What is the difference between price discrimination and perfect price discrimination?

Have you ever visited a museum with your family and realized that your parents, grandparents, siblings, and yourself are charged differently? Here is the term for it: price discrimination. How does it work, exactly? What benefits does it bring to the producer and consumer? And what types of price discrimination are there?

What is price discrimination?

Different consumers have different preferences and their willingness to pay for a product varies. When a firm price discriminates, it tries to single out groups of customers who are prepared to pay a higher price. The firm, therefore, doesn’t base its pricing decisions on the cost of production. Price discrimination allows the company to gain more profits than it would if it did not price discriminate.

Price discrimination occurs when different consumers are charged different prices for the same product or service. Specifically, those who are willing to pay more will be charged a higher price whereas price-sensitive individuals will be charged less.

A football fan will pay any price to get Lionel Messi's signed t-shirt while another person would feel indifferent about it. You will get more money selling the signed t-shirt of Messi to a super fan than a person with no interest in football.

Figure 1 simplifies the definition of price discrimination.

To understand price discrimination, we should also look at two key concepts of economic welfare: consumer surplus and producer surplus.

Consumer surplus is the difference between the consumer’s willingness to pay and the price they actually pay. The higher the market price, the smaller the consumer surplus.

Producer surplus is the difference between the minimum price a producer is willing to sell a product for and the actual price charged. The higher the market price, the greater the producer surplus.

The goal of price discrimination is to capture more of the consumer surplus, thereby maximising producer surplus.

Price discrimination types

Price discrimination can be classified into three types: first-degree price discrimination, second-degree price discrimination, and third-degree price discrimination (look at Figure 2).

First-degree price discrimination

First-degree price discrimination is also known as perfect price discrimination. In this type of discrimination, producers charge their customers the maximum amount they are willing to pay and capture the entire consumer surplus.

A pharmaceutical company that discovered a cure for a rare disease can charge very high for their product as customers will pay any price to get cured.

Second-degree price discrimination

Second-degree discrimination happens when the company charges prices based on the amounts or quantities consumed. A buyer making bulk purchases will receive a lower price compared to those purchasing a small quantity.

A well-known example is the phone service. Customers are charged different prices for the number of minutes and mobile data they use.

Third-degree price discrimination

Third-degree price discrimination occurs when the company charges different prices for customers from different backgrounds or demographics.

Museums charge adults, children, students, and the elderly differently for their tickets.

Examples of price discrimination

Another example of price discrimination that we can study is train tickets. The tickets usually have different prices depending on the urgency of consumer travel. When bought in advance, train tickets are typically much cheaper than those bought on the day of travel.

Figure 3. Price discrimination example: train tickets, StudySmarter Originals

Figure 3 shows different prices charged to customers who purchase train tickets from Hamburg to Munich on different days. Those who buy tickets on the day of their travel (Submarket A) are charged a higher price than those who buy the ticket in advance (Submarket B): P1 > P2.

Graph C shows the combined market with the average revenue curves of submarkets A and B added together. The marginal revenue curves have also been combined. Here we see that the combined marginal cost curve is sloping upward, representing the law of diminishing returns.

Without price discrimination, all passengers would pay the same price: P3 as in panel C. The customer surplus is depicted by the light green area in each diagram. A firm earns more profit by converting the consumer surplus into the producer surplus. It will price-discriminate when the profit of splitting the market is greater than keeping the same price for everyone.

Necessary conditions for price discrimination

Here are some conditions for price discrimination to occur:

• A degree of monopoly power: the company must have sufficient market power in order to price discriminate. In other words, it needs to be a price maker.

• The ability to define customer segments: the company must be able to separate the market based on customers’ needs, characteristics, time, and location.

• The elasticity of demand: consumers must vary in the elasticity of their demand. For example, demand for air travel from low-income consumers is more price elastic. In other words, they will be less willing to travel when the price increases compared to wealthier people.

• Prevention of re-sale: the company must be able to prevent its products from being resold by another group of customers.

Advantages and disadvantages of price discrimination

A firm only considers price discrimination when the profit of separating the market is greater than keeping it whole.

Advantages

• Brings more revenues for the seller: price discrimination gives the firm a chance to increase its profit more than when charging the same price for everyone. For many businesses, it’s also a way to make up for losses during the peak seasons.

• Lowers the price for some customers: some groups of customers such as older people or students can benefit from lower prices as a result of price discrimination.

• Regulates the demand: a company can utilise low pricing to encourage more purchases during the off-season and avoid crowdedness during the peak seasons.

Disadvantages

• Reduces consumer surplus: price discrimination transfers the surplus from consumer to producer, thus reducing the benefit consumers can receive.

• Lower product choices: some monopolies can take advantage of price discrimination to capture a greater market share and establish a high barrier to entry. This limits the product choices on the market and results in lower economic welfare. In addition, lower-income consumers may not be able to afford the high prices charged by the companies.

• Creates unfairness in society: customers who pay a higher price are not necessarily poorer than those paying a lower price. For example, some working-class adults have less income than retired people.

• Administration costs: there are costs for businesses that carry out price discrimination. For example, the costs to prevent customers from reselling the product to other consumers.

Price discrimination exists to help businesses capture more consumer surplus and maximise their profits. The types of price discrimination vary wildly from charging the customers by their maximum willingness to pay, the quantities purchased, or their age and gender.

For many groups of customers, price discrimination provides a huge benefit as they can pay a lower price for the same product or service. However, there may be potential unfairness in society and high administration costs for firms to prevent re-selling among customers.

Price Discrimination - Key takeaways

• Price discrimination means charging different customers different prices for the same product or service.
• Companies will price discriminate when the profit of separating the market is greater than keeping the same price for everyone.
• There are three types of price discrimination: first degree, second degree, and third degree.
• Some benefits of price discrimination include more revenues for the seller, lower prices for some customers, and well-regulated demand.
• The disadvantages of price discrimination are a potential reduction in consumer surplus, possible unfairness, and administration costs for separating the market.
• To price discriminate, a firm must have a certain level of monopoly, the ability to separate the market, and prevent re-sale. Additionally, the consumers must vary in their price elasticity of demand.

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