One of the strategies available for firms with
price-setting power is the potential to engage in price discrimination. Price
discrimination occurs when a producer charges different prices to consumers
for the same good or service for reasons not associated with the costs of
production. We will look at
first, second and third degree price discrimination.
Degree Price Discrimination.
This will occur when the firm is able to charge each
customer the maximum price he or she is prepared to pay for the good or
service. It is assumed that the
firm has very detailed knowledge of its consumers demand curves.
The seller will sell each unit of output depending upon the customers
Stallholders in a foreign market will attempt to do this
when they haggle with their customers. Elements
of first degree price discrimination can also be found at a Dutch auction,
such as the flower markets in Amsterdam.
In a Dutch auction the price starts very high and gradually falls
until the first bidder bids and takes the good or service.
This means that the price paid is going to be very close to the
maximum price the consumer is willing to pay, thereby allowing the producer
to extract as much consumer surplus as it possibly can.
This differs from a normal English auction where a consumer may win
with a bid that was far below what they were prepared to pay for it.
Perfect price discrimination occurs when the producer is
able to charge every consumer the price he is willing to pay, in this case
the consumer surplus will be equal to zero.
This is shown in the diagram below.
Second Degree Price Discrimination
This type of price discrimination occurs when a firm is
trying to sell off any excess capacity it has remaining at a lower price than
the normal published price. This
is often done in the airline and hotel industries, where spare seats and
rooms are sold at the last minute at greatly reduced prices.
In these industries fixed costs will typically be very
large and marginal costs will be relatively small and constant, e.g., the
cost of having an extra person on an aeroplane or in a hotel is very small.
The product can be provided at a constant marginal cost until a rigid
fixed capacity is reached; this means that the marginal cost curve will be
horizontal up to the point where full capacity is reached where it becomes
Second degree price discrimination can be shown on the
The firm will initially charge the profit maximising
price of P1 and producing quantity Q1.
The firm will have a large amount of spare capacity, this is equal to
the difference between Q1 and Full Capacity.
The firm will be willing to sell this volume for any price so long as
it covers the marginal cost of producing them, as it will be the contributing
to its fixed costs or profits. This
will occur at the lower price of P2 and increase total consumer
surplus by xyz. The firm will
also benefit as there is no point in having empty rooms or seats.
A hotel must remain open and a plane must fly even if there only a few
Examples of second degree price discrimination can be
seen in any market where excess capacity needs to be eliminated, examples
traditional end of season sale.
prices for cinema and theatre in the afternoons.
minute bargain holidays.
The increased use of the internet has made it easier to
consumers to access information about last minute deals.
A large number of sites have been set up specifically to deal with the
excess capacity that occurs in a number of industries, e.g., www.lastminute.com.
Third Degree Price Discrimination
There are basically three main conditions required for
price discrimination to take place
power - Firms must have some price setting power – this means we
don't see price discrimination in perfectly competitive markets.
of the market - The firm must be able to split the market into
different groups of consumers; this is normally done by separating markets
by geography, time or income. The
must prevent the good or service being resold between consumers. (For
example a rail operator must make it impossible for someone paying a
"cheap fare" to resell to someone expected to pay a higher fare.
This is easier in the provision of services rather than goods. The
costs of separating the market and selling to different groups (or market
segments) must not be prohibitive.
of demand - There must be a different price elasticity of demand for
the product in each group of consumers. This allows the firm to charge a
higher price to those consumers with a relatively inelastic demand and a
lower price to those with a relatively elastic demand.
The firm will then be able to extract more consumer surplus which
will lead to additional revenue and profit.
Examples of price discrimination
There are numerous good examples of discriminatory
pricing policies. We must be careful to distinguish between discrimination
(based on consumer's willingness to pay) and product differentiation - where
price differences might also reflect a different quality or standard of
service. Some examples of
discrimination worth considering include:
and theatres cutting prices to attract younger and older audiences
discounts for rail travel, nightclubs, restaurant meals and holidays
hour in bars
taxi fares during the night
offering cheap weekend breaks and winter discounts
The aims of price discrimination
It must be remembered that the main aim of price
discrimination is to increase the total revenue and hopefully the profits of
the supplier. It helps them to
off-load excess capacity and can also be used as a technique to take market
share away from rival firms. It is possible to demonstrate on a diagram
how a monopolist is able to earn greater profits by discriminating.
Assume that a monopolist is able to divide its market into two - A and
B - and that the costs of production are identical in each market.
The firm needs to allocate production between the two
markets so that the marginal revenue in each market is identical in order to
maximise profit. This occurs
because if the firm was earning more in market A it could earn more revenue
by switching goods from B to A. If
MR in market A is £10 and market B £6, the firm could gain an extra £4 by
switching the marginal unit of production from B to A.
It will keep doing this until there is no more advantage in doing so,
which is when the MRs are even.
We draw the MRs and ARs in markets A and B first.
These are then horizontally summed to give the total market.
The profit maximising monopolist will produce where MC=MR across the
whole market at an output level QM.
This output is then split between the two markets (QA and QB)
so that the MR is equal (MR). The
AR curve in each of the markets will determine the relevant price (PA,
PB and PM).
The average cost is the same in all of the markets, and
the levels of abnormal profit in each market is shown by the shaded area.
The monopolist will be better off if the profits earned
in markets A and B are greater than in the total market.
Some consumers do benefit from this type of pricing -
they are "priced into the market" when with one price they might
not have been able to afford a product. For most consumers however the price
they pay reflects pretty closely what they are willing to pay. In this
respect, price discrimination seeks to extract consumer surplus and turn it
into producer surplus (or monopoly profit).
It is possible that cross-subsidisation may occur as the
profits earned in one sector are used to subsidise the losses made in another
market. This may be beneficial
to society as a whole, e.g., allowing train companies to operate rural
services during off-peak periods.