Concepts in Industrial Organization: Price Discrimination

Price discrimination occurs when a seller charges different consumers different prices for the same product supplied at the same cost or when consumers are charged the same price, although the costs of supplying the good are different for each consumer. Price discrimination exists when prices different consumers pay are not proportional to the costs the seller incurs in delivering a given product to the consumers.

Price discrimination is only possible to conduct for a firm that has some kind of market power. Market power exists if a firm can increase the price it charges without losing all of its sales. A perfectly competitive firm cannot engage in price discrimination.

Effective price discrimination requires the ability to separate consumers into different groups, each with a different price elasticity of demand. Price discrimination also requires the ability to prevent transfers of the good from one group to another - or else the group that is charged a lower price will engage in pure arbitrage and sell the product to the group that is charged a higher price.

Price discrimination can improve efficiency, but only compared to a monopoly or oligopoly situation; it cannot improve efficiency compared to a perfectly competitive situation.

There are 3 types of price discrimination: 1^st-degree, 2^nd-degree, and 3^rd-degree price discrimination.

1^st-degree price discrimination is the rarest and is virtually impossible to achieve in its entirety. It is also known as "perfect" discrimination. Under 1^st-degree price discrimination, sellers can charge each consumer his reservation price - the maximum price he is willing to pay for a unit of the good. There is no real-world situation that wholly fits this scenario, but haggling is an example of an attempt to get at first-degree price discrimination. Sellers will try to discover consumers' reservation prices, and consumers will attempt to hide their reservation prices from sellers and pretend that their reservation prices are lower than is in fact the case.

2^nd-degree price discrimination occurs when sellers know that buyers have different elasticities of demand but are unable to separate those elasticities. Thus, the sellers will simply present a price schedule for the consumers to self-select into different price categories, subject to a variety of constraints, if the price schedule is drawn up properly to successfully distinguish among groups of buyers.

Air fares provide an example of 2^nd-degree price discrimination, as they depend on the time at which tickets were bought and how long travelers plan to stay at their destination. Many airlines used to charge travelers more if they were unwilling to stay over a Saturday night. In this manner, the airlines sought to separate business flyers from pleasure flyers and tourists, as the former had far less elastic demand schedules than the latter.

Coupons are another example of 2^nd-degree price discrimination. A person with a coupon pays a lower price for the same good than a person without a coupon. Thereby, sellers try to capture two different elasticity groups into which buyers separate themselves. Some individuals have an extremely high cost of time and are willing to pay higher prices instead of expending time to search for coupons. Others with more time on their hands will seek to bring their expenses down by taking the time to look through the coupon books and clip the coupons they need. By offering coupons, sellers are able to capture sales from both groups.

In either case, sellers are not able to outright identify groups of consumers with accuracy, so setting up a price schedule and allowing consumers to distribute themselves among these groups can be highly useful.

3^rd-degree price discrimination occurs when sellers charge consumers in different groups different prices on the basis of some of the consumers' characteristics, such as age, wealth, or geographic location. Here, consumers are not allowed to self-select. Rather, the sellers determine who pays what price based on characteristics that the sellers can identify. This also enables sellers to separate groups of consumers based on their elasticities of demand.

An example of 3^rd-degree price discrimination is found in movie theaters, which charge different ticket prices to different ages of movie goers; for instance, children and the elderly will often be charged reduced prices. Movie theater owners assume that these consumer groups have much more elastic demand for films and thus need to be attracted by a lower price.

The Welfare Implications of Price Discrimination on Total Surplus

What happens if a monopolist can engage in successful price discrimination? The deadweight loss of monopoly is gone. The producer captures the former monopoly deadweight loss as well as the former consumer surplus. The monopoly which can engage in first-degree price discrimination can produce an output at the allocatively efficient level. Thus, first-degree price discrimination can be beneficial from a social perspective.

But successful first-degree price discrimination also implies a complete loss of consumer surplus, though with an offsetting aspect. The consumers who were not willing to pay the previous monopoly profit-maximizing price can now pay a much lower price and get the product. Some consumers will be better off, and others will be worse off as a result of the price discrimination. Economics as such cannot evaluate the desirability of these distributional effects; whether or not they are an improvement is a matter of one's value judgments.

With 2^nd and 3^rd degree price discrimination, considerable and complicated analysis is required to arrive at the welfare implications in particular cases, and considerable ambiguity regarding these exists as well. In an ideal situation, successful 2^nd-degree price discrimination can accomplish equivalent results to those of first-degree price discrimination, but this rarely if ever happens. More often than not, however, price discrimination of any degree will improve efficiency. A general though not perfect guideline is that price discrimination improves efficiency whenever output is increased as a result. The outcome truly depends on whether the drop in consumer surplus relative to a one-price policy is outweighed by the gain in producer surplus. If this holds, then the price discrimination will have improved efficiency.

One case in which general agreement about the desirability of price discrimination exists is the situation where demand for a product is less than average total cost of providing it at every point. If there were a single price, the product would not be supplied at all. This is the situation of a country doctor, who would not have enough revenue to break even if he charged all patients the same price. Price discrimination allows the doctor to stay in a small town or village; he charges high prices for rich patients, lower prices for moderate-income patients, and extremely low prices for poor patients. If he charges so that his overall revenues offset his overall total costs, then it makes sense for him to stay in business by means of price discrimination.

Some of the most successful price discrimination is performed by colleges via scholarships. Students who have demonstrated that their reservation price is low and that their demand for the college's services is highly elastic are charged a lower price for their education than those who have not.

There exist two specific instances of 2^nd-degree price discrimination that deserve further mention.

Two-Part Tariffs

In a two-part tariff, the consumer is charged a lump-sum payment for the good or service in question, combined with a per-unit user charge. For instance, a country club might charge a membership fee and then a user charge for its specific services. An amusement park might charge an entrance fee and then a separate fee for going on each ride.

The basic idea of a two-part tariff is for the seller to set the lump-sum payment equal to the consumer surplus of the lowest-demand consumer and then set the per-unit price equal to the marginal cost of the product or service. A two-part tariff can usually but not always improve welfare. More people will tend to consume the product or service than under a single-price policy.

Tie-in Sales

With tie-in sales, consumers can purchase a good only if they agree to purchase another good as well. There are two types of tie-in sales, bundling and requirements tie-in sales.

Bundling or package tie-in sales occur when consumers can only purchase goods in fixed proportions. If a consumer buys a unit of good X, he must also purchase k units of good Y, where k is set by the seller. For example, Microsoft practiced bundling when it tied its Internet Explorer browser to the Windows operating system. Older movie theaters would often bundle two movies - a highly popular one and a less popular one - together in the same showing. Bundling depends on consumers having different relative valuations of the two bundled goods. In some such situations, if the seller charges consumers their lowest reservation prices for each good separately, it will not make as much money as if it charges consumers their lowest reservation prices for the combined bundle of goods.

Requirements tie-in sales are agreements in which consumers agree to purchase goods in variable proportions. For instance, the McDonalds franchise requires individual restaurants to purchase their paper cups only from McDonalds, but the number of paper cups purchased depends on each particular restaurant's requirements. Can-closing machinery manufacturers also used to require that whosever purchased their can-closing machines also purchased their cans. With requirements tie-in sales, consumers will end up paying different amounts for the same product - so this policy constitutes a kind of 2^nd-degree price discrimination.

Source Used

Pongracic, Ivan. Lecture on Price Discrimination. Hillsdale College. Hillsdale, MI. November 15, 2007.

All lecture material is used with explicit permission.