In our economics tuition, this jc economics note provides a good understanding on the concept of price discrimination and the three degrees of price discrimination.
What is price discrimination?
Examine price setting behaviour of firms
In technical terms, price discrimination is essentially a practice of charging different prices to different groups of customers for the exact same product. This can be applied to many types of market so long the firm is able to understand the varying price elasticity of demand for each group of customers and adjust the prices accordingly. But price discrimination is not as easy as it sounds. Do you know that there are in fact 3 types of price discrimination? All 3 types are distinct from each other, with unique characteristics and practices and we shall cover in the following.
Starting with the 1st degree price discrimination, the price difference rests merely on different buyers’ valuation of the same product, which is discriminatory in nature. If successful, this type of the price discrimination will increase the firm’s total profits. Some examples will include auctioning and even surge-pricing, which I am sure that the most of you are familiar with when taking Grab or Uber.
Onward to 2nd degree price discrimination, the price difference arises when a producer sells different quantities of a specific product at two or more prices, for reasons not associated with cost differences. Basically, the price of the product will depend on the quantity of consumption by the customer. Often enough, retail shops use this kind of price discrimination in the form of “buy 2, free 1” or “buy 2 at 20% discount and buy 3 at 30% discount” etc.
Lastly, we have 3rd degree price discrimination which is the practice of charging different prices depending on a particular market segment, e.g. time of use, income group and age profile. Prominent in the theatres, the 3rd degree price discrimination allows for price difference between the adults and students, with students experiencing cheaper movie rates due to a higher price sensitivity.
Now that you understand how price discrimination works, proceed to the next section to learn more about the prerequisites for price discrimination.
What are the conditions for price discrimination?
Determining factors for price discrimination
For price discrimination to function, there has to be conditions to put in place to ensure the willingness of the consumers to abide to the price of the product. Conditions for price discrimination are as such:
The simplest of all, price discrimination functions when there are two or more prices being charged for a product or service. This allows for a price difference and hence targets different groups of customers. Moreover, the good or service must be exactly same, with no difference whatsoever, so as to develop the same amount of price-elasticity of demand for the good.
Additionally, price differences must not arise out of cost differences as the price discrimination is based on the arbitrarily set price rather than the cost of production. Having the same cost of production ensures equal treatment of the product despite differing groups of customers.
Furthermore, the seller must be able to control the supply of the good and thus prevent the resale of the good from one market to another. This is important because the control of supply gives the seller the sole ability to fix prices in the market. This ability is vital in the creation of a difference in prices. Also, if other sellers control the supply, they will have the capability to fix their own price, be it low or high, which negates the need for price discrimination.
In the case of a monopoly market, the monopolist must be able to separate the markets into different segments. These segments is dependent on the type of market and represents a difference in demand between two or more groups of customers. Segments include geography, type of demand, time and nature of product (different value of PED) that a monopolist can employ.
Hence, the above conditions are all important in order for the seller to create a difference in price of the same goods and employ price discrimination in the market. Having understood the function of price discrimination, there is a need to conduct a cost-benefit analysis so as to understand the challenges in executing price discrimination.
What are the advantages and disadvantages of price discrimination?
Why should firms engage in price discrimination
Now that we understand the functionality of price discrimination from the previous article, we have to learn the rationale of such pricing strategy in firms and the impact it plays on the consumers and society at large. These impacts can be divided into pros and cons which this article shall explore.
One rationale for adopting price discrimination is that it makes supplying a good, which otherwise could not have been produced, possible. This is done by covering the loss from a lower priced market with the profits from a higher priced market, thus sustaining the provision of the good by the seller. One example will be that of a surgeon’s service. Despite charging a lower price for students and elderly which results in profit loss, this can recovered by the charging of higher prices on normal adults, thereby extending surgery services to even the price-sensitive group.
As a follow-up, price discrimination makes it possible for a greater number of consumers to benefit from the product/services. By charging higher price on normal adults and lower price on students/elderly, the consumer market is able to extend to include those who could not afford surgery originally. Therefore, consumer welfare increases while access to surgery opens up to consumers with lower purchasing power.
In the firm’s perspective, price discrimination allows for a cultivation of consumer loyalty. As the consumer group expands, consumption will increase naturally. This may breed familiarity as well as trust in the brand as consumption ensues over a span of time. Having consumer loyalty ensures that the firm has a stable source of price-inelastic demand for their present and future products.
Moreover, price discrimination can help a firm to produce above a larger quantity level so as to reap Economies of Scale (EOS). This is possible due to the increased consumption from the growth in the consumer market. With EOS, the firm is able to lower the average cost of production and raise profitability in turn.
In spite of its advantages, price discrimination has its ugly side too and may pose a disadvantage to the firm per se and the consumers. In the eyes of the consumer, price discrimination may be a form of consumer exploitation for certain consumer groups. In the case of 3rd degree price discrimination, some consumers may pay a higher than necessary price for the same product. This creates allocative inefficiency as deadweight loss is generated from the additional cost of the product.
As for the firm, price discrimination may generate additional cost of production and branding, which can be translates into the cost of market separation and the cost of engaging a change in product imagery respectively. In the field of market separation, there needs to be proper research done on the consumer market to identify the right consumer groups to segmentize. Additionally, price strategists have to work out an appropriate price difference of the same product which only adds on to the cost of production.
With respect to the cost of engaging in the changing product imagery, marketing cost shoots up as firms attempt to convey the product change to the different consumer groups. This extra cost, therefore, decreases profitability for the firm.
In conclusion, price discrimination has both its merits and demerits. It is thus important to understand the impacts on the firm, consumer and society so that you know the intent of price discrimination when firms employ it. Ultimately, you must also know its societal impact in depth in order to ensure social welfare in the economy, which will be approached in the next article.