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Price discrimination

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Price discrimination exists when sales of identical goods or services are transacted at different prices from the same provider. In a theoretical market with perfect information, no transaction costs or prohibition on secondary exchange (or re-selling) to prevent arbitrage, price discrimination can only be a feature of monopolistic and oligopolistic markets[1], where market power can be exercised. Otherwise, the moment the seller tries to sell the same good at different prices, the buyer at the lower price can arbitrage by selling to the consumer buying at the higher price but with a tiny discount. However, product heterogeneity, market frictions or high fixed costs (which make marginal-cost pricing unsustainable in the long run) can allow for some degree of differential pricing to different consumers, even in fully competitive retail or industrial markets. Price discrimination also occurs when the same price is charged to customers which have different supply costs.

The effects of price discrimination on social efficiency are unclear; typically such behavior leads to lower prices for some consumers and higher prices for others. Output can be expanded when price discrimination is very efficient, but output can also decline when discrimination is more effective at extracting surplus from high-valued users than expanding sales to low valued users. Even if output remains constant, price discrimination can reduce efficiency by misallocating output among consumers.

Price discrimination requires market segmentation and some means to discourage discount customers from becoming resellers and, by extension, competitors. This usually entails using one or more means of 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 are referred to as a rate fence. Price discrimination is thus very common in services, where resale is not possible; an example is student discounts at museums.

Price discrimination can also be seen where the requirement that goods be identical is relaxed. For example, so-called "premium products" (including relatively simple products, such as cappuccino compared to regular coffee) have a price differential that is not explained by the cost of production. Some economists have argued that this is a form of price discrimination exercised by providing a means for consumers to reveal their willingness to pay.


[edit] Types of price discrimination

[edit] First degree price discrimination

In first degree price discrimination, price varies by customer's willingness or ability to pay. 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 fewer goods. With an increase of 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 or by threatening not to buy it.

An alternative way to understand First Degree Price Discrimination is as follows: This type of price discrimination is primarily theoretical because it requires the seller of a good or service to know the absolute maximum price that every consumer is willing to pay. As above, it is true that consumers have different price elasticities, but the seller is not concerned with such. The seller is concerned with the maximum willingness to pay (or reservation price) of each customer. By knowing the reservation price, the seller is able to absorb the entire market surplus, thus taking all consumer surplus from the consumer and transforming it into revenues. From a social welfare perspective, first degree price discrimination is not undesirable. That is, the market is still entirely efficient and there is no deadweight loss to society. However, it is the complete opposite of a perfectly competitive market. In a perfectly competitive market, the consumers receive the bulk of surplus. In a market with first degree price discrimination, the seller(s) capture all surplus. Efficiency is unchanged but the wealth is transferred. This type of market does not much exist in reality, hence it is primarily theoretical. Examples of where this might be observed are in markets where consumers bid for tenders, though still, in this case, the practice of collusive tendering undermines efficiency.

[edit] Second degree price discrimination

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.

Additionally to second degree price discrimination, sellers are not able to differentiate between different types of consumers. Thus, the suppliers will provide incentives for the consumers to differentiate themselves according to preference. As above, quantity "discounts", or non-linear pricing, is a means by which suppliers use consumer preference to distinguish classes of consumers. This allows the supplier to set different prices to the different groups and capture a larger portion of the total market surplus.

[edit] Third degree price discrimination

In third degree price discrimination, price varies by attributes such as location or by customer segment, or in the most extreme case, by the individual customer's identity; where the attribute in question is used as a proxy for ability/willingness to pay.

Additionally to third degree price discrimination, the supplier(s) of a market where this type of discrimination is exhibited are capable of differentiating between consumer classes. Examples of this differentiation are student or senior discounts. For example, a student or a senior consumer will have a different willingness to pay than an average consumer, where the reservation price is presumably lower because of budget constraints. Thus, the supplier sets a lower price for that consumer because the student or senior has a more elastic price elasticity of demand (see the discussion of price elasticity of demand as it applies to revenues from the first degree price discrimination, above). The supplier is once again capable of capturing more market surplus than would be possible without price discrimination.

Note that it is not always advantageous to the company to price discriminate even if it is possible, especially for second and third degree discrimination. In some circumstances, the demands of different classes of consumers will encourage suppliers to simply ignore one/some class(es) and target entirely to the other(s). Whether it is profitable to price discriminate is determined by the specifics of a particular market.

[edit] Price skimming

In price skimming, price 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.

[edit] Combination

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). In online ticket sales this is achieved by using the customer's credit card billing address to determine his location.
  • Discounted tickets requiring advance purchase and/or Saturday stays. Both restrictions have the effect of excluding business travelers, who typically travel during the workweek and arrange trips on shorter notice.
  • 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.

[edit] Modern taxonomy

The first/second/third degree taxonomy of price discrimination is due to Pigou (Economics of Welfare, 4th edition, 1932). See, e.g., modern taxonomy of price discrimination. However, these categories are not mutually exclusive or exhaustive. Ivan Png (Managerial Economics, 2nd edition, 2002) suggests an alternative taxonomy:

  • Complete discrimination -- where each user purchases up to the point where the user's marginal benefit equals the marginal cost of the item;
  • Direct segmentation -- where the seller can condition price on some attribute (like age or gender) that directly segments the buyers;
  • Indirect segmentation -- where the seller relies on some proxy (eg, package size, usage quantity, coupon) to structure a choice that indirectly segments the buyers.

The hierarchy—complete/direct/indirect—is in decreasing order of

  • profitability and
  • information requirement.

Complete price discrimination is most profitable, and requires the seller to have the most information about buyers. Indirect segmentation is least profitable, and requires the seller to have the least information about buyers.

[edit] Explanation

Sales revenue without and with Price Discrimination

The purpose of price discrimination is generally 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. Strictly, a consumer surplus need not exist, for example where some below-cost selling is beneficial due to fixed costs or economies of scale. An example is a high-speed internet connection shared by two consumers in a single building; if one is willing to pay less than half the cost, and the other willing to make up the rest but not to pay the entire cost, then price discrimination is necessary for the purchase to take place.

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 diagrammatically.

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).

Multiple Market Price Determination

The firm decides what amount of the total output to sell in each market by looking at the intersection of marginal cost with marginal revenue (profit maximization). This output is then divided between the two markets, at the equilibrium marginal revenue level. Therefore, the optimum outputs are Qa and Qb. From the demand curve in each market we can determine the profit maximizing prices of Pa and Pb.

It is also important to note that the marginal revenue in both markets at the optimal output levels must be equal, otherwise the firm could profit from transferring output over to whichever market is offering higher marginal revenue.

Given that Market 1 has a price elasticity of demand of E1 and Market of E2, the optimal pricing ration in Market 1 versus Market 2 is <math>P1/P2 = [1-1/E2]/[1-1/E1]</math>.

[edit] Examples of price discrimination

[edit] Retail price discrimination

In certain circumstances, it is a violation of the Robinson-Patman Act, (a 1936 Federal U.S. antitrust statute) for manufacturers of goods to sell their products to similarly situated retailers at different prices based solely on the volume of products purchased.

[edit] Travel industry

Airlines and other travel companies use differentiated pricing regularly, as they sell travel products and services simultaneously to different market segments. This is often done by assigning capacity to various booking classes, which sell for different prices and which may be linked to fare restrictions. The restrictions or "fences" help ensure that market segments buy in the booking class range that has been established for them. For example, schedule-sensitive business passengers who are willing to pay $300 for a seat from city A to city B cannot purchase a $150 ticket because the $150 booking class contains a requirement for a Saturday night stay, or a 15-day advance purchase, or another fare rule that discourages, minimizes, or effectively prevents a sale to business passengers.

Notice however that in this example "the seat" is not really always the same product. That is, the business person who purchases the $300 ticket may be willing to do so in return for a seat on a high-demand morning flight, for full refundability if the ticket is not used, and for the ability to upgrade to first class if space is available for a nominal fee. On the same flight are price-sensitive passengers who are not willing to pay $300, but who are willing to fly on a lower-demand flight (say one leaving an hour earlier), or via a connection city (not a non-stop flight), and who are willing to forgo refundability.

On the other hand, an airline may also apply differential pricing to "the same seat" over time, e.g. by discounting the price for an early or late booking (without changing any other fare condition). This could present an arbitrage opportunity in the absence of any restriction on reselling. However, passenger name changes are typically prevented or financially penalized by contract.

Since airlines often fly multi-leg flights, and since no-show rates vary by segment, competition for the seat has to take in the spatial dynamics of the product. Someone trying to fly A-B is competing with people trying to fly A-C through city B on the same aircraft. This is one reason airlines use yield management technology to determine how many seats to allot for A-B passengers, B-C passengers, and A-B-C passengers, at their varying fares and with varying demands and no-show rates.

With the rise of the Internet and the growth of low fare airlines, airfare pricing transparency has become far more pronounced. Passengers discovered it is quite easy to compare fares across different flights or different airlines. This helped put pressure on airlines to lower fares. Meanwhile, in the recession following the September 11, 2001, attacks on the U.S., business travelers and corporate buyers made it clear to airlines that they were not going to be buying air travel at rates high enough to subsidize lower fares for non-business travelers. This prediction has come true, as vast numbers of business travelers are buying airfares only in economy class for business travel.

There are sometimes group discounts on rail tickets and passes. This may be in view of the alternative of going by car together.

[edit] Premium pricing

For certain products, premium products are priced at a level (compared to "regular" or "economy" products) that is well beyond their marginal cost of production. For example, a coffee chain may price regular coffee at $1, but "premium" coffee at $2.50 (where the respective costs of production may be $0.90 and $1.25). Economists such as Tim Harford in the Undercover Economist have argued that this is a form of price discrimination: by providing a choice between a regular and premium product, consumers are being asked to reveal their degree of price sensitivity (or willingness to pay) for comparable products. Similar techniques are used in pricing business class airline tickets and premium alcoholic drinks, for example.

This effect can lead to (seemingly) perverse incentives for the producer. If, for example, potential business class customers will pay a large price differential only if economy class seats are uncomfortable while economy class customers are more sensitive to price than comfort, airlines may have substantial incentives to purposely make economy seating uncomfortable. In the example of coffee, a restaurant may gain more economic profit by making poor quality regular coffee—more profit is gained from up-selling to premium customers than is lost from customers who refuse to purchase inexpensive but poor quality coffee. In such cases, the net social utility should also account for the "lost" utility to consumers of the regular product, although determining the magnitude of this foregone utility may not be feasible.

[edit] Segmentation by age group and student status

Many movie theaters, amusement parks, tourist attractions, and other places have different admission prices per market segment: typical groupings are Youth, Student, Adult, and Senior. Each of these groups typically have a much different demand curve. Children, people living on student wages, and people living on retirement generally have much less disposable income.

[edit] Discounts for members of certain occupations

Many businesses, especially in the Southern United States, offer reduced prices to active military members. In addition to increased sales to the target group, businesses benefit from the resulting positive publicity, leading to increased sales to the general public. Less publicized are discounts to other service workers such as police; off-duty police customers in high-crime areas are said to constitute free security.

[edit] Employee discounts

Discounts that businesses give to their own employees are also a form of price discrimination.

[edit] Retail incentives

A variety of incentive techniques may be used to increase market share or revenues at the retail level. These include discount coupons, rebates, bulk and quantity pricing, seasonal discounts, and frequent buyer discounts.

[edit] Incentives for industrial buyers

Many methods exist to incentivize wholesale or industrial buyers. These may be quite targeted, as they are designed to generate specific activity, such as buying more frequently, buying more regularly, buying in bigger quantities, buying new products with established ones, and so on. Thus, there are bulk discounts, special pricing for long-term commitments, non-peak discounts, discounts on high-demand goods to incentivize buying lower-demand goods, rebates, and many others. This can help the relations between the firms involved.

[edit] Gender-based examples

Many gender-based price differences are held to be illegal in countries such as the United States and the United Kingdom.

[edit] "Ladies' night"

Many North American or European 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.

[edit] Dry cleaning

Dry cleaners typically charge higher prices for the laundering of women's clothes than for men's. Some US communities, have reacted by outlawing the practice. Dry cleaners justify the price differences because women's clothes typically require far more time to press than men's clothes due to more pleating.

[edit] Haircutting

Women's haircuts are often more expensive than men's haircuts which in past times could be accounted for as women generally had longer, more complex hairstyles whereas men generally had shorter hairstyles. Nowadays men's and women's styles are more varied but the price discrimination continues. Some salons have modified their pricing to reflect "long hair" versus "short hair" or style instead of gender.

[edit] 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.

Middle- and lower-income students may be offered discounts in the form of tuition waivers, scholarships, work-study programs that pay partly in free course hours, and government guaranteed loans.

[edit] 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 to non-existent in retail, but common when automobiles and homes are sold. Negotiation often requires knowledge, confidence, and the ability to manage confrontational personalities, and vendors know that many customers will pay higher prices in order to avoid negotiating.

[edit] International price discrimination

Pharmaceutical companies may charge customers living in wealthier countries (such as the United States) a much higher price than for identical drugs in poorer nations, as is the case with the sale of anti-retroviral drugs in Africa. Since the purchasing power of African consumers is much lower, sales would be extremely limited without price discrimination. The ability of pharmaceutical companies to maintain price differences between countries is often reinforced by national drugs laws and regulations. (or lack thereof)

Another example is textbooks. Publishers such as Prentice Hall and Pearson have low cost editions of textbooks for countries such as India. The textbooks are often printed on cheaper paper, are paperbacks and priced at 15-20% of the dollar price. This pricing has largely eliminated the practice of photo copying these books.

Although not common in modern times, governments have traditionally raised revenues from tariffs. When these are not flat tariffs, the government effectively sets the prices of goods that are not produced locally and are only imported.

Even online sales for non material goods, which do not have to be shipped, may change according to the geographic location of the buyer. A song in Apple's iTunes costs 79 pence (1.49 USD) for Britons but only 99 cents for Americans. (~50% more for the same song) These differences may arise because of changes in exchange rates that occur much more frequently than changes in prices, or they may arise because the license-holders (in this case, record companies) are enforcing their existing pricing policy on new licensees or intermediaries.

[edit] Academic pricing

Companies will often offer discounted software to students and faculty at K-12 and university levels. These may be labeled as academic versions, but perform the same as the full price retail software. Academic versions of the most expensive software suites may be priced as little as one fifth or less of retail price. Some academic software may have differing licenses than retail versions, usually disallowing their use in activities for profit or expiring the license after a given number of months. This also has the characteristics of an "initial offer" - that is, the profits from an academic customer may come partly in the form of future non-academic sales if they get "hooked" on the product.

[edit] Dual pricing

Even within a country, differentiated pricing may be established to ensure that citizens receive lower prices than non-citizens; this is known as dual pricing. This is particularly common for goods that are subsidized or otherwise provided by the state (and hence paid by taxpayers). Thus Finns, Thais, and Indians (among others) may purchase special fare tickets for public transportation that are available only to citizens. Many countries also maintain separate admission charges for museums, national parks and similar facilities, the usually professed rationale being that citizens should be able to educate themselves and enjoy the country's natural wonders cheaply, but other visitors should pay the market rate.

Many publicly run universities in the United States are subsidized by taxpayers of the state in which they are located; residents of said state are frequently given a discount on tuition as a result.

[edit] Wage discrimination

Wage discrimination is when the price of equivalent labor is discriminated among different groups of workers. This may be seen as just one kind of price discrimination or as an example of its inverse, one buyer buying identical goods at different rates.

[edit] Price discrimination by online search type

Some online stores and companies attempt to price discriminate between their customers by using information they gather about how a particular customer is searching for a product. For example, some travel firms have been shown to mark-up prices for all the holiday packages they list when a customer asks to see their holidays ranked with the most expensive package first (which suggests the customer may be price insensitive). The same packages may be available for less if the customer changes their search type. Variants of this behavior have been reported on other e-commerce sites, where the more specific your search for a particular good, the lower price is displayed for that good.

[edit] 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.

[edit] Two Necessary Conditions for Price Discrimination

There are two conditions that must be met if a price discrimination scheme is to work. First the firm must be able to identify market segments by thier price elasticity of demand and second the firms must be able to enforce the scheme.[2]For example, airlines routinely engage in price discrimination by charging high prices for customers with relatively inelastic demand - business travelers - and discount prices for tourist who have relatively elastic demand, The airlines enforce the scheme by making the tickets non-transferable thus 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 it would be difficult for average business traveler to meet.[3]

[edit] See also

[edit] Notes

  1. ("Price Discrimination and Imperfect Competition", Lars A. Stole)
  2. Samuelson $ Marks, Managerial Economics 4th ed. (Wiley 2003)
  3. Samuelson $ Marks, Managerial Economics 4th ed. (Wiley 2003) Airlines typically attempt to maximize revenue rather than profits because airlines variable costs are small. Thus airlines use pricing strategies designed to fill seats rather than equate marginal revenue and marginal costs.

[edit] References

[edit] External links