First-degree price discrimination

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This article describes a pricing strategy used by sellers, typically in markets that suffer from imperfect competition, significant transaction costs or imperfect information.
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Definition

First-degree price discrimination, also called perfect price discrimination or individual targeting is a practice of a single seller offering different prices to different individual buyers for the same good or service.

First-degree price discrimination is a special case of price discrimination, which involves a single seller offering difference prices to different buyers for the same good or service. The key differentiating feature of first-degree price discrimination is that prices are determined at the level of individual buyers, rather than through group-targeting (second-degree price discrimination) or volume-based targeting (third-degree price discrimination).

Forms of first-degree price discrimination

Bargaining

Further information: Bargaining as price discrimination

Bargaining is a strategy where an individual seller first quotes a price for a good or service, and the seller and buyer then negotiate the price downward to a price that both buyer and seller are willing to agree upon. Bargaining is a form of price discrimination in two ways:

  • The initial price quoted by the seller is based on the seller's estimate of the buyer's reservation price based on whatever information the seller gleans from the buyer.
  • The extent to which the seller and buyer reduce the price through negotiations itself is a cause for different final prices, even for the same initial quoted price.

Individual profiling

In some cases, sellers maintain extensive individual profiles of buyers and are able to use these profiles to offer deals to buyers at specific prices. This extensive profiling may be done by human sellers, or it may be done through computerized algorithms used by large-scale retailers, particularly electronic retailers.

Motivation behind first-degree price discrimination

Assuming that the cost of determining the reservation prices of buyers is zero, first-degree price discrimination is efficient, eliminates deadweight loss, maximizes social surplus. Further, all the social surplus is captured by sellers, making it extremely lucrative for sellers. This is the opposite to a situation of perfect competition, where social surplus is maximized but all of it is captured by buyers.

Costs of first-degree price discrimination

The cost of determining reservation prices

It may be costly for sellers to determine the reservation prices of individual buyers, which they need in order to make good initial price offers. This information is not easy to obtain directly since buyers, who prefer to have things cheaper, may be unwilling to reveal their true reservation prices. The cost of estimating reservation prices is a net social cost since buyers do not directly benefit from the extra cost incurred by sellers in determining their reservation price. (If the reservation price estimates are correct, it may be compensated by the overall gain in efficiency brought about because of the elimination of deadweight loss). It may also impose costs on buyers, in their attempt to hide their personal reservation price.

Similarly, the bargaining process, which is time-consuming, is costly to both buyers and sellers.

The cost of being wrong

In some cases, sellers may overestimate or underestimate the reservation prices of buyers. When a seller overprices for a buyer because of overestimating the buyer's reservation price, even though the buyer's actual reservation price exceeds the seller's, an opportunity for a mutually beneficial purchase is lost, and a deadweight loss occurs.

When a seller underestimates a buyer's reservation price, there is no deadweight loss, because the buyer will still make the purchase. The social surplus is not adversely affected by underestimation. However, the seller captures a smaller share of the social surplus.

Note that in the bargaining setup, estimation errors are somewhat mitigated by the fact that buyers and sellers can negotiate. Thus, sellers can quote an initial price on the higher side and let the buyers bargain it down.

Behavioral response

Unpopularity

First-degree price discrimination may be unpopular or considered unfair. However, the extent to which it is considered unfair is largely dependent on the way it is framed. For instance:

  • Charging some individuals extra money for a good because they seem to want it more is seen as unpopular.
  • However, special, personalized discounts, as often offered by electronic retailers as well as small stores, are often viewed favorably by those receiving the discounts, and are generally not as unpopular.

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