what is price discrimination? price discrimination involves market segmentation practiced by...

What is Price Discrimination?

• Price discrimination involves market segmentation

• Practiced by monopolists or any firm with price setting power

• Does not occur in perfectly competitive markets

• A firm price discriminates when it charges different prices to different consumers for reasons that do not reflect cost differences

• This involves extracting consumer surplus from buyers and turning this into additional revenue and profit

• A business is exploiting the fact that consumers have a different willingness and ability to pay for goods and services

Conditions Required for Price Discrimination

• The firm must have some price-setting power in at least one market (I.e. operating in an imperfectly competitive market)

• There must be at least two consumer groups a with different price elasticity of demand

• The firm should be able to identify consumers in each group, and set prices differently for consumers in the groups (requires sufficient information)

• The firm must prevent consumers in one group selling to consumers in the other (no market arbitrage or market seepage)

1st Degree (Perfect) Price Discrimination

• Involves perfect segmentation of the market by the supplier

• Every customer is charged his or her “willingness to pay”

• So there is no consumer surplus in the transaction

• The monopolists’ demand curve becomes the marginal revenue curve, i.e. you do not have to lower the price to the higher value customers in order to sell more!

• More goods are sold; but price is higher to some customers

• Total output is higher than under normal profit-maximization

1st Degree Price Discrimination

AR (Market Demand)Marginal Revenue

P1

AC = MC

Q1

Normal profit maximising price and output is P1 and Q1 (where marginal revenue meets marginal cost)

Price

Quantity

1st Degree Price Discrimination – Equilibrium Output

Normal profit maximising price and output is P1 and Q1 (where MR=MC)

With perfect price discrimination, output may rise to Qe where MC meets the demand curve

Price

Quantity

MR AR= market demand

AC = MC

Pmon

Qm Qe

Extracting the Consumer Surplus

Quantity of Output (Q)

Price (P)

AR (Market Demand)MR

P1

AC = MC

Q1

P2

P3

Q3Q2

Extracting the Consumer Surplus

Quantity of Output (Q)

Price (P)

AR (Market Demand)MR

P1

AC = MC

Q1

Each consumer is charged what they are willing to pay – the market is segmented and the seller aims to extract the consumer surplus and turn this into revenue and extra (marginal) profit

P2

P3

Q3Q2

Equilibrium output with perfect price discrimination – the monopolist will sell an extra unit providing that the next unit adds as much to revenue as it does to cost

Examples of 1st Degree Discrimination

• First degree discrimination takes place when bartering exists between buyers and sellers

• The bid and offer system in the housing market where potential home buyers put in an offer on an individual property

• Negotiating prices with dealers for second hand cars

• Haggling for the price of a hotel room

• Antiques fairs and car boot sales!

Excess Capacity Pricing?

• Excess capacity pricing exists when sellers try to off-load their spare output to buyers

• Examples

– Cheaper priced restaurant menus at lunchtime

– Cinema and theatre tickets for matinees

– Hotels offering winter discounts

– Car rental firms reducing prices at weekends

• Not always the case that prices are lower if consumers delay their purchases

– Advance discounts on season tickets for soccer clubs

– Discounts for early booking of package holidays

3rd Degree : Market Separation

• Separate markets based on some identifiable characteristic

• Monopolist seeks to maximize profits in each sub-market

• Sell additional output in elastic market (lower price)

• Reduce sales in inelastic market (increase price)

• Prevent resale of the good or service

• Examples of Market Separation / Segmentation

– Discounts to Seniors / Senior Citizens

– Different prices for students and adults for bus travel

– Gender pricing in some bars/night clubs

Market A Market B

QuantityQuantity

Price Price

Third Degree Price Discrimination

MRa MRb ARb

ARa

Market A Market B

MC=AC

QuantityQuantity

Price Price

Third Degree Price Discrimination

MRa MRb ARb

ARa

Market A Market B

MC=AC

QuantityQuantity

Price Price

Pa

Pb

Third Degree Price Discrimination

MRa MRb ARb

ARa

Market A Market B

MC=AC

QuantityQuantity

Price Price

Pa

Third Degree Price Discrimination

MRa MRb ARb

ARa

Market A Market B

MC=AC

QuantityQuantity

Price Price

Pa

Third Degree Price Discrimination

MRa MRb ARb

ARa

Profit from selling to market A – relatively elastic demand – lower price

Market A Market B

MC=AC

QuantityQuantity

Price Price

Pa

Pb

Third Degree Price Discrimination

MRa MRb ARb

ARa

Profit from selling to market A – relatively elastic demand – lower price

Profit from selling to market B – relatively inelastic demand – higher market price