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.

First 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 demand curve. 

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 vertical.

Second degree price discrimination can be shown on the diagram below.

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 paying customers.

Examples of second degree price discrimination can be seen in any market where excess capacity needs to be eliminated, examples are:

• The traditional end of season sale.
• Reduced prices for cinema and theatre in the afternoons.
• Last 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

• Monopoly power - Firms must have some price setting power – this means we don't see price discrimination in perfectly competitive markets.
• Separation 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. 

• Elasticity 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:

• Cinemas and theatres cutting prices to attract younger and older audiences
• Student discounts for rail travel, nightclubs, restaurant meals and holidays
• Happy hour in bars
• Expensive taxi fares during the night
• Hotels 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 Q_M.  This output is then split between the two markets (Q_A and Q_B) so that the MR is equal (MR).  The AR curve in each of the markets will determine the relevant price (P_A, P_B and P_M). 

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.