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Price discrimination

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For other pricing strategies and policies see: Pricing Strategies

Price discrimination exists when sales of identical goods or services are transacted at different prices from the same provider. In a theoretical market with perfect information, no transaction costs and a prohibition on secondary exchange (or re-selling) to prevent arbitrage, price discrimination can only be a feature of monopoly markets. Otherwise, the moment the seller tries to sell the same good at different prices, the buyer at the lower price can arbitrage by selling to the consumer buying at the higher price but with a tiny discount. However, market frictions in oligopolies such as the airlines, and even in fully competitive retail or industrial markets allows for a limited degree of differential pricing to different consumers. Price discrimination also occurs when it costs more to supply one customer than it does another, and yet the supplier charges both the same price.

Although the term "discrimination" has negative connotations, "price discrimination" is merely a technical term meaning differentiation in price to increase efficiency.

However, the effects of price discrimination on social efficiency are unclear. Typically such behavior leads to lower prices for some consumers and higher prices for others. Output can be expanded as when price discrimination is very efficient, but output can also decline when discrimination is more effective at extracting surplus from high-valued users than expanding sales to low valued users. Even if output remains constant, price discrimination can reduce efficiency by misallocating output among consumers.

Price discrimination requires market segmentation and some means to discourage discount customers from becoming resellers and, by extension, competitors. This usually entails using one or more means of preventing any resale, 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. Price discrimination is thus very common in services, where resale is not possible; an example is student discounts at museums.


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, such as by pretending to like the product less than he or she really does, and by threatening not to buy it.

An alternative way to understand First Degree Price Discrimination is as follows: This type of price discrimination is primarily theoretical because it requires the seller of a good or service to know the absolute maximum price that every consumer is willing to pay. As above, it is true that consumers have different price elasticities, but the seller is not concerned with such. The seller is concerned with the maximum willingness to pay of each customer. By knowing the max. WTP, the seller is able to absorb the entire market surplus, thus stealing all consumer surplus from the consumer and transforming it into revenues. From a social welfare perspective, first degree price discrimination is not undesirable. That is, the market is still entirely efficient and there is no deadweight loss to society. However, it is the complete opposite of a perfectly competitive market. In a perfectly competitive market, the consumers receive the bulk of surplus. In a market with first degree price discrimination, the seller(s) capture all surplus. Efficiency is unchanged but the wealth is transferred. This type of market does not much exist in reality, hence why it is primarily theoretical. Examples of where this might be observed are in markets where consumers bid for tenders.

  • In second degree price discrimination, price varies according to quantity sold. Larger quantities are available at a lower unit price. This is particularly widespread in sales to industrial customers, where bulk buyers enjoy higher discounts.

Additionally to second degree price discrimination, sellers are not able to differentiate between different types of consumers. Thus, the suppliers will provide incentives for the consumers to differentiate themselves according to preference. As above, quantity "discounts", or non-linear pricing, is a means by which suppliers use consumer preference to distinguish classes of consumers. This allows the supplier to set different prices to the different groups and capture a larger portion of the total market surplus.

Additionally to third degree price discrimination, the supplier(s) of a market where this type of discrimination is exhibited are capable of differentiating between consumer classes. Examples of this differentiation are student or senior "discounts". For example, a student or a senior consumer will have a different willingness to pay than an average consumer, where the WTP is presumably lower because of budget constraints. Thus, the supplier sets a lower price for that consumer because the student or senior has a more elastic price elasticity of demand (see the discussion of price elasticity of demand as it applies to revenues from the first degree price discrimination, above). The supplier is once again capable of capturing more market surplus than would be possible without price discrimination.

NOTE ABOUT SECOND AND THIRD DEGREE: It is not always advantageous to price discriminate (note that "discrimination" does not carry the same negative connotation in economics as it does in normal setting; instead, it simply notes that the supplier does not treat all consumers equally-- this is often advantageous to the consumer, as well). In some circumstances, the demands of different classes of consumers will encourage suppliers to simply ignore one/some class(es) and target entirely to the other(s). Whether it is profitable to price discriminate is determined by analyzing the particular industry.

These types are not mutually exclusive. Thus a company may vary pricing by location, but then offer bulk discounts as well. Airlines use several different types of price discrimination, including:

  • Bulk discounts to wholesalers, consolidators, and tour operators
  • Incentive discounts for higher sales volumes to travel agents and corporate buyers
  • Seasonal discounts, incentive discounts, and even general prices that vary by location. The price of a flight from say, Singapore to Beijing can vary widely if one buys the ticket in Singapore compared to Beijing (or New York or Tokyo or elsewhere).
  • First degree price discrimination based on customer. It is not accidental that hotel or car rental firms may quote higher prices to their loyalty program's top tier members than to the general public.

Modern Taxonomy

The first/second/third degree taxonomy of price discrimination is due to Pigou (Economics of Welfare, 4th edition, 1932). However, these categories are not mutually exclusive or exhaustive. Ivan Png (Managerial Economics, 2nd edition, 2002) suggests an alternative taxonomy:

  • Complete discrimination -- where each user purchases up to the point where the user's marginal benefit equals the marginal cost of the item;
  • Direct segmentation -- where the seller can condition price on some attribute (like age or gender) that directly segments the buyers;
  • Indirect segmentation -- where the seller relies on some proxy (eg, package size, usage quantity, coupon) to structure a choice that indirectly segments the buyers.

The hierarchy -- complete/direct/indirect -- is in decreasing order of

  • profitability and
  • information requirement.

Complete price discrimination is most profitable, and requires the seller to have the most information about buyers. Indirect segmentation is least profitable, and requires the seller to have the least information about buyers.

Explanation

Sales revenue without and with Price Discrimination

The purpose of price discrimination is generally 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. Strictly, a consumer surplus need not exist, for example where price discrimination is necessary merely to pay the costs of production. An example is a high-speed internet connection shared by two consumers in a single building; if one is willing to pay less than half the cost, and the other willing to make up the rest but not to pay the entire cost, then price discrimination is necessary for the purchase to take place.

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).

Multiple Market Price Determination

The firm decides what amount of the total output to sell in each market by looking at the intersection of marginal cost with marginal revenue (profit maximisation). This output is then divided between the two markets, at the equilibrium marginal revenue level. Therefore, the optimum outputs are Qa and Qb. From the demand curve in each market we can determine the profit maximizing prices of Pa and Pb.

It is also important to note that the marginal revenue in both markets at the optimal output levels must be equal, otherwise the firm could profit from transferring output over to whichever market is offering higher marginal revenue.

Examples of price discrimination

Travel industry

Airlines and other travel companies use differentiated pricing regularly, as they sell travel products and services simultaneously to different market segments. This is often done by assigning capacity to various booking classes, which sell for different prices and which may be linked to fare restrictions. The restrictions or "fences" help ensure that market segments buy in the booking class range that has been established for them. For example, schedule-sensitive business passengers who are willing to pay say, $300 for a seat from city A to city B, cannot purchase a $150 ticket because the $150 booking class contains a requirement for a Saturday night stay, or a 15-day advance purchase, or another fare rule that effectively prevents a sale to business passengers.

Notice also that even in this simple example, the "seat" is not the same product. That is, the business person who purchases the $300 ticket may be willing to do so in return for a seat on a high-demand morning flight, for full refundability if the ticket is not used, and for the ability to upgrade to first class if space is available for a nominal fee. On the same flight are price-sensitive passengers who are not willing to pay $300, but who are willing to fly on a lower-demand flight (say one leaving an hour earlier), or via a connection city (not a non-stop flight), and who are willing to forego refundability.

Since airlines often fly multi-leg flights, and since no-show rates vary by segment, competition for the seat has to take in the spatial dynamics of the product. Someone trying to fly A-B is competing with people trying to fly A-C through city B on the same airplane. This is one reason airlines use yield management technology to determine how many seats to allot for A-B passengers, B-C passengers, and A-B-C passengers, at their varying fares and with varying demands and no-show rates.

With the rise of the Internet and the growth of low fare airlines, airfare pricing transparency became far more pronounced. Passengers discovered it quite easy to compare fares across different flights or different airlines. This helped put pressure on airlines to lower fares. Meanwhile, in the recession following the September 11, 2001 attacks on the U.S., business travelers and corporate buyers made it clear to airlines that they were not going to be buying air travel at rates high enough to subsidize lower fares for non-business travelers. This prediction has come true, as vast numbers of business travelers are buying airfares only in coach class for business travel.

As to the absolute level of airfares, they continue their 35-year downward trend line. Whereas following World War II it took an Australian the equivalent of a year's wages to fly from Sydney to London, today that can be done for approximately two week's average Australian wages, purchasing a far faster and more comfortable journey. The same trends are true in all deregulated areas of the world, including the U.S., intra-E.U. flights, and UK

Segmentation by age group and student status

Many movie theaters, amusement parks, tourist attractions, and other places have different admission prices per market segment: typical groupings are Youth, Student, Adult, and Senior. Each of these groups typically have a much different supply curve. Children, people living on student wages, and people living on retirement generally have much less disposable income.

Retail incentives

A variety of incentive techniques may be used to increase market share or revenues at the retail level. These include discount coupons, rebates, bulk and quantity pricing, seasonal discounts, and frequent buyer discounts.

Incentives for industrial buyers

Many methods exist to incentivize wholesale or industrial buyers. These may be quite targeted, as they are designed to generate specific activity, such as buying more frequently, buying more regularly, buying in bigger quantities, buying new products with established ones, and so on. Thus, there are bulk discounts, special pricing for long-term commitments, non-peak discounts, discounts on high-demand goods to incentivize buying lower-demand goods, rebates, and many others. This can help the relations between the firms involved.

Gender-Based

Many gender-based price differences are held to be illegal in the United States.

"Ladies' night"

Many U.S. nightclubs feature a "ladies' night" in which women are offered discount or free drinks, or are absolved from payment of cover charges. This differs from conventional price discrimination in that the primary motive is not, usually, to increase revenue at the expense of consumer surplus. Rather, establishments benefit by maintaining an equitable gender balance; if the clientele of an establishment is primarily male, it will lose popularity with both men and women, and therefore it is better for the establishment to lower its prices for women if they show less demand.

Dry cleaning

Dry cleaners typically charge higher prices for the laundering of women's clothes than for men's. Even though this involves smaller amounts of money (compared to, say, college tuition), this has provoked reactions in some US communities, who occasionally have outlawed the practice. Although many people have reacted negatively to the "discrimination" of this practice, economic investigation (including that done by Steven Landsburg - see external link at bottom of this article) indicates that prices are higher for women not because of discrimination, but because the cost to provide these services is in fact different. For dry cleaners, women's shirts tend to be less consistent and more fragile, and therefore have to be pressed by hand, whereas men's shirts can be pressed by a machine, accounting for the higher cost.; [;

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Haircutting

Women's haircuts are often more expensive than men's haircuts which in past times could be accounted for as women generally had longer hairstyles whereas men generally had shorter hairstyles. Nowadays men's and women's styles are more varied but the price discrimination continues. Some salons have modified their pricing to reflect "long hair" versus "short hair" or style instead of gender.

Financial aid in education

Financial aid as offered by U.S. colleges and universities is a form of price discrimination that is widely accepted, and completely legal.

While tuition is set according to cost-recovery formulas for universities (which are non-profit organizations), increasing costs mean inevitably that tuition costs rise. (This is true even after legislatures, which control tuition rates at state schools, try to hold down tuition rates.)

Despite this, middle- and lower-income students are often afforded discounts in the form of tuition waivers, scholarships, work-study programs that pay partly in free course hours, and government guaranteed loans.

Little objection is given to this version of price discrimination, because of the well-established funding mechanism which does a good job of allocating positions to members of all income classes in the US.

"Haggling"

Many cultures involve "haggling" in market transactions — inflated prices are posted, but the customer can negotiate with the vendor. In the United States, haggling is rare if not nonexistent in grocery stores and with retailers, but common when automobiles and homes are sold. Negotiation often requires knowledge, confidence, and a confrontational personality, and vendors know that many customers will pay higher prices in order to avoid haggling.

Because dealers will usually offer more concessions to men, it is not uncommon for women to send male friends or relatives to purchase automobiles and homes for them.

International price discrimination

Price discrimination also occurs on an international level. For example, prescription drugs may cost considerably less in Canada than in the US, because of governmental price controls in place in Canada. Similar government price controls exist for fuels (India, among others) and tobacco products (Indonesia).

Governments can also use tax policy to increase prices in order to limit consumption, such as automobile prices, which incur a 100% tax in many 3rd world countries.

Academic pricing

Companies will often offer discounted software to students and faculty at K-12 and university levels. These may be labeled as academic versions, but perform the same as the full price retail software. Academic versions of the most expensive software suites may be priced as little as one fifth or less of retail price. Some academic software may have differing licenses than retail versions, usually disallowing their use in activities for profit or expiring the license after a given number of months. Companies that offer academic pricing include Microsoft, Adobe Systems, and Apple Computer.

Dual pricing

Even within a country, differentiated pricing may be established to ensure that citizens receive lower prices than non-citizens; this is known as dual pricing. This is particularly common for goods that are subsidized or otherwise provided by the state (and hence paid by taxpayers). Thus Finns, Thais, and Indians (among others) may purchase special fare tickets for public transportation that are only available to citizens. Many countries also maintain separate admission charges for museums, national parks and similar facilities, the usually professed rationale being that citizens should be able to educate themselves and enjoy the country's natural wonders cheaply, but other visitors should pay the market rate.

Wage discrimination

Wage discrimination is when the price of equivalent labor is discriminated among different groups of workers. This may be seen as just one kind of price discrimination or as an example of its inverse, one buyer buying identical goods at different rates.

Universal pricing

"Universal" pricing is the opposite of price discrimination — one price is offered for the good or service. This is usually preferred by consumers over tiered pricing. For example, the European Union is currently making efforts to set a single-price protocol for automobile sales.

See also

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