Price discrimination
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Price discrimination exists when sales of identical goods or services are transacted at different prices from a single vendor. Theoretically, price discrimination is a feature only of monopoly markets, but in practice it occurs with oligopolies such as the airlines. In addition to a monopoly market, price discrimination requires some means to discourage discount customers from becoming resellers and, by extension, competitors. This usually entails either 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.
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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.
- 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.
- In third degree price discrimination, price varies by location or by customer segment. See economics of location.
- In price skimming, prices varies over time. Typically a company starts selling a new product at a relatively high price then gradually reduces the price as the low price elasticity segment gets satiated. Price skimming is closely related to the concept of yield management.
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.
Explanation
In economic terms, the purpose of price discrimination is 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.
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).
The firm decides what amount of the total output to sell in each market. This is determined from the marginal revenue curves in each market. The intersection of the total market price with the marginal revenue curves in each market yields optimum outputs of Qa and Qb. From the demand curve in each market we can determine the profit maximizing prices of Pa and Pb.
Examples of price discrimination
Travel industry
Travel classes as used by airlines and some railways are sometimes quoted as price discrimination. Technically, they are not, since first class vs. economy class accomodations are not identical services. However, within each service class there are often different booking classes, employed to further price discriminate.
With U.S. airlines following deregulation in the 1980s, airfares are notoriously irregular and only loosely correlate to the costs of the service provided. To avoid getting a raw deal, strategic consumption is necessary on the part of an individual purshasing airline tickets. An individual purchasing tickets for dates far in advance, or alternatively too close, will suffer inflated fares. Additionally, airfares are higher during the holidays and high travel seasons than during the rest of the year, though the costs of providing the services (responsive primarily to prices of jet fuel) do not change.
It is likely that the irregular and often inflated fares exacted by U.S. airlines result from the radical deregulatory policies of neoconservatives in the 1980s, as without a laissez faire business environment, the airlines would never be able to get away with such policies.
"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 ("sausage party") 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.
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.
These institutions often price discriminate by setting their prices well outside the reach of most families, sometimes as high as $170,000 for four years of education. Middle- and lower-income students are often afforded discounts and loans to lower these costs to the institution's estimation of the family's willingness to pay.
Since financial aid is awarded according to parental income, students whose parents are wealthy but refuse to pay for college are often unable to afford a college education at all.
Little objection is given to this version of price discrimination because, allegedly, the per annum costs of educating one student exceed even the tuition rate one pays without financial aid.
Dry cleaning
In some communities, some dry cleaners would charge higher prices for the laundering of women's clothes than for mens', despite no difference in the costs of the cleaning. This practice was outlawed.
"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 (the Saturn company is an exception.) 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.
National price discrimination
Price discrimination also occurs on an international level. For example, prescription drugs often cost four times as much in the United States than in Canada, because the latter country limits these prices by law.
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.
Resale
Consumers can avoid many forms of price discrimination through resale. For example, many Americans purchase prescription drugs from Canadian pharmacies at rates lower than they would pay to purchase them from American pharmacies. In order to price discriminate effectively, a firm must restrict resale. Airlines do this by the nontransferrability of airline tickets. The claims of this policy having been set for the sake of passenger safety are outright lies. Rather, tickets are made nontransferrable to prevent high-demand consumers (purchasing tickets shortly before the flight) from buying them from others who bought the tickets at a lower price.
