Price discrimination

Overview

Price discrimination, known also by several other names, is a microeconomic pricing strategy whereby identical or largely similar goods or services are sold at different prices by the same provider to different buyers, based on which market segment they are perceived to be part of. Price discrimination is distinguished from product differentiation by the difference in production cost for the differently priced products involved in the latter strategy. Price discrimination essentially relies on the variation in customers' willingness to pay and in the elasticity of their demand. For price discrimination to succeed, a seller must have market power, such as a dominant market share, product uniqueness, sole pricing power, etc.

Some prices under price discrimination may be lower than the price charged by a single-price monopolist. Price discrimination can be utilized by a monopolist to recapture some deadweight loss. This pricing strategy enables sellers to capture additional consumer surplus and maximize their profits while offering some consumers lower prices. Price discrimination can take many forms and is common in many industries, such as travel, education, telecommunications, and healthcare.

Terminology

Price discrimination is also referred to as differential pricing, equity pricing, preferential pricing, segmented pricing, dual pricing, and tiered pricing. "Price fences" are the criteria which segment customers into groups to which differentiated prices can be charged.

Legality

Many forms of price discrimination are legal, but in some cases charging consumers different prices for the same goods is illegal. For example, in the United States, the Robinson–Patman Act makes price discrimination illegal in certain anti-competitive interstate sales of commodities.

Types

Within the broader domain of price differentiation, a common classification dating to the 1920s is the following.

First degree: perfect price discrimination

"Personalized pricing" (or first-degree price differentiation) – selling to each customer at a different price; this is also called one-to-one marketing. The optimal incarnation of this is called "perfect price discrimination" and maximizes the price that each customer is willing to pay. As such, in "first degree" price differentiation the entire consumer surplus is captured for each individual. Exercising first degree (or perfect or primary) price discrimination requires the seller of a good or service to know the absolute maximum price (or reservation price) that every consumer is willing to pay. By knowing the reservation price, the seller is able to sell the good or service to each consumer at the maximum price they are willing to pay (greater or equal to the marginal cost), and thus fully capture consumer surplus. The resulting profit is equal to the sum of consumer surplus and seller surplus. This is the most profitable realm as each consumer buys the good at the highest price they are willing to pay. The marginal consumer is the one whose reservation price equals the seller's marginal cost. Sellers that engage in first degree price discrimination produce more product than they would otherwise. Hence first degree price discrimination can eliminate deadweight loss that occurs in monopolistic markets. Examples of first degree price discrimination can be observed in markets where consumers bid for tenders, though, in this case, the practice of collusive tendering could reduce the market efficiency.

Second degree: quantity discount

"Product versioning" or simply "versioning" (or "second-degree" price differentiation) – offering a product line by creating slightly differentiated products for the purpose of price differentiation, i.e. a vertical product line. Another name given to versioning is "menu pricing". In second-degree price discrimination, the price of the same good varies according to the quantity demanded. It usually comes in the form of a quantity discount that exploits the law of diminishing marginal utility. Diminishing marginal utility claims that consumer utility decreases (diminish) with each successive unit consumed (think bonbons). By offering a quantity discount for a larger quantity the seller is able to capture some of the consumer surplus. This is because diminishing marginal utility may mean the consumer would not be willing to purchase an additional unit without a discount since the marginal utility received from the good or service is no longer greater than the price. However, by offering a discount the seller can capture some of consumers surplus by encouraging them to purchase an additional unit at a discounted price. This is particularly widespread in sales to industrial customers, where bulk buyers enjoy discounts. Mobile phone plans and subscriptions are instances of second-degree price discrimination. Consumers usually require a one-year subscription to be less expensive than a monthly one. Whether or not consumers need the longer subscription, they are more likely to accept one if the cost is less.

Third degree: market segregation

"Group pricing" (or "third-degree" price differentiation) – dividing the market into segments and charging a different price to each segment (but the same price to each member of that segment). This is essentially a heuristic approximation that simplifies the problem in face of the difficulties with personalized pricing. Typical examples include student and senior discounts. Third-degree price discrimination means charging a different price to a group of consumers based on their different elasticities of demand: the less elastic group is charged a higher price. For example, rail and tube (subway) travelers can be subdivided into commuters and casual travelers, and cinema goers can be subdivided into adults and children. Splitting the market into peak and off-peak use of service is common and occurs with energy and cinema tickets, as well as gym membership and parking. In order to offer different prices for different groups of people in the aggregate market, the seller has to group its consumers. Prices must be set prices to match to buyer preferences. Sub-markets must be separated by time, physical distance, nature of use, etc. For example, back-to-school pricing may be lower than in other seasons. The markets must be structured so that buyers who purchase at the lower price in the elastic sub-market cannot resell at a higher price in the inelastic sub-market.

Two-part tariff (razor and blades)

The two-part tariff is another form of price discrimination wherein the seller charges a low (loss-making) initial fee in hopes of freezing consumer choice while charging a higher secondary fee for continuing to use the product. This pricing strategy yields a result similar to second-degree price discrimination. The two-part tariff increases welfare because the monopolistic markup is eliminated. However, an upstream monopolist may set higher secondary prices, which may reduce welfare. An example of two-part tariff pricing is in the market for razors. The customer pays an initial cost for the razor and then pays for replacement blades. This pricing strategy works because it shifts the demand curve to the right: since the customer has already paid for the initial blade holder and will continue to buy the blades as long as they are cheaper than alternatives.

Combination

These types are not mutually exclusive. Thus a seller may vary pricing by location, while offering bulk discounts as well. Airlines combine types, 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 location-sensitive prices. 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). Discounted tickets requiring advance purchase and/or Saturday stays. Both restrictions have the effect of excluding business travelers, who typically arrange trips on shorter notice.

User-controlled

While conventional theory generally assumes that prices are set by the seller, in one variant prices are set by the buyer, such as pay what you want pricing. Such user-controlled price discrimination exploits similar ability to adapt to varying demand curves or individual price sensitivities, and may avoid the negative perceptions of price discrimination when imposed by a seller. In the matching markets, the platforms will internalize the impacts in revenue to create a cross-side effects. In return, this cross-side effect will differentiate price discrimination in matching intermediation from the standard markets.

Theoretical basis

In a theoretical market with perfect information, perfect substitutes, and no transaction costs or prohibition on secondary exchange (or re-selling) to prevent arbitrage, price discrimination can only be a feature of monopoly and oligopoly markets, where market power can be exercised. Without market power when the price is higher than the market equilibrium, consumers will switch to sellers selling at the market equilibrium. Moreover, when the seller tries to sell the same good at differentiating prices, the buyer at the lower price can arbitrage by selling to the consumer buying at the higher price with a small discount from the higher price. Price discrimination requires market segmentation and some means to discourage discount customers from becoming resellers and, by extension, competitors. This usually entails 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 is referred to as a rate fence (a rule that allows consumers to segment themselves based on their needs, behaviour, and willingness to pay). Price discrimination is thus very common in services where resale is not possible; an example is student discounts at museums: Students may get lower prices than others, but do not become resellers, because the service is consumed at point of sale. Another example of price discrimination is intellectual property, enforced by law and by technology. In the market for DVDs, laws require DVD players to be designed and produced with hardware or software that prevents inexpensive copying or playing of content purchased legally elsewhere in the world at a lower price. In the US the Digital Millennium Copyright Act has provisions to outlaw circumventing of such devices to protect the profits that copyright holders can obtain from price discrimination against higher price market segments. Price discrimination attempts to capture as much consumer surplus as possible. By understanding the elasticity of demand in various segments, a business can price to maximize sales in each segment. When a seller identifies a consumer (or group) that has a lower willingness to pay, price discrimination maximizes profits. There are two conditions which must be met if a price discrimination scheme is to work. First the seller must be able to identify market segments by their price elasticity of demand and second the sellers must be able to enforce the scheme. For example, airlines routinely engage in price discrimination by charging high prices for customers with relatively inelastic demand – business travelers – and discount prices for tourists who have relatively elastic demand. The airlines enforce the scheme by enforcing a no resale policy on the tickets preventing a tourist from buying a ticket at a discounted price and selling it to a business traveler (arbitrage). Airlines must also prevent business travelers from directly buying discount tickets. Airlines accomplish this by imposing advance ticketing requirements or minimum stay requirements – conditions that would be difficult for the average business traveler to meet.

Degrees

Market power refers to the ability of a seller to increase price without losing share (sales). Factors that affect market power include:

Number of competitors Product differentiation between suppliers Entry restrictions The degree of market power can usually be divided into 4 categories (listed in the table below in order of increasing market power):

Since price discrimination is dependent on a seller's market power, monopolies use price discrimination, however, oligopolies can also use price discrimination when the risk of arbitrage and consumers moving to other competitors is low.