Price discrimination exists when sales of identical goods are transacted at different prices from a single vendor. Theoretically, price discrimination is a feature only of monopoly markets. In addition to a monopoly market, price discrimination requires some means to discourage discount customers from becoming resellers and by extension competitors. This usually entails either 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.
There are three 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 less goods. With an increase of the price 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, e.g. by pretending to like the product less than he or she really does, and by "threatening" not to buy it.
- In second degree price discrimination, price varies according to quantity sold. Larger quantities are available at a lower unit price.
- In third degree price discrimination, price varies by location or by customer segment. See economics of location.
In economic terms, the purpose of price discrimination is 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.
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).
The firm decides what amount of the total output to sell in each market. This is determined from the marginal revenue curves in each market. The intersection of the total market price with the marginal revenue curves in each market yields optimum outputs of Qa and Qb. From the demand curve in each market we can determine the profit maximizing prices of Pa and Pb.
Price skimming is a type of price discrimination. It is price discrimination 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.
A closely related concept is yield management. In price discrimination firms charge different prices depending on who buys the product, who buys what quantities, and who buys in what locations. In some jurisdictions this is illegal. In yield management, firms charge different prices depending on minor variations in the product. These firms typically engage in product differentiation. They modify their product offerings so that each product is optimized for a particular target market. Hense charging a business traveller three times the cost of an economy airplane seat is not price discrimination. It is yield management because the product is different (larger seats, and better food than economy class). Typically yield management groupings are at the aggregate, rather than individual, level. When a market segment is charged one price, they are said to be in a price bucket.
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