Price Discrimination

Price Discrimination Price discrimination: occurs when different prices are charged to different consumer for the same good by the same provider. Example; Selling YRT bus tickets at a lower price to students than non-students Price discrimination can take three forms: Charging each customer in a single market the maximum she or he is willing to pay (First degree) Charging each customer one price for the first set of units purchased and a lower price for subsequent units purchased (Second degree) Charging some customers one price and other customers another price (Third degree)

Conditions for Price Discrimination Price discrimination is only possible when the following conditions are met: 1) Price-Setting Ability: the seller must possess some degree of market power and have the ability to control output and prices 2) Market Segregation: the seller must be able to segregate buyers into distinct classes, each of which has a different willingness or ability to pay for the product This separation is usually based on different price elasticities of demand 3) No Resale: the original purchaser cannot resell the product or service for profit

Ability to Separate Consumers For price discrimination to work, it must be difficult or impossible for those able to buy at the cheaper price to resell at a discount to high-price customers (No Resale) Firms separate customers in the following ways, 1) Time: demand for a service can peak at different times Example; During the winter holiday’s, a high-travel time, the prices of air tickets and hotel rooms rise accordingly. 2) Age: older people often have a fixed income and are given discounts Example; Discounts for movie tickets are often given to children, students and seniors.

3) Income: professional services often charge more to high-income clients. Example; Lawyers perform ‘pro bono’ work (i.e. for low fees or for free) which is subsidized by their wealthier customers 4) Taste: producers can market products with only a small amount of differentiation and charge significantly higher prices 5) Gender: firms sometimes charge different prices for men and women Example; Insurance companies charge men more than women for car insurance 6) Location: distance between markets means that firms in one market may charge a higher price, based on greater elasticity of demand 7) Consumer type: airlines are able to discriminate between leisure and business travelers

Reasons for Price Discriminating Different people put different values on the same product This means that different people are willing to pay different prices for a product, this is reflected by the downward sloping demand curve All of the consumers whose demand is represented by the portion of the demand curve above X are willing to pay more for the produce than the market price P

Consumer surplus: is the difference between what a consumer would be willing to pay and market price The firm may be able to capture some of this consumer surplus by selling the product at different prices for different consumers By separating consumers into two groups, and selling at MR = MC in each market, the firm can sell at a higher price in market 2

First Degree- Price Discrimination First-degree price discrimination occurs when firms are able to charge the maximum price that each customer is willing to pay. As a ‘perfect price discriminator’, all consumer surplus disappears and goes to producers who now gain surplus of A + B The firm enjoys significantly higher revenue (and most likely higher profits) than if it were charging a single price

There are several advantages to a monopolist who is able to price discriminate. Consumer surplus is eliminated Profits are greatly expanded Output is greater (QPD compared to QSP) Area of welfare loss is also eliminated Allocative efficiency is achieved with price discrimination if P=MC

Second Degree- Price Discrimination In second degree price discrimination, price varies according to quantity demanded. Larger quantities are available at a lower unit price. Example; ‘Buy two, get one free’ offers in retail markets of food and consumer items. Second-degree price discriminators earn extra revenue in distinct blocks which corresponds to the discounted price levels. Total revenue increases over the single-price firm

Third Degree- Price Discrimination Third-degree price discrimination takes advantage of the fact that different consumer groups have differing price elasticities. It moves to separate the groups and charge the highest price possible. Example; Airlines charging more to customers who book closer to the flight date. To maximize profits, the firm must take the differing demand elasticities into account. Example; Restaurants and cinemas often charge less to children, elderly people and students who have less disposable income

The firm produces where MR1 + MR2 = MC and then the firm calculates where MR = MC for the separate markets. Profits and total revenue are likely to increase over firms that do not price- discriminate. Prices may increase for some groups and decrease for others

Price Discrimination- Example Suppose that the market for widgets can be segmented into two groups. Market for Students QS = 200 – 0.1P MRS = 2000 – 20Q = −2000 + 2P Market for Non-Students QNS = 300 – 0.1P MRNS = 3000 -20Q = − 3000 + 2P Price QS QNS QTOTAL $3,000 -100 $2,500 -50 50 $2,000 100 $1,500 150 200 $1,000 300 $500 250 400 500

We can graph the marginal revenues and demand curves for each segment as well as the entire market The demand curve in the student market is relatively elastic compared to the demand curve for non-students. A price-discriminating monopolist will be able to charge a higher price in the non-student market

Suppose for simplicity that the marginal costs are constant and equal to $200 regardless of the number of units produced. Profits are higher for price discriminating firms than for firms charging a single price. Students are better off, while non-students are worse off.

Evaluation of Price Discrimination Compared with single pricing by a monopolist, price discrimination results in greater profit and greater output Price discrimination will enhance monopoly power over consumers Deadweight losses may be reduced or eliminated. Many consumers pay higher prices, but other buyers pay prices below the single price Consumer surplus is reduced, sometimes completely

Example; Price Discrimination Question: Explain why an airline would want to practice price discrimination. Under what conditions would the airline be able to do so? Solution- (10 Marks/20 Minutes) Price discrimination: the selling of a product to different buyers at different prices when the price differences are not justified by differences in costs An airline will be able to practice price discrimination if, Producers have price setting ability (i.e. monopoly power) because the market is imperfect The market is segmented and the airline can distinguish between separate groups of buyers on the basis of age, income etc.

Consumers have different price elasticity of demand (i. e Consumers have different price elasticity of demand (i.e. different demand curves for different consumers e.g. holidaymakers, business people and therefore some consumers are willing to pay higher prices than others) There is no resell, producers must be able to keep the markets separate. Consumers willing to pay different prices for airline tickets is reflected in the diagram below

All of the consumers whose demand is represented by the portion of the demand curve above X are willing to pay more for the produce than the market price P An airline may practice price discrimination as part of a profit maximization strategy Compared with single pricing by a monopolist, price discrimination results in greater profit and greater output The airline can earn higher revenues and earn greater economic (supernormal) profits through the capture of consumer surplus This is illustrated in the diagram below, where the airline charges each customer according to their willingness to pay, using the demand curve

The airline can also drive higher cost competitors out of the market by lowering prices for some consumer groups, and therefore it can increase its monopoly power An airline can practice price discrimination by splitting the market and discriminating between different buyers. Single Price Monopolist Price Discriminating Monopolist

This can be accomplished through the following means, Charge the elderly lower prices on certain days Give discounts for students’ weekend travel Offer lower fares to travelers who make advance bookings Charge higher fares to those making their travel plans closer to the day of travel