Economics Terms A-Z
Price discrimination is a pricing strategy in which firms charge different prices for different units of the same physical good or service, either to different consumers or to the same consumer. By doing so firms can increase their profits compared to selling each unit of the good at the same price.
If and how a firm can successfully price discriminate depends crucially on the information that the firm has about its customers and on the possibilities of the consumers to engage in arbitrage. Note that it is not price discrimination if price differences reflect differences in the costs of serving those consumers. Price discrimination is usually studied in a monopoly and we distinguish between three different types of price discrimination:
First degree price discrimination
First degree price discrimination is also called perfect price discrimination and from the perspective of the firm this type of price discrimination yields the highest possible profit. To perform first degree price discrimination the monopolist needs to know the exact willingness-to-pay or demand function of each of its consumers and it has to be able to perfectly distinguish the customers from each other (i.e. no customer can lie about his true willingness-to-pay). Then the monopolist can charge each consumer exactly his or her maximum willingness-to-pay for the good. Clearly, consumers will be worse off than without price discrimination, because consumer surplus is zero. The entire surplus goes to the monopolist. The quantity exchanged will be the same as in perfect competition which means that there is no efficiency loss or deadweight loss if a monopolist can perfectly price discriminate.
Perfect price discrimination is rare, because firms rarely possess perfect information about the exact willingness to pay of each customer. Additionally, the possibility of arbitrage might prevent the monopolist from discriminating between consumers. Arbitrage means that the consumers can exploit the differences in prices and there are two possible types of arbitrage that may prevent price discrimination: First, consumers may be able to resell the good to other consumers. Consumers who can buy at a lower price would do so and then resell the good to consumers who were supposed to pay a higher price. Second, consumers may pretend to have a lower willingness-to-pay than they actually do. That is why for first-degree price discrimination to work the monopolist needs to know the exact willingness-to-pay of each single customer personally.
Now you may wonder whether there are even situations in which first-degree price discrimination is possible. One situation in which perfect price discrimination may be possible is when the exchange of the good involves bargaining or haggling between the buyer and seller (e.g. on a flea market). A skilled seller may be able to sell his or her goods at a price that is very close to the maximum willingness-to-pay of the consumer. Besides this, when determining the price of a completely new good or service, where the potential buyers have difficulties evaluating the product due to lack of experience, a monopolist might be able to extract the entire consumer surplus. Think, for example, about a firm who is considering to buy a completely new software or use a novel technology to reduce production costs for the first time when it does not yet know how this change will impact profits and costs.
Second degree price discrimination
In the case of second-degree price discrimination, the monopolist knows that it has different types of customers (because of a market survey or experience) and knows the willingness-to-pay or demand function of each type of customer. In contrast to third-degree price discrimination the firm cannot distinguish between consumers of different types and therefore cannot charge a different price to each group. To maximize profits the monopolist will offer different options and let the consumers decide themselves which of the options to buy. The prices are designed in such a way that consumers of different types will choose different options. An example are quantity discounts. We all have already come across offers such as “Buy 3 for the price of 2”. Why does it make sense for the firm to offer such deals? This makes sense if the firm knows that some consumers usually like to buy one unit, but that by offering the third unit “for free”, they might be encouraged to buy the second unit. Other examples of second-degree price discrimination include sales (a famous one is Black Friday), bundling or tying.
Third degree price discrimination
Third degree price discrimination is used to describe the common practice of charging a different price to different groups of customers, like, for instance, student discounts. The monopolist faces different groups of customers and knows the aggregate demand function of each group. Customers might be grouped according to age categories, occupation, gender, location, religion, language, etc. The monopolist can tell its customers apart, meaning that it knows to which group a particular customer belongs by using a signal. For example, in order to benefit from a reduced price for students, you normally have to present your student ID. Then the monopolist simply charges a different price for each group of customers. The mark-up that the monopolist charges will be higher in groups with a lower price-elasticity of demand.
Third-degree price discrimination is the preferred option for the monopolist if they cannot discriminate within a particular group. So even if the monopolist knows that some students are more price sensitive than others, it cannot charge a different price within the group of students, because they cannot tell them apart and they might engage in arbitrage. Charging different prices to different groups of customers only works if customers who obtain the lower price cannot resell the good to customers who should pay the higher price. When you think about examples of third-degree price discrimination, you will soon realize that in most of them reselling is not possible. For example, if you get a reduced entry into a museum, you have to present your student ID not only when buying the ticket, but also when entering the museum and this means that you cannot buy the ticket at a reduced price and resell to a non-student, because he or she would not be allowed to enter with the reduced-price ticket.
The monopolist´s profit with third degree price discrimination is higher than without price discrimination. Consumer surplus may increase or decrease. Consumers who are more price sensitive are better off with price discrimination, because they will get a lower price than without price discrimination (the students, for example). Consumers who are less price sensitive will be worse off, because they will have to pay a higher price with price discrimination than without.
Price discrimination is very common in practice and we observe it every day in the supermarket, when buying tickets to concerts or museums, when buying a plane ticket or booking a holiday. In fact, most companies price discriminate somehow. One important question is whether discrimination in prices targets the same groups that face discrimination in many other aspects as well as e.g. people of color, women or people with certain religious beliefs. For example, Goldberg (1996) studied dealer price discrimination in new car purchases and found no evidence that the buyers´ characteristics determine dealer discounts, but rather the characteristics of the car and the purchase itself.
Good to know
We all know how tedious it can be to book a plane ticket with a low-cost airline. The fare that you see in the search engine rarely reflects the price you will end up paying, because you have to pay extra for literally everything: Luggage (hand luggage and checked luggage separately of course), a preferred seat (includes sitting next to your travel companions), food, credit card fees, insurance, and so forth. Who do you think came up with this type of pricing strategy? Some clever economists, who know that different consumers have a different willingness-to-pay for different services and therefore additional consumer surplus can be extracted by designing the prices in a clever way. If you by default assign people travelling together seats in different rows, many of them will be willing to pay some extra money to be able to sit next to each other.