● ● ● ● 11 2 ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● ● 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: l 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 l l l 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) l 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 $12, and so on. If the trader did not price discriminate, then total revenue for the day would be the shaded pale blue rectangle. However, by discriminating, the trader has eliminated the consumer surplus of the tourists and so the trader’s total revenue is the shaded pale blue area plus the shaded dark blue triangle. Also, since the extra revenue received from each shirt (the marginal revenue) is equal to the price of the shirt, in this case, D = MR. ● Price discrimination 40 30 20 10 0 D=AR 50 100 Quantity of text messages (per month) Figure 11.2 Second-degree price discrimination 3Third-degree price discrimination is said to take place when consumers are identified in different market segments, and a separate price is charged in each market segment that recognizes the different price elasticities in each segment. This is the most common form of price discrimination. Figure 11.3 shows a typical example of price discrimination in a cinema. Student tickets Adult tickets Total tickets Price ($) 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 ($) l Price ($) 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 ● 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 ● 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. l l l 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: l l 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. l l l 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: l 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 ● 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 ● 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.