Price Discrimination
A pricing strategy where a firm selling a similar or identical product charges different prices to different markets.
What Is Price Discrimination?
Price discrimination is a pricing strategy where a firm selling a similar or identical product charges different prices to different markets.
Right away, that sounds like a bad thing. But if you’re a college student using your ID to get a sweet deal on a meal, it’s not so bad.
This pricing strategy relies on differences in the customer’s willingness to pay or their individual demand. As the customer’s demand increases, so do the price they’ll accept per unit. However, the lower the price, the more customers will be attracted to that good or service.
Price elasticity, or how sensitive customers are to changes in the price of a good, is also essential. Goods for which customers are less sensitive to price changes are more suitable for price discrimination.
Imagine an ice cream truck in New York City. Everyone’s demand for ice cream is low in the winter. Come summer. Demand has risen due to the heat. In the Upper West Side, the truck can charge higher prices because residents of that neighborhood often have high incomes.
If the truck sets up shop outside a middle school, it will charge lower prices. After all, kids don’t have much disposable income since they can’t work. The truck charges lower prices in that area, knowing it will attract more customers to compensate for the decrease in unit price.
Does the truck serve homemade gelato in the Upper West Side and cheaper air-filled ice cream to the middle schoolers? No, that’d raise the costs of production. This discrimination aims to make more profit using the same product.
If production costs did change significantly between what is served to both groups, that would indicate the truck is selling two different products. Then, the ice cream truck would be using product differentiation.
Note that “differential pricing” can refer to this strategy or a mix of price discrimination and product differentiation. If the truck sold just the cheaper flavors to the middle schoolers at a slightly lower price, that would be differential pricing.
But this ice cream truck scheme isn’t perfect. Our truck is competing with countless other trucks throughout the city, selling the same product.
One ice cream truck alone can’t set the price in such a market. If another truck sets up shop in the Upper West Side and charges lower prices, our truck loses business. In this case, price discrimination can be difficult.
What are the circumstances needed to make this strategy work?
Conditions for Price Discrimination
As the example above demonstrates, price discrimination isn’t always easy or effective. Done poorly, it can hurt a firm and product’s image and erode its bottom line.
Many factors determine how well this strategy works, including:
- The type of product (e.g., agriculture, luxury goods, services)
- The size and number of customer base(s)
- How many firms are producing a comparable product
There are three major conditions for using this price strategy, but imperfect competition is the most important to discuss and understand.
Imperfect Competition
In theory, this discrimination would only work in markets that don’t experience perfect competition. Markets in the imperfect competition are oligopolies or monopolies. Oligopolies have several firms, and monopolies have one firm controlling production.
Perfect competition occurs in markets when:
- There are a large number of buyers and sellers
- No firm has the power to set prices, regardless of market share
- It’s easy for firms to enter or exit the market
- The product is completely homogenous
- Buyers and sellers have perfect information
Why Wouldn’t This Method Work In Perfect Competition?
With perfect information, if a seller tries to charge different prices for the same good, buyers would buy it from one of the countless other firms.
Other firms will enter the market if a firm makes a substantial profit. There are no barriers to entry. These firms will then increase supply in that market and drive prices down until all firms have no incentive to enter or exit the marketplace.
Therefore, firms in a perfectly competitive market earn a normal profit - enough to keep them in business and compensate the owner for their opportunity cost. “Opportunity cost” refers to how much the owner forgoes for not taking the next best opportunity - e.g., the wage they’d earn.
But real life is rarely a perfect competition circumstance. Consumers often knowingly accept higher prices for various reasons, such as convenience.
Firms are aware of this and take advantage of it through the remaining conditions.
Market Segmentation and Prevention of Resale
Market segmentation is the act of dividing your customers into different groups. This is a common marketing strategy.
Separating the market allows firms to take advantage of the fact that different groups may have different demand elasticities for the same good. This is called “price segmentation.”
Price segmentation includes pricing based on the customer, product, location, and time. In this case, customers are primarily categorized by how much they’re willing to pay for a good or service.
In some cases, there is more than one type of price segmentation taking place. Airplane tickets for flights that leave or arrive at inconvenient times are usually cheaper. This is time and price segmentation.
But the cheaper flights also attract customers who aren’t willing or able to pay for flights at more convenient times. So, this is also price segmentation based on the customer’s income and demand.
When the same goods are being sold at different prices, customers in the market receiving a lower price can resell the product to make a profit. In doing so, they undercut the original seller.
Customers with higher demand for the good, willing to pay higher prices, may choose to buy the resold product. The firm producing the good or service would lose out on profit.
Thus, the firm will act to prevent reselling. A senior can’t sell their cheaper movie ticket to a young adult because the adult won’t be able to use it. Some products must be registered and can only be used by the original buyer.
Why are some customers willing to tolerate higher prices for the same exact good? Some market segments have higher incomes than others and spend a smaller fraction of their income on goods. They will be less sensitive to increases in the good’s price than lower-income consumers.
Some consumers might have less time to look for alternatives and are willing to accept a higher price. These are various factors of price elasticity of demand.
Groups with Different Elasticities of Demand
The firm won’t even be able to take advantage of price segmentation if there aren’t groups with different price elasticities of demand.
As a reminder, price elasticity of demand measures how much a change in price affects the quantity demanded. In simpler terms, it refers to how sensitive consumers are to prices for a certain good.
Let’s return to the airline example. Suppose we have a group traveling overseas for a meeting this week and a group thinking of flying to a vacation spot.
The customers traveling to a meeting have to arrive by a certain time. They’ll want to be well rested and might prepare during the flight.
As a result, these customers will accept higher prices to be able to travel during peak hours. Their demand is relatively inelastic because they must book a flight regardless of price changes.
The group thinking of flying to a vacation spot has more options. Depending on where the vacation is, they might even have transport alternatives like a road trip or train ride. They don’t need to fly out the same way the business people going to a meeting do.
As a result, their demand is much more elastic since they are much more responsive to changes in pricing.
They’ll want lower prices and be more accepting of off-peak travel times. So, the airline can propose a lower price to attract customers to fly at less convenient times. They also have more alternatives and more time to choose.
By charging both parties different prices, the airline makes more profit than if it charged everyone the same price. The people traveling to a meeting pay higher fares for each ticket, and the vacationers buy more tickets.
There are also other benefits. In this case, price discrimination is helping the airline regulate demand and fully use its capacity. It can offer other travelers lower prices by charging some travelers higher prices.
First Degree Price Discrimination
“First degree” is sometimes referred to as “personalized pricing” or “perfect price discrimination.” When first-degree price discriminating, sellers charge each individual customer a different price.
The goal is for consumers to pay the highest possible price they will accept. That price is called the “absolute maximum price” or “reservation price.”
First-degree discrimination eliminates consumer surplus and maximizes producer surplus. As a result, it increases revenues and is the most profitable discrimination method.
Consumer surplus is the difference between the price paid by a consumer for a good and the maximum price they’d be willing to pay.
Its counterpart is producer surplus, the difference between the marginal (additional) cost to produce that unit and the price the firm receives for it.
The firm must know exactly the highest acceptable price to capture the consumer surplus.
Auctions are one-way firms can determine this price since each customer bids to indicate they are willing to pay a higher price than the customer before them.
Likewise, negotiations for professional services or certain goods (e.g., cars) can help firms determine the absolute maximum price.
Nowadays, firms can also get a better idea through data mining. By checking what consumers buy online and what prices they accept, firms can get a general idea of our demand elasticity and budget.
Suppose a consumer often looks up tents and purchases expensive camping equipment. Large retailer’s sites will know to show them higher prices for tents but show another uninterested consumer a lower price.
Most airplane ticket websites' price discriminates using information gathered through data mining.
Airlines represent an oligopoly, which gives them significant price-setting power. In practice, no two flights are identical (food and crew quality varies by airline, weather conditions, etc.), but consumers still have different price options among similar flights.
Monopolies can capture consumer surplus since they’re the sole producer of a certain good.
Of course, this method isn’t perfect. An easier way to implement price discrimination is through how many units the consumer purchases simultaneously.
Second Degree Price Discrimination
Second-degree discrimination is when the price varies by quantity demanded. The key to this pricing strategy is to use non-linear pricing so that each unit becomes cheaper.
Unlike first-degree discrimination, this method doesn’t aim to capture the consumer surplus by charging them the highest possible per-unit price. Instead, it aims to capture more market surplus by convincing them to buy more units each at a lower price.
For example, many shops in tourist traps will offer one hoodie for $20 but two for $35. The consumer pays slightly less for each hoodie ($17.50), but the firm recoups the lower price on each unit because it sells more.
A classic example of this is any retail store that sells in bulk, such as Costco and BJ - such pricing is at the heart of their business strategy. While consumers pay more up-front because of the quantities available, each unit is cheaper, encouraging customers to spend more.
Wholesalers not only use this strategy but also benefit from having price-discriminating suppliers. Such suppliers are a major benefit and key component of economies of scale.
“Economies of scale” refers to when a firm increases mass production while lowering its average total costs. This gives firms a competitive edge when it comes to pricing and margins. As firms scale production and sales, they place larger orders with their suppliers.
In business-to-business sales, suppliers often offer their customers lower per-unit prices for bulk orders. Accessing these quantity discounts allows distributors to maintain low per-unit production costs.
Bulk purchases aren’t the only way to discriminate second-degree prices. Many small or chain businesses, such as bubble tea shops, offer loyalty cards. After buying nine drinks, some shops free you the tenth one.
Other methods are less immediately obvious but encourage further sales, such as buy two get one free offer, discounts, coupons, and store credit offered after an initial sale.
Third Degree Price Discrimination
Third-degree discrimination relies on identifying and segmenting different consumer groups and finding prices those groups would pay.
The essential difference between first and third-degree price discriminators is that the first-degree method identifies the highest price an individual consumer will pay. In contrast, the third-degree method identifies the certain price groups would pay.
Imagine a passenger rail company, Consumer Rail Co. Consumer Rail, offers train trips throughout the United States, from major cities to tourist attractions and smaller residential areas. Consumer Rail can segment and price discriminate in countless ways.
The firm can charge different prices based on the type of traveler. You might wonder how the firm could tell what segment a customer belongs to.
In this case, the firm could guess based on the destination. Most traffic to a destination like Keystone, South Dakota, where Mount Rushmore is located, would be from tourists.
These consumers are willing to pay higher prices than those going to less popular destinations like suburban residential towns, even if the distance from point A to B is the same.
These more popular destinations might be further away or more expensive to offer train rides. Or maybe a ride to a tourist attraction isn’t the same as a ride to a residential town.
Third-degree discrimination strategies are often used with somewhat differentiated products, resulting in the differential mentioned above prices.
A classic method of third-degree discrimination is dividing customers by age. Seniors often have less disposable income than working adults. Likewise, parents may consider taking the train as an alternative to road trips or flights if they can pay less for their children’s tickets.
Consumer Rail Co. could also offer discounts to busy and esteemed occupations, such as lower prices for healthcare workers. Here, the lower price makes up for a perceived disadvantage to the consumer group, such as the length of the train trip.
Researched and Authored by Sara De Meyer | LinkedIn
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