant drop in sales made. However, where the price elasticity is low, raising the price could make it possible for the business to collect the consumer surplus thus raising their profits
Main Requirements for Price Discrimination to Be Possible
Several conditions have to be met for it to be possible for a business to practice price discrimination. There, for example, there ought to be market segments with less price elasticity than others, some form of monopoly power by the business and the firm has also got to be able to isolate the market segments based on their characteristics that will affect their response to a price change. However, the two main requirements for a firm to practice price discrimination are:
Firstly, there has to be no easy way of communication between the two market segments in which the price discrimination is occurring. If this happened, consumers would make profits by buying from the segments where the prices are low and selling to the market segments where the prices are high thus making price discrimination impossible (Armstrong, Mark and John Vickers 579).
Secondly, the two market segments have to be kept apart by some form of a barrier either physical in nature, or through time or via nature of use of the said product. For example, in airline travel businesses, prices are different depending on the time of travel (Stavins and Joanna 200). During the working days of Monday to Friday, the prices are normally high as business people may not be able to wait until weekend to be able to travel. It is the same during holidays such as Easter and Christmas. The logic is that no one would wait until Christmas is over in order to enjoy. More correctly put, the price elasticity of demand is inelastic during those days but more elastic on weekends. As such, a hike in the prices of the same service that consumers usually get at a much lower service hardly ever affects the likeliness that a consumer will buy the good or service.
Types of Price Discrimination
There exists several types of price discrimination. The most common are discussed here below:
First-Degree Price Discrimination
In this type of price discrimination, the seller knows how much every consumer is willing to pay for a particular product and thus charges that price for the product. An important feature for this type of price discrimination is that the seller takes all the consumer surplus. This type of price discrimination is also known as perfect price discrimination. In practice, this type is rare since, logically, it is hard to determine how much each consumer is willing to pay for a given unit. Where it occurs, it involves a buyer paying for more for the same product based on the factors discussed above. A perfect example of a first degree price discrimination is issuance of coupons to select consumers based on their previous spending habits (Leslie and Phillip 520). A business may establish that a certain loyal customer spends a certain amount of money in their outlet. To encourage the customer to spend more, the business could issue the customer a coupon that entitles him to a discount when they shop beyond their current usage.
The logic is that by a customer spending such a sum of money, that illustrates their willingness and ability to pay and as such, they are likely to increase their spending upon being presented with some incentive for the same. Several other companies practice this type of price discrimination especially in the voice telephony in countries where the customer is billed based on their usage or airtime. The business offers a certain discount percentage for customers who spend beyond their usual spend. Loyalty cards issued by supermarkets and petrol stations are also a common type of first-degree price discrimination.
Second-Degree Price Discrimination
This type of price discrimination affects people based on the quantity they buy. Most commonly this type affects people who buy from either monopoly businesses or well-established businesses. The element of price discrimination is observed in the sense that for a consumer who buys in bulk, they end up paying less for every item as compared to another consumer who buys the same item but in less quantity. For the business, the production cost is the same for every item. Therefore, selling at a high price for one consumer than the other based solely on the amount bought is viewed as price discrimination. The best example of this kind of price discrimination is seen in the energy market (Rassenti, et. al., 109). For example, a certain electricity supplying company may charge the first 100 units of power consumed at $3 per unit, and charge $1 per every additional unit consumed. The idea behind this is that the first 100 units are essential and as such subscribe to an in elastic kind of demand. For the other units above 100, the consumer can easily choose not to consume as they are not essential. For all units above 100, the consumer becomes price sensitive and thus is charged less by the power company.
Third-Degree Price Discrimination
This kind of price discrimination involves classifying consumers and charging them different prices based on their groups and the characteristics of the various groups. The business assesses the spending ability of the various groups and how the good or service in question impact the group. For example, the spending ability of a student is obviously lower than that of a working citizen and therefore, would be charged lower for a similar product than the adult. Third-degree price discrimination is the commonest type due to the likeliness of people to fall into various groups with varying characteristics and different ability to pay. Due to this, there are several forms of this type of price discrimination. For example, a movie theatre may classify people into either adults or children and charge different process for the same movie. In the same way, museums and amusement parks could charge different fees for students and regular civilians to watch the same sceneries. Division of times into peak and off peak is also a form of third degree price discrimination since it thrives on the fact that a certain group of people would, for example, pay the bus fare however high since that time is essential to them while a different group of people pays a different amount for the same ride only because that time is not as important to them.
Fourth-Degree Price Discrimination
This type is also known as reverse price discrimination. It occurs when prices are the same for all consumers but the product faces slight variations in production cost. A good example is when clients on board a flight order meals that cost differently yet they paid the same airfares. In essence, the air ticket of the consumer who orders less expensive food cost more than that of his colleague who orders more expensive food.
Premium Pricing
In this case, the consumer pays slightly more for a product than other consumers due to a slight increase in the features of the product (Shaffer, Greg, and John 397). The element of price discrimination sets in due to the fact that the business charges more mark-up than was incurred to differentiate the products. For example, a business may incur $0.1 to make a litre of unleaded petrol but charge $1 more for unleaded petrol.
Works cited
Stole, Lars A. "Price discrimination and competition." Handbook of industrial organization 3 (2007): 2221-2299.
Armstrong, Mark, and John Vickers. "Competitive price discrimination." rand Journal of economics (2001): 579-605.
Leslie, Phillip. "Price discrimination in Broadway theater." RAND Journal of Economics (2004): 520-541.
Stavins, Joanna. "Price discrimination in the airline market: The effect of market concentration." Review of Economics and Statistics 83.1 (2001): 200-202.
Rassenti, Stephen J., Vernon L. Smith, and Bart J. Wilson. "Discriminatory price auctions in electricity markets: low volatility at the expense of high price levels." Journal of regulatory Economics 23.2 (2003): 109-123.
Shaffer, Greg, and Z. John Zhang. "Pay to Switch or Pay to Stay: Preference‐Based Price Discrimination in Markets with Switching Costs."Journal of Economics & Management Strategy 9.3 (2000): 397-424.
