Price discrimination

Price discrimination or price differentiation exists when sales of identical goods or services are transacted at different prices from the same provider. In a theoretical market with perfect information, perfect substitutes, and no transaction costs or prohibition on secondary exchange (or re-selling) to prevent arbitrage, price discrimination can only be a feature of monopolistic and oligopolistic markets, where market power can be exercised.

Different Types of Price Discrimination

1. First Degree Price Discrimination

This involves charging consumers the maximum price that they are willing to pay. There will be no consumer surplus.

2. Second Degree Price Discrimination

This involves charging different prices depending upon the quantity consumed.

E.g. after 10 minutes phone calls become cheaper.

3. Third Degree Price Discrimination

This involves charging different prices to different groups of people. E.g. students, OAPs and peak travelers e.t.c.

Conditions Necessary for Price Discrimination

1. The firm must operate in imperfect competition; it must be a price maker

with a downwardly sloping demand curve.

2. The firm must be able to separate markets and prevent resale. E.g.

stopping an adult using a child’s ticket.

3. Different consumer groups must have elasticity of demand. E.g. students

with low income will be more price elastic.

Profit Maximization under Price Discrimination

Profit is maximized where MR=MC. Because demand is more inelastic in market (A) it leads to a higher price being set. In market (B) demand is price elastic, so profit maximizing price is lower.

Advantages of Price Discrimination

1. Firms will be able to increase revenue. This will enable some firms to stay

in business who otherwise would have made a loss. For example price discrimination is important for train companies who offer different prices for peak and off peak.

2. Increased revenues can be used for research and development which

benefit consumers

3. Some consumers will benefit from lower fares. E.G. old people benefit from

lower train companies; old people are more likely to be poor. Disadvantages of Price Discrimination

1. Some consumers will end up paying higher prices. These higher prices are

likely to be allocatively inefficient because P > MC.

2. Decline in consumer surplus.

3. Those who pay higher prices may not be the poorest. E.g. adults could be

unemployed, OAPs well off.

4. There may be administration costs in separating the markets.

5. Profits from price discrimination could be used to finance predatory pricing. Importance of Marginal Cost in Price Discrimination

In markets where the marginal cost of an extra passenger is very low. E.G. a bus traveler the firm has an incentive to use price discrimination to sell all the tickets. This is why sometimes prices for airlines can be very low just before their date. Once the company is due to fly the MC of an extra passenger will be very low. Therefore this justifies selling the remaining tickets at a low price.