Price discrimination is a practice used by firms with monopoly power, monopolies or oligopolies. This is because consumers in monopolistic markets have no choice but to buy from the monopolist. An identical product is sold to different consumers. It costs the same to produce the product, i.e., the marginal cost of production is the same for two units of the good but the two consumers who get these two identical units are charged differently. This raises the question of how fair price discrimination is since some consumers are charged more than others. It is usually wealthy consumers who get the higher price for a good which does not cost much to produce. Since price discrimination is considered unfair, it is illegal and, therefore, difficult for the discriminating monopolies to disguise. There are three types of price discrimination: 1) first-degree price discrimination (perfect price discrimination), 2) second-degree price discrimination, and 3) third-degree price discrimination.

First-degree price discrimination

First-degree price discrimination is also known as perfect price discrimination. Since consumers all have different reservation prices and there are multiple consumers in the market with one seller, each consumer is charged his reservation price. Reservation price reflects not only: 1) the income level of the respective consumer but also 2) his need for the product and desire to own it. Thus, perfect price discrimination implies infinite levels of the price with the most opulent consumers being charged the highest price. Consumers who are less wealthy or less willing to own the good are charged a lower price. By charging every customer his reservation price, i.e., the highest he is able and willing to pay, the monopolist extracts all consumer surplus and what was previously consumer surplus now turns into producer surplus. This maximizes the profit of the discriminating monopolist immensely. The practice of charging consumers different prices for the same good is unacceptable to wealthy consumers who declare it unfair but from the social point of view poor consumers get access to the good. In the absence of price discrimination all consumers would have to pay the monopoly price and receive the monopoly output at the point where marginal revenue and marginal cost are equal for the producer. This leaves some consumers out of the market and renders them uncompetitive since they cannot afford the monopoly price. With perfect price discrimination the monopolist makes the good in question affordable for poor consumers whose reservation prices are lower than the monopoly price. Consumers who previously could not afford the good now buy it at their reservation price. Some social economists argue the opposite, i.e., that price discrimination is fair and socially justified because it makes an essential good affordable to the poor layers of society. An example would be medical services in a small town where the local doctor charges poor patients lower than he charges rich patients. If there is a uniform price for all patients then some socially weaker patients would be unable to get treatment. A similar example is the service provided by a lawyer in a small town. It is impossible for large companies to know their customers’ reservation price perfectly but a lawyer practicing in a small town or village would know his customers relatively well. Thus, he is likely to charge them based on the information he has about their income, class, or social group. Generally, perfect price discrimination is hard to practice because: 1) it is almost impossible for the discriminating monopolist to establish the reservation price of each customer in a market with numerous buyers and 2) even if the monopolist has a way of establishing all reservation prices, he cannot disguise charging all those since this would be visible for the authorities. Such practices are illegal, and the discriminating company must somehow justify to the authorities the need for those. Generally, perfect price discrimination is resisted because all of the consumer surplus enjoyed at the monopoly price and output in the absence of price discrimination is now transformed into producer surplus. In other words, the monopoly appropriates the whole surplus enjoyed by consumers in the form of excessive monopoly profits.

third-degree price discrimination

A type of price discrimination very similar to perfect price discrimination is third-degree price discrimination. Since it is difficult for the monopoly to charge infinite price levels, as with perfect price discrimination, the monopoly groups consumers into two or three groups based on their price elasticity. Consumer groups whose demand for the good is more price-elastic are charged a lower price while those with a lower own-price elasticity of demand get the higher price. This optimization pricing strategy maximizes the cumulative profit of the discriminating monopolist since at the optimal point of production the firm sets the marginal revenue of each market equal to its marginal cost. The customer groups with a higher price sensitivity get the lower price by this optimization condition. For instance, movie theaters and other service firms charge pensioners and students a price lower than what they charge working professionals. Age-wise young students (even upon graduation from the university) rank closer to young professionals and can hardly group with retirees. But because of their price sensitivity college students and retirees get different prices for the same product or service as that of young working professionals or yuppies. It is worth noting that the price elasticity of each group has two key determinants: 1) income level and 2) available search time. It is well known that both retirees and college students have much less income than yuppies who take high-level jobs. At the same time, the first group has much more leisure and may successfully search for substitutes while the second group of young professionals has no free time and is, therefore, very price inelastic. Their demand curve for the respective good or service is shown as very steep while that of the retirees and students relatively flat. At the same level of the marginal cost of production, the price would be much higher for young professionals while they would get a much lower amount of the good. Although students are close to the age of working professionals, in terms of own price elasticity of demand they rank very close to pensioners.

quality discrimination

Because of its profitability and applicability this type of price discrimination is much more often practiced than generally believed. It is easy to hide it under different promotional campaigns, seasonal discounts, peak and off-peak sales, etc. It is a common practice to charge foreigners more than locals in developing countries. Foreigners, especially from the developed western world, are believed to have more income but lack information about the local prices and available substitutes. Airlines charge business customers (using business class) a higher price than that offered in the economy class. In the context of our previous example working professionals are likely to use business class while retired tourists and college students taking summer trips use the economy class which is less comfortable but cheaper. Airlines also charge last minute buyers much more than the early buyers who book flights half a year earlier. An example of elastic and inelastic demand is peak and off-peak demand. Train tickets in the off-peak period cost less than those in the peak because consumer demand is much more elastic in the off-peak period. Consumption of electricity in the peak period is less price-elastic which is why electrical companies charge two rates, a daily and a nightly one. The nightly one is usually lower since consumers are less flexible during the day when they need electricity the most.

Peak and off-peak

Peak and off-peak pricing can also be viewed as a form of second-degree price discrimination because this type of price discrimination charges consumers different rates based on their usage levels. The customers are roughly divided into two categories, heavy and light users. Heavy users are said to consume a lot of the good and to represent a “heavy half” of the market demand. Light users on the contrary use the good or service lightly or rarely. Second-degree price discrimination is also known as “self-discrimination” because the consumer is left to “self-select”, i.e., decide how much of the good he or she wants to consume. If the consumer self-determines how much he needs, he picks a plan and a rate which suit his choice with heavy users being charged a much lower rate. These committed customers are thus being stimulated by the discriminating monopolist to consume more of the good. They represent a large part of the market demand but their consumption increases even further at the preferential rate. The light users, on the contrary, are charged a much heavier price. Since they are a small part of the market, they do not contribute much to sales and do not enjoy the benefits of heavy usage. The monopolist in a way penalizes them for their modest consumption by charging them a rate even higher than what they are worth of. Thus, the trend is for price to go into an extreme – one group is charged lower than it actually costs, whereas the other is charged much higher than the actual. Mobile phone operators are said to practice second-degree price discrimination. They introduce subscription plans to heavy users who benefit from discounts. Light users of phone services are charged a higher price per minute or use pre-paid vouchers and cards which are much more expensive than subscription plans on a per-minute basis or other service terms such as roaming, wi-fi, TV, etc. Some musicians and rock bands offer cheap tickets for their concerts to stimulate their most dedicated fans. This is also an example of block-booking since the most committed fans are also expected to buy a lot of the band’s commercial or other items, albums, logos, t-shirts, mugs, etc. representing thus much of the sales of the band. The same would be true of football fans and their favorite football clubs.

quality discrimination

Price discrimination is inherently related to quality discrimination. The discriminating company offers two quality levels of the good or service in question. The purpose again is profit maximization. The two quality levels could be moderate, one relatively low and the other relatively high. Logically the high-end consumers are charged a higher price for demanding the better quality. But the discriminating monopolist intentionally reduces the low-quality to an unacceptable level so that to push some of the low-end customers to the high-quality good. The quality is kept so low at a given price level that the consumers opt to move to the high-end group thus paying a high price although they can potentially put up with a lower price and quality. Airlines reduce the space between the seats, offer smaller seats so that more passengers can be seated in the salon, offer less food or none, etc. in the economy class which drives some passengers to the business class. Airlines thus intentionally suppress the quality in the low-quality segment with the purpose of moving some clients to the high-quality one which is more profitable for the firm.

Price discrimination is against the law but there are three grounds on which such practices can be justified by the authorities: 1) if the service firm can prove that it costs differently to serve different market segments, for instance, on a geographical basis (where there may be need to transport the good to a particular geographic market, not in direct proximity to the firm or other markets), 2) if the good is perishable, i.e., the firm uses flexible pricing strategies to dispose of its produce before it goes bad. For instance, companies selling flowers or strawberries may offer discounts to certain customers before the products rot. A third case is 3) when the firm needs to meet competition “in good faith,” that is, the firm responds to the predatory or other strategic pricing of competitors. It is rarely expected that a monopolist would be faced with fierce competition. In the USA cases of price discrimination are usually referred to the Federal Trade Commission which deals with antitrust and violations of competition.