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Price discrimination
By the end of this chapter, you should be able to:
define and explain price discrimination
HL
define, illustrate, give examples of, and distinguish between first
degree, second degree, and third degree price discrimination.
1 Microeconomics
HL
Price discrimination
Price discrimination exists when a producer sells the exact same
product to different consumers at different prices. For example, a
child’s ticket to fly from Vienna to Toronto may cost ?500, while his
mother’s ticket costs ?700. The product, a seat on a plane, is exactly
the same but the price is different.
In order for a producer to be able to price discriminate, three
conditions are necessary.
1The producer must have some price-setting ability, i.e. the market
must be imperfect. The more price-setting ability the producer has,
the easier it is for price discrimination to take place, which is why it
is most often found in monopoly and oligopoly markets. Price
discrimination is not possible in perfect competition.
2The consumers must have different price elasticities of demand for
the product. If they do not, then they would not be prepared to
pay different prices for the product. It follows that a consumer
with relatively inelastic demand for a product will be prepared
to pay a higher price than a consumer with relatively elastic
demand, since elasticity tends to signify the importance of a
product to consumers.
3The producer must be able to separate the consumers, so that they
are not able to buy the product and then sell it to another
consumer. If this were not the case, then the consumers who buy
the product at a low price would simply sell to those who were
paying the higher price, at a price below that one. This would
destroy the ability of the producer to practise price discrimination.
Producers are able to separate markets in a number of different
ways. They can do so by:
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Time: Consumers are often prepared to pay higher prices at
certain times than at others. For example, commuters heading
to work in the morning on the train are making a necessary
journey and so will be prepared to pay a higher fare than a
person who is free all day and would like to go shopping. The
commuter’s elasticity of demand for travel is more inelastic
than that of the shopper. Thus the train company charges
higher fares during peak times and lower fares during nonpeak times.
133
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If the three conditions above do not exist, then price discrimination
will not be possible. We need to be careful with price discrimination,
since there are often cases that seem to be price discrimination, but
are in fact simply examples of sales promotion. For example, students
often say that nightclubs letting girls in for free while boys have to
pay is an example of price discrimination. However, in reality this is
not the case. It is unlikely that there is any difference in the price
elasticity of demand for nightclubs between girls and boys. The
motivation for the nightclubs is to offer a promotion that will attract
girls to the nightclubs, so that lots of boys will then go, attracted by
the high number of girls!
There are three degrees/levels of price discrimination to be considered:
134
1First-degree price discrimination is said to take place when
each consumer pays exactly the price that he/she is prepared to
pay. This is how it is assumed that traders in a bazaar or market
operate when they bargain to try to get the highest price that they
can. In Figure 11.1, we see the case of a trader selling World Cup
t-shirts to tourists in a market.
2Second-degree price discrimination is said to take place when
a firm charges different prices to consumers depending upon how
much they purchase. This is often how utilities companies (e.g.
electricity and gas providers) operate. They may charge a high
price for the first number of units, the essential ones, and then a
lower price for any extra units consumed. Figure 11.2 shows the
situation for the pricing of text messages by a mobile phone
company. The first 50 messages per month are charged at a rate of
30¢ each. Any messages sent over this number are charged at the
reduced rate of 20¢ per message.
Price (cents)
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The trader attempts to bargain with the tourists to sell each shirt at
the highest price that the tourist is prepared to pay. If the trader is
successful then, as we can see, on that day the trader will sell one
shirt at $14, one at $13, one at $12, and so on. If the trader did
not price discriminate, then total revenue for the day would be
the shaded pale blue rectangle. However, by discriminating, the
trader has eliminated the consumer surplus of the tourists and so
the trader’s total revenue is the shaded pale blue area plus the
shaded dark blue triangle. Also, since the extra revenue received
from each shirt (the marginal revenue) is equal to the price of the
shirt, in this case, D = MR.
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Price discrimination
40
30
20
10
0
D=AR
50
100
Quantity of text messages (per month)
Figure 11.2 Second-degree price
discrimination
3Third-degree price discrimination is said to take place when
consumers are identified in different market segments, and a
separate price is charged in each market segment that recognizes
the different price elasticities in each segment. This is the most
common form of price discrimination. Figure 11.3 shows a typical
example of price discrimination in a cinema.
Student tickets
Adult tickets
Total tickets
Price ($)
Age: Firms may charge different prices to consumers based
upon their ages. For example, children are often charged
lower prices than adults for visiting the cinema. The children
have a more elastic demand, because their incomes are lower.
Gender: Firms may charge different prices to men than to
women. For example, a football club in Sweden charges lower
prices for female supporters than for male supporters. It is
alleged that female supporters are not as keen on football as
males, and so have a more elastic demand.
Income: Firms may charge higher prices to people with high
incomes. For example, lawyers will often charge higher fees to
wealthy clients and lower fees to clients who do not have
high incomes. The wealthy clients will have a relatively
inelastic demand for legal services, since they can afford them
more easily.
Geographical distance: Firms often sell products in different
regions at different prices. This is possible as long as the cost of
transferring the product is greater than the difference in the
prices. If this is the case, then consumers in the low price
region cannot transfer the goods to the high price region,
without incurring transport costs that raise their total cost
above the price in the high price region. For example, CDs are
sold for a lower price in the USA than they are in the EU. This
is possible because there are different price elasticities in the
two countries and the transportation costs between the
countries are greater than the price differential.
Types of consumer: Firms sometimes sell at different prices to
different users. For example, electricity companies may charge
different rates to industrial users and domestic users. The rates
will reflect their different elasticities of demand for power.
Museums may charge people who are registered as
unemployed a lower price than the standard rate. Market
traders may charge foreign tourists a higher price for a
product than they charge local consumers.
Price ($)
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Price ($)
11
Price discrimination
10.25
MC
7.50
5
5
MR(S)
0
5
D(S)
3.75
10
Customers per week (00s)
MR(A) D(A)
0
3.25
10
Customers per week (00s)
MR (A+S)
0
5 7
10
Customers per week (00s)
Figure 11.3 Third degree price discrimination
Price ($)
1 Microeconomics
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1 Microeconomics
11
15
MC
10
5
0
D = MR
5 8 10
Quantity of World Cup t-shirts
Figure 11.1 First-degree price
discrimination
The management of the cinema have identified two distinct
market segments in their audience, adults and students. The
students have a more elastic demand for going to films because
they have lower incomes. Thus the management know that they
will have to charge a lower price for students than for adults. They
can separate the market segments, because the students need to
show some proof of their status before they are allowed into the
cinema with a lower price ticket.
Figure 11.3 shows the exact situation for a week at the cinema.
The demand curve for students, D(S), is relatively more elastic
than the demand curve for adults, D(A). The respective marginal
135
11
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1 Microeconomics
When the marginal cost is transferred to each market segment, we
can find the profit-maximizing position in each. In the student
segment, when MC=MR=$5, profits are maximized by charging a
price of $7.50 and attracting 375 students. In the adult segment,
when MC=MR=$5, profits are maximized by charging a price of
$10.25 and attracting 325 adults.
In third-degree price discrimination, a market may be broken up
into more than two segments, but the principle will be the same.
In cinemas, there are many different prices offered, such as
normal adult, student, senior citizen, and under 12, but they all
take account of different elasticities and they are all examples of
third-degree price discrimination.
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prices to wealthy customers and this enables them to deal with
lower-income clients for little or no fee. Doctors often do the
same.
Similarly, price discrimination allows some people to purchase a
product at a lower price than they would have had to pay if the
producer had not been able to secure higher prices from others.
For example, many universities charge foreign students higher
tuition fees than for domestic students.
Price discrimination usually increases total output in a market and
so the product is available to more consumers.
As stated above, price discrimination may lead to economies of
scale, lower unit costs, and thus lower prices for consumers in all
market segments.
The disadvantages to the consumer are that:
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Any consumer surplus that existed before the price discrimination
will be lost.
Some consumers will pay more than the price that would have
been charged in a single, non-discriminated market.
hatever the degree, price discrimination can be both a good thing
W
and a bad thing; it really depends upon the situation and who the
stakeholder is.
Case study
There are clear advantages to the firm:
The Twin City Liner is a 75-minute boat journey
on the Danube, connecting Vienna and
Bratislava which are the capital cities of Austria
and Slovakia. The boat makes five daily journeys
from Vienna to Bratislava and five from
Bratislava to Vienna.
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Price discrimination enables the producer to gain a higher level of
revenue from a given amount of sales. This occurs because
consumer surplus is eroded.
Price discrimination may enable the producer to produce more of
the product and thus gain from economies of scale. This could
benefit everyone, by lowering average costs and lowering prices in
all of the market segments.
Price discrimination may enable a firm to drive competitors out of
the more elastic market. If the firm is able to price discriminate,
then it may use profits gained in the inelastic market segment to
lower prices in the more elastic segment and thus undercut its
competitors in that segment. This especially occurs in international
trade, where a firm may have inelastic demand in the home
market and more elastic demand in foreign markets. Price
discrimination may allow the exporting firm to be aggressively
competitive in the foreign markets. According to global trading
rules set out by the World Trade Organization, firms may not sell
in foreign markets at prices below the costs of production. This is
known as dumping, and is illegal. However, firms are permitted to
sell at lower prices in foreign markets, prices that are below the
domestic market prices.
There are also some advantages to the consumer:
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Price discrimination may allow some consumers to purchase a
product that they would not have been able to if other consumers
were not paying a higher price and thus “subsidizing” the poorer
consumers. For example, in many countries, lawyers charge high
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Price discrimination
Student workpoint 11.1
1 Microeconomics
revenue curves are twice as steeply sloping as the demand curves.
We assume that the cinema is attempting to maximize profits and
so we use the figure for total ticket sales on the right hand side.
The marginal cost curve is for the cinema as a whole and the
marginal revenue curve is a total of MR(S) and MR(A). This is
why it is kinked. The cinema will maximize profits when MC=MR,
so it will serve 700 customers per week and the marginal cost will
be $5.
136
11
Price discrimination
Be inquisitive—investigate the
following
Find three real-world examples of
price discrimination. Provide details
of the different prices charged to
the different groups. Suggest why
the elasticities of demand might
be different between the market
segments, and explain how the
producer/seller manages to keep
the markets separate (e.g. time,
identity card).
The Twin City Liner
16.30
€17
€19
18.30
€17
€19
Children – 50% discount
Departing from Bratislava (Main tourist season)
Time
Weekday
Weekends and holidays
10.30
€17
€19
14.30
€28
€30
16.00
€28
€30
18.30
€17
€30
22.30
€17
€19
Children – 50% discount
The prices for the journeys are as follows:
Departing from Vienna (Main tourist season)
Time
Weekday
Weekends and holidays
8.30
€28
€30
9.00
€28
€30
12.30
€28
€19
Here we have an excellent example of price
discrimination. People who want to make the
journey might want to make a day of it. If they
are in Vienna then this means that they would
like to take the first or second boat of the day at
8.30 or 9.00 and come back in time for dinner,
leaving Bratislava at 16.00 or 18.30. This will
make the price of the round trip €56. Almost
any other combination of journeys will be less
137
11
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Price discrimination
1 Microeconomics
expensive than this. It would seem that the Twin
City Liner company feels that this will be the
most desirable trip and are pricing to take
advantage of people’s different elasticities of
demand. They must also be assuming that more
people will want to make the round trip journey
starting from Vienna rather than from Bratislava
as combinations starting from Vienna and
returning the same day cost more than their
equivalent from Bratislava.
The fact that they are charging a higher price on
Saturdays, Sundays, and holidays is also due to
differing elasticities of demand. These may be
the only days that certain people can travel, thus
their demand will be less elastic. The company
can “take advantage” of this by charging a
higher price.
The fact that children are offered a lower price
is also an example of price discrimination. They
will still occupy a seat, so the “product” is
identical but they only pay 50% of the price.
It is worth noting that up to two years ago the
company had one boat and ran three journeys a
day from Vienna and three from Bratislava. Now
they have two boats and have increased the
number of journeys. Furthermore, the price has
increased. Look at this situation from the
perspective of an economist. Clearly there has
been strong demand for the service. The extra
demand may have led to a price increase, and
also an increase in the supply. The decision by the
firm to increase the supply of boats (capital) was
an example of a change in a fixed factor of
production, and took the company to a new short
run average cost at a higher scale of production.
Perhaps the extra abnormal profits earned by
price discriminating allowed the firm to increase
its capital and therefore increase its output?
Examination questions
Paper 1, part (a) question
1 Explain the conditions necessary for a seller of a good to be able to
price discriminate.
[10 marks]
Paper 1, essay question
1 a Explain the concept of price discrimination.
[10 marks]
[15 marks]
b Evaluate the effects of price discrimination on producers and consumers.
ist
You be the journal
Headline: Government announces plans to raise tuition fees for
foreign students
Economics concept: Price discrimination
Diagram: Different elasticities of demand for domestic students and
foreign students
Hint: Try to explain why the government might want to do this and
consider why the demand for universities from foreign students might
be less elastic than the demand from domestic students.
138
Assessment advice: using
examples
Always remember to include
examples in your written answers. For
example, in explaining the concept of
price discrimination, you will be able
to do so much more effectively if you
give examples of situations where
price discrimination takes place. To
evaluate the effects, you need to be
able to consider the effects on the
stakeholders in different examples.
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