Price discrimination exists when sales of identical goods or
services are transacted at different prices from
the same provider. In a theoretical market with perfect information, no
transaction costs or prohibition on secondary exchange (or re-selling) to prevent
arbitrage, price discrimination can be a feature only of monopoly markets. Otherwise, the moment the seller tries to sell the same good
at different prices, the buyer at the lower price can arbitrage by selling to the consumer buying at the higher price but with a
tiny discount. However, market frictions in oligopolies such as the airlines, and even in
fully competitive retail or industrial markets allow for a limited degree of differential pricing to different consumers. Price
discrimination also occurs when it costs more to supply one customer than it does another, and yet the supplier charges both the
same price.
Although the term "discrimination" has negative (e.g. racist, sexist) connotations, the literal meaning of the word "discrimination"
(from discriminatio, "a distinction") is neutral. "Price discrimination" is a technical term meaning only differentiation
in price by customer, and is not intended as an accusation of criminal or unfairly biased behavior. The effects of price
discrimination on social efficiency are unclear; typically such behavior leads to lower prices for some consumers and higher
prices for others. Output can be expanded when price discrimination is very efficient, but output can also decline when
discrimination is more effective at extracting surplus from high-valued users than expanding sales to low valued users. Even if
output remains constant, price discrimination can reduce efficiency by misallocating output among consumers.
Price discrimination requires market segmentation and some means to discourage
discount customers from becoming resellers and, by extension, competitors. This usually entails using one or more means of
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 are 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.
Price discrimination can also be seen where the requirement that goods be identical is relaxed. For example, so-called
"premium products" (including relatively simple products, such as capuccino compared to regular coffee) have a price differential
that is not explained by the cost of production. Some economists have argued that this is a form of price discrimination
exercised by providing a means for consumers to reveal their willingness to pay.
Types of price discrimination
- In first degree price discrimination, price varies by customer. This arises from the fact that the value of goods is
subjective. A customer with low price elasticity is less deterred by a higher
price than a customer with high price elasticity of demand. As long as the price elasticity (in absolute value) for a customer is less than one, it is very advantageous to increase the price: the
seller gets more money for fewer goods. With an increase of the price elasticity tends to rise above one. One can show that in
the optimum the price, as it varies by customer, is inversely proportional to one minus the reciprocal of the price elasticity of
that customer at that price. This assumes that the consumer passively reacts to the price set by the seller, and that the seller
knows the demand curve of the customer. In practice however there is a bargaining situation,
which is more complex: the customer may try to influence the price, such as by pretending to like the product less than he or she
really does, and by threatening not to buy it.
An alternative way to understand First Degree Price Discrimination is as follows: This type of price discrimination is
primarily theoretical because it requires the seller of a good or service to know the absolute maximum price that every consumer
is willing to pay. As above, it is true that consumers have different price elasticities, but the seller is not concerned with
such. The seller is concerned with the maximum willingness to pay of each customer. By knowing the max. WTP, the seller is able
to absorb the entire market surplus, thus taking all consumer surplus from the consumer and transforming it into revenues. From a
social welfare perspective, first degree price discrimination is not undesirable. That is, the market is still entirely efficient
and there is no deadweight loss to society. However, it is the complete opposite of a perfectly competitive market. In a
perfectly competitive market, the consumers receive the bulk of surplus. In a market with first degree price discrimination, the
seller(s) capture all surplus. Efficiency is unchanged but the wealth is transferred. This type of market does not much exist in
reality, hence it is primarily theoretical. Examples of where this might be observed are in markets where consumers bid for
tenders.
- In second degree price discrimination, price varies according to quantity sold. Larger quantities are available at a
lower unit price. This is particularly widespread in sales to industrial customers, where bulk buyers enjoy higher
discounts.
Additionally to second degree price discrimination, sellers are not able to differentiate between different types of
consumers. Thus, the suppliers will provide incentives for the consumers to differentiate themselves according to preference. As
above, quantity "discounts", or non-linear pricing, is a means by which suppliers use consumer preference to distinguish classes
of consumers. This allows the supplier to set different prices to the different groups and capture a larger portion of the total
market surplus.
Additionally to third degree price discrimination, the supplier(s) of a market where this type of discrimination is
exhibited are capable of differentiating between consumer classes. Examples of this differentiation are student or senior
"discounts". For example, a student or a senior consumer will have a different willingness to pay than an average consumer, where
the WTP is presumably lower because of budget constraints. Thus, the supplier sets a lower price for that consumer because the
student or senior has a more elastic price elasticity of demand (see the discussion of price elasticity of demand as it applies
to revenues from the first degree price discrimination, above). The supplier is once again capable of capturing more market
surplus than would be possible without price discrimination.
Note that it is not always advantageous to the company to price discriminate even if it possible, especially for second and
third degree discrimination. In some circumstances, the demands of different classes of consumers will encourage suppliers to
simply ignore one/some class(es) and target entirely to the other(s). Whether it is profitable to price discriminate is
determined by the specifics of a particular market.
- In price skimming, price varies over time. Typically a company starts selling a new
product at a relatively high price then gradually reduces the price as the low
price elasticity segment gets
satiated. Price skimming is closely related to the concept of yield management.
These types are not mutually exclusive. Thus a company may vary pricing by location, but then offer bulk discounts as well.
Airlines use several different types of price discrimination, including:
- Bulk discounts to wholesalers, consolidators, and tour operators
- Incentive discounts for higher sales volumes to travel agents and corporate buyers
- Seasonal discounts, incentive discounts, and even general prices that vary by location. The price of a flight from say,
Singapore to Beijing can vary widely if one buys the ticket in Singapore compared to Beijing (or New York or Tokyo or elsewhere).
In online ticket sales this is achieved by using the customer's credit card billing address to determine his location.
- First degree price discrimination based on customer. It is not accidental that hotel or car rental firms may quote higher
prices to their loyalty program's top tier members than to the general public.
Modern Taxonomy
The first/second/third degree taxonomy of price discrimination is due to Pigou (Economics of Welfare, 4th
edition, 1932). See, e.g., modern taxonomy of price discrimination. However, these categories are not mutually exclusive or exhaustive.
Ivan Png (Managerial
Economics, 2nd edition, 2002) suggests an alternative taxonomy:
- Complete discrimination -- where each user purchases up to the point where the user's marginal benefit equals the
marginal cost of the item;
- Direct segmentation -- where the seller can condition price on some attribute (like age or gender) that
directly segments the buyers;
- Indirect segmentation -- where the seller relies on some proxy (eg, package size, usage quantity, coupon) to structure
a choice that indirectly segments the buyers.
The hierarchy -- complete/direct/indirect -- is in decreasing order of
- profitability and
- information requirement.
Complete price discrimination is most profitable, and requires the seller to have the most information about buyers. Indirect
segmentation is least profitable, and requires the seller to have the least information about buyers.
Explanation
Sales revenue without and with Price Discrimination
The purpose of price discrimination is generally to capture the market's consumer
surplus. This surplus arises because, in a market with a single clearing price, some customers (the very low price
elasticity segment) would have been prepared to pay more than the single market price. Price discrimination transfers some of
this surplus from the consumer to the producer/marketer. Strictly, a consumer surplus need not exist, for example where price
discrimination is necessary merely to pay the costs of production. An example is a high-speed internet connection shared by two
consumers in a single building; if one is willing to pay less than half the cost, and the other willing to make up the rest but
not to pay the entire cost, then price discrimination is necessary for the purchase to take place.
It can be proved mathematically that a firm facing a downward sloping demand curve that is convex to the origin will always
obtain higher revenues under price discrimination than under a single price strategy. This can also be shown diagramatically.
In the top diagram, a single price (P) is available to all customers. The amount of revenue is represented by area P, A,Q, O.
The consumer surplus is the area above line segment P, A but below the demand curve (D).
With price discrimination, (the bottom diagram), the demand curve is divided into two segments (D1 and D2). A higher price
(P1) is charged to the low elasticity segment, and a lower price (P2) is charged to the high elasticity segment. The total
revenue from the first segment is equal to the area P1,B, Q1,O. The total revenue from the second segment is equal to the area E,
C,Q2,Q1. The sum of these areas will always be greater than the area without discrimination assuming the demand curve resembles a
rectangular hyperbola with unitary elasticity. The more prices that are introduced, the greater the sum of the revenue areas, and
the more of the consumer surplus is captured by the producer.
Note that the above requires both first and second degree price discrimination: the right segment corresponds partly to
different people than the left segment, partly to the same people, willing to buy more if the product is cheaper.
It is very useful for the price discriminator to determine the optimum prices in each market segment. This is done in the next
diagram where each segment is considered as a separate market with its own demand curve. As usual, the profit maximizing output
(Qt) is determined by the intersection of the marginal cost curve (MC) with the marginal revenue curve for the total market
(MRt).
Multiple Market Price Determination
The firm decides what amount of the total output to sell in each market by looking at the intersection of marginal cost with
marginal revenue (profit maximisation). This output is then divided between the two markets, at the equilibrium marginal revenue
level. Therefore, the optimum outputs are Qa and Qb. From the demand curve in each market we can determine the profit maximizing
prices of Pa and Pb.
It is also important to note that the marginal revenue in both markets at the optimal output levels must be equal, otherwise
the firm could profit from transferring output over to whichever market is offering higher marginal revenue.
Examples of price discrimination
Retail Price Discrimination
In certain circumstances, it is a violation of the Robinson-Patman Act, (a 1936
Federal U.S. antitrust statute) for manufacturers of goods to sell their products to similarly situated retailers at different
prices based solely on the volume of products purchased.
Travel industry
Airlines and other travel companies use differentiated pricing regularly, as they sell travel
products and services simultaneously to different market segments. This is often done by assigning capacity to various booking
classes, which sell for different prices and which may be linked to fare restrictions. The restrictions or "fences" help ensure
that market segments buy in the booking class range that has been established for them. For example, schedule-sensitive business
passengers who are willing to pay $300 for a seat from city A to city B cannot purchase a $150 ticket because the $150 booking
class contains a requirement for a Saturday night stay, or a 15-day advance purchase, or another fare rule that discourages,
minimizes, or effectively prevents a sale to business passengers.
Notice also that even in this simple example, the "seat" is not the same product. That is, the business person who purchases
the $300 ticket may be willing to do so in return for a seat on a high-demand morning flight, for full refundability if the
ticket is not used, and for the ability to upgrade to first class if space is available for a nominal fee. On the same flight are
price-sensitive passengers who are not willing to pay $300, but who are willing to fly on a lower-demand flight (say one leaving
an hour earlier), or via a connection city (not a non-stop flight), and who are willing to forego refundability.
Since airlines often fly multi-leg flights, and since no-show rates vary by segment, competition for the seat has to take in
the spatial dynamics of the product. Someone trying to fly A-B is competing with people trying to fly A-C through city B on the
same aircraft. This is one reason airlines use yield management technology to determine
how many seats to allot for A-B passengers, B-C passengers, and A-B-C passengers, at their varying fares and with varying demands
and no-show rates.
With the rise of the Internet and the growth of low fare airlines, airfare pricing transparency has become far more
pronounced. Passengers discovered it is quite easy to compare fares across different flights or different airlines. This helped
put pressure on airlines to lower fares. Meanwhile, in the recession following the September
11, 2001, attacks on the U.S., business travelers and corporate buyers made it clear to
airlines that they were not going to be buying air travel at rates high enough to subsidize lower fares for non-business
travelers. This prediction has come true, as vast numbers of business travelers are buying airfares only in economy class for
business travel.
Premium pricing
For certain products, premium products are priced at a level (compared to "regular" or "economy" products) that is well beyond
their marginal cost of production. For example, a coffee chain may price regular coffee at
$1, but "premium" coffee at $2.50 (where the respective costs of production may be $0.90 and $1.25). Economists such as
Tim Harford in the Undercover Economist
have argued that this is a form of price discrimination: by providing a choice between a regular and premium product, consumers
are being asked to reveal their degree of price sensitivity (or willingness to pay) for comparable products. Similar techniques
are used in pricing business class airline tickets and premium alcoholic drinks, for example.
This effect can lead to (seemingly) perverse incentives for the producer. If, for example, potential business class customers
will pay a large price differential only if economy class seats are uncomfortable while economy class customers are more
sensitive to price than comfort, airlines may have substantial incentives to purposely make economy seating uncomfortable. In the
example of coffee, a restaurant may gain more economic profit by making poor quality regular coffee--more profit is gained from
up-selling to premium customers than is lost from customers who refuse to purchase inexpensive but poor quality coffee. In such
cases, the net social utility should also account for the "lost" utility to consumers of the regular product, although
determining the magnitude of this foregone utility may not be feasible.
Segmentation by age group and student status
Many movie theaters, amusement parks,
tourist attractions, and other places have different admission prices per market
segment: typical groupings are Youth, Student, Adult, and Senior. Each of these groups typically have a much different demand
curve. Children, people living on student wages, and people living on retirement generally have much less disposable income.
Discounts for members of certain occupations
Many businesses, especially in the Southern United States, offer reduced
prices to active military members. In addition to increased sales to the target group,
businesses benefit from the resulting positive publicity, leading to increased sales to the general public. Less publicized are
discounts to other service workers such as police; off-duty police customers in high-crime areas
are said to constitute free security.
Employee discounts
Discounts that businesses give to their own employees are also a form of price discrimination.
Retail incentives
A variety of incentive techniques may be used to increase market share or revenues at the retail level. These include discount
coupons, rebates, bulk and quantity pricing, seasonal discounts, and frequent buyer discounts.
Incentives for industrial buyers
Many methods exist to incentivize wholesale or industrial buyers. These may be quite targeted, as they are designed to
generate specific activity, such as buying more frequently, buying more regularly, buying in bigger quantities, buying new
products with established ones, and so on. Thus, there are bulk discounts, special pricing for long-term commitments, non-peak
discounts, discounts on high-demand goods to incentivize buying lower-demand goods, rebates, and many others. This can help the
relations between the firms involved.
Gender-Based
Many gender-based price differences are held to be illegal in the United States.
"Ladies' night"
Many North American nightclubs feature a "ladies' night" in which women are offered
discount or free drinks, or are absolved from payment of cover charges. This differs from
conventional price discrimination in that the primary motive is not, usually, to increase revenue at the expense of consumer
surplus. Rather, establishments benefit by maintaining an equitable gender balance; if the clientele of an establishment is
primarily male, it will lose popularity with both heterosexual men (who go to nightclubs to date, and thus want as many women to
choose from as possible) and women (who often come to socialize asexually with other women, and, even if looking for men, do not
enjoy the pushy interest that a skewed gender ratio foments), and therefore it is better for the establishment to lower its
prices for women if they show less demand.[citation needed]
Dry cleaning
Dry cleaners typically charge higher prices for the laundering of women's clothes than for men's. Even though this involves
small amounts of money (compared to, say, college tuition), this has provoked reactions in some US communities, who occasionally
have outlawed the practice. Although many people have reacted negatively to the "discrimination" of this practice, economic
investigation (including that done by Steven Landsburg - see external link at bottom of
this article) indicates that prices are higher for women not because of discrimination, but because the cost to provide these
services is in fact different. For dry cleaners, women's shirts tend to be less consistent and more fragile, and therefore have
to be pressed by hand, whereas men's shirts can be pressed by a machine, accounting for the higher cost.
Haircutting
Women's haircuts are often more expensive than men's haircuts which in past times could be accounted for as women generally
had longer hairstyles whereas men generally had shorter hairstyles. Nowadays men's and women's styles are more varied but the
price discrimination continues. Some salons have modified their pricing to reflect "long hair" versus "short hair" or style
instead of gender.
Financial aid in education
Financial aid as offered by U.S. colleges and
universities is a form of price discrimination that is widely accepted, and completely
legal.
Despite this, middle- and lower-income students are often afforded discounts in the form of tuition waivers, scholarships,
work-study programs that pay partly in free course hours, and government guaranteed loans.
Little objection is given to this version of price discrimination, because of the well-established funding mechanism which
does a good job of allocating positions to members of all income classes in the US.
"Haggling"
Many cultures involve "haggling" in market transactions — inflated prices are posted, but the customer can negotiate with the
vendor. In the United States, haggling is rare if not nonexistent in grocery stores and
with retailers, but common when automobiles and homes are sold. Negotiation often requires
knowledge, confidence, and a confrontational personality, and vendors know that many customers will pay higher prices in order to
avoid haggling.[citation needed]
International price discrimination
Pharmaceutical companies may charge customers living in wealthier countries (such as the United States) a much higher price
than for identical drugs in poorer nations, as is the case with the sale of anti-retroviral drugs in Africa. Since the purchasing
power of African consumers is much lower, sales would be extremely limited without price discrimination. The ability of
pharmaceutical companies to maintain price differences between countries is often reinforced by national drugs laws and
regulations. Another example is textbooks, publishers such as Prentice Hall and Pearson have low cost editions of textbooks for
countries such as India. The textbooks are often printed on cheaper paper, are paperbacks and priced at 15-20% of the dollar
price. This pricing has largely eliminated the practice of photo copying these books.
Governments can also use tax policy to increase prices in order to limit consumption and increase tax revenue, such as
automobile prices, which incur a 100% tax in many countries with low automobile population.
Even online sales for non material goods, which do not have to be shipped, may change according to the geographic location of
the buyer. A song in Apple's itunes costs 79 pence (1.49 USD) for Britons but only 99 US-cents for Americans. Britons pay 49%
more than Americans for the same song. These differences may arise because of changes in exchange
rates that occur much more frequently than changes in prices, or they may arise because the license-holders (in this case,
record companies) are enforcing their existing pricing policy on new licensees or intermediaries.
Academic pricing
Companies will often offer discounted software to students and faculty at K-12 and
university levels. These may be labeled as academic versions, but perform the same as the
full price retail software. Academic versions of the most expensive software suites may
be priced as little as one fifth or less of retail price. Some academic software may have differing licenses than retail
versions, usually disallowing their use in activities for profit or expiring the license after a given number of months. This
also has the characteristics of an "initial offer" - that is, the profits from an academic customer may come partly in the form
of future non-academic sales if they get "hooked" on the product.
Dual pricing
Even within a country, differentiated pricing may be established to ensure that citizens receive lower prices than
non-citizens; this is known as dual pricing. This is particularly common for goods that are subsidized or otherwise
provided by the state (and hence paid by taxpayers). Thus Finns, Thais, and Indians (among others) may purchase special fare
tickets for public transportation that are available only to citizens. Many countries also maintain separate admission charges
for museums, national parks and similar facilities, the usually professed rationale being that citizens should be able to educate
themselves and enjoy the country's natural wonders cheaply, but other visitors should pay the market rate.
Wage discrimination
Wage discrimination is when the price of equivalent labor is discriminated among different groups of workers. This may
be seen as just one kind of price discrimination or as an example of its inverse, one buyer buying identical goods at different
rates.
Price discrimination by online search type
Some online stores and companies attempt to price discriminate between their customers by using information they gather about
how a particular customer is searching for a product. For example, some travel firms have been shown to mark-up prices for all
the holiday packages they list when a customer asks to see their holidays ranked with the most expensive package first (which
suggests the customer may be price insensitive). The same packages may be available for less if the customer changes their search
type. Variants of this behaviour have been reported on other ecommerce sites, where the more specific your search for a
particular good, the lower price is displayed for that good.
Universal pricing
"Universal" pricing is the opposite of price discrimination — one price is offered for the good or service. This is usually
preferred by consumers over tiered pricing. For example, the European Union is currently
making efforts to set a single-price protocol for automobile sales.[citation needed]
See also
References
- The Strategy and Tactics of Pricing by Thomas Nagle and Reed Holden. ISBN 0-13-026248-X.
External links
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