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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Price discrimination is the following pricing strategy used by a single seller: selling identical goods (identical in terms of production costs) at different prices to different buyers.

A somewhat different definition of price discrimination is due to George Stigler (Theory of Price, 1987): price discrimination is present when two or more goods are sold at prices that are in different ratios to marginal costs.

Price discrimination is counter to the law of one price and is related to the phenomenon of price dispersion. Price discrimination refers to a single seller selling the same good at different prices, while price dispersion refers to the spread in prices of identical goods across the market, usually across multiple sellers.

Motivation behind price discrimination

Price discrimination practiced for profit

Price discrimination is profitable in situations where different consumers have different demand curves for the same product. Here is a simple illustrative example that assumes a single yes/no decision for purchase rather than a decision on volume. This example illustrates first-degree price discrimination.

Suppose a seller produces a good at a price of 5 money units, and there is no competition. Buyer A is willing to pay a maximum of 10 units for the good, and buyer B is willing to pay 30 units for the good. In other words, the reservation prices of buyers A and B are 10 and 30 units respectively.

The situation without price discrimination:

If the seller has to choose a single price, the seller has the option of pricing the good at 10 units, in which case both A and B buy the good.

The producer surplus in this case is 2(10 - 5) = 10.

The consumer surplus in this case is 0 for A and 30 - 10 = 20 for B. The total consumer surplus is 20 units. The total of producer surplus and consumer surplus is 30 units.

On the other hand, if the seller prices the good at 30 units, buyer A does not buy, while buyer B buys one unit. Here, the consumer surplus is zero, while the producer surplus is 30 - 5 = 25. The total surplus is 25 units. Here, the producer surplus is more, but the consumer surplus is less, and the total surplus suffers.

The prices of 10 and 30 chosen by the seller are both local maxima in terms of producer surplus. Further, the price of 10 is also a maximum in terms of the total social surplus, and the price of 30 is a maximum in terms of the producer surplus alone.

The situation with price discrimination:

Now, the seller sells to A at a price of 10 and to B at a price of 30. The total consumer surplus is zero, because each buyer is being charged to the maximum, whereas the producer surplus is (10 - 5) + (30 - 5) = 30 units. Note that the total social surplus is the same as in the situation of a uniform price of 10, but now, all the surplus is captured by the seller.

The situation with competition:

In a market with perfect competition among sellers, the price is bid down to very close to 5 units. The total social surplus is 30 units, but this time, all the social surplus is captured by the buyers.

Price discrimination practiced for social goals

Price discrimination may be practiced by governmental or private firms for social reasons, which may be negative (prejudice or bigotry) or positive (giving greater opportunities to deprived sections).

Conditions for price discrimination

The main problem with price discrimination strategies is the leakage of the low-price product to customers who might have been willing to pay the higher price.

Differences in willingness/ability to pay

Different buyers need to be different in some meaningful way for price discrimination to make sense. This difference may be in the following ways:

  • Differences in the buyers' reservation price. This may, in turn, be caused by different degrees of (perceived) private benefit they receive, or due to wealth effects or income effects. Note that such differences can exist even in markets with perfect information and zero transaction costs.
  • Difference in the awareness of buyers about alternatives. Different buyers with the same reservation price may effectively be willing to pay different amounts because of different degrees of awareness of alternatives.
  • Difference in the transaction costs imposed on buyers either for that product or for alternatives, which affects their effective reservation prices.

Market power

Further information: Price discrimination requires market power

For a seller to practice price discrimination, i.e., to price the same good differently to different buyers, the seller must have at least some market power. For instance, if a seller has both a low price for some buyers and a high price for other buyers, another seller can come along and offer the same good at a medium price for all buyers. The other seller is thus able to steal the most profitable customers from the original seller, forcing the original seller to lower prices. In this manner, a competitive market erodes price discrimination.

Preventing high-price buyers from choosing low-price alternatives

Price discrimination requires strategies to prevent customers in the high-price segment form choosing the low-price version. The strategies are of two kinds:

  • Requiring certain eligibility conditions to qualify for the low-price product. The eligibility criteria may include geographic location (lower prices in developing and backward areas), time, or demographic characteristics of the buyer (for instance, student discount cards, senior citizen discount cards, clipper coupons).
  • Requiring customers to put in extra work to obtain the low-price product: This includes methods for arranging items in supermarkets so that price-insensitive customers are likely to pick the high-price versions while bargain shoppers are likely to pick the low-price versions.
  • Deliberately sabotaging low-price products at added cost to prevent people willing to pay a higher price from switching to the lower price: This is observed in knowledge goods. Further information: Price discrimination for knowledge goods
  • Using marketing techniques to make high price payers believe that the high-price product is different or superior.

Difficult to resell

If it is easy for people to resell goods obtained at the low price to buyers willing to pay the higher price, price discrimination is difficult to maintain.

Alternative explanations for apparent price discrimination

If price discrimination seems to be occurring, but the conditions necessary for successful price discrimination are not satisfied, there are likely to be alternative explanations. Alternative explanations to price discrimination usually hinge on hidden costs, such as opportunity costs, greater expectations of customers paying higher prices, and non-obvious differences in quality. Here are some examples:

  • Greater price as a proxy for costs of time, space, or other options that are not directly charged for: For instance, food and drink items that are typically ordered by customers seeking to stay for long may be charged higher, to compensate for the time spent occupying the table.
  • Greater price for clients who are likely to be more demanding: Buyers who are more likely to demand better goods and service, or place other additional demands on the sellers, may be charged more to compensate.

Models of behavior and organization for price discrimination

In perfectly competitive markets with completely rational behavior and no transaction costs

Price discrimination has no place in perfectly competitive markets where transaction costs are zero and everybody has perfect information and is rational.

In non-competitive markets

In a market where some sellers have market power, the conditions for price discrimination (difficult to resell, easy to prevent leakage of low-price versions to high-price buyers) may exist even with completely rational behavior, zero transaction costs and perfect information.

With variable transaction costs and variable degrees of imperfect information

In a perfectly competitive market where all players behave rationally, price discrimination may still exist if different buyers have different transaction costs or different degrees of information, leading to a difference in the prices they are effectively willing to pay. In fact, such a difference may emerge even with very similar reservation prices, and it may even act in a direction opposite to reservation prices. (Thus, rich buyers may also be better informed about alternatives and may thus get lower prices for goods even though their reservation prices may be higher).

However, if the market is sufficiently competitive, these differences tend to remain small, because competing sellers, in conjunction with smart buyers who put pressure on them, help spread information about the cheaper versions even to individual buyers who do not have enough information.

With irrational behavior

Even in the presence of low transaction costs, the complete availability of information, and perfectly competitive markets, irrational behavior on the part of buyers could lead to small amounts of price discrimination. These amounts must, however, remain small because competitors to a seller practicing significant price discrimination can raise awareness of the issue.

In practice, we see price discrimination practiced in situations where there is a reasonable degree of market power (though far from a monopoly), non-negligible transaction costs and lack of perfect information, and further, the techniques used for price discrimination typically try to exploit systemic behavioral biases.

Types of price discrimination

The classification of price discrimination discussed here is that outlined in Pigou's book.

First-degree price discrimination

Further information: First-degree price discrimination

First-degree price discrimination, also called perfect price discrimination is a form of individual targeting. It describes a situation where a seller can charge different prices to different consumers, based on whatever price the seller thinks is best for each consumer. Here, the seller uses various methods to try to determine the reservation price of each consumer (reservation price is the maximum price the consumer is willing to pay) and charge close to that. Thus, the seller can milk the maximum profit from each consumer without ever losing a buyer because of high prices. First-degree price discrimination has huge costs both in terms of the cost needed to gather enough information about buyers to guess reservation prices well, and in terms of the added costs when buyers catch on to the strategy and put moral pressure on the seller or otherwise try to fool the seller.

If the costs of discerning reservation prices are zero, first-degree price discrimination is efficient, maximizes social surplus (at least in the short run), and avoids deadweight loss. However, all the social surplus is captured by the seller, which is the opposite of the situation in perfect competition, which is efficient and where the social surplus is captured either by consumers or by producers who are more efficient than other producers.

First-degree price discrimination includes the related practice of bargaining or haggling.

Second-degree price discrimination

Further information: Second-degree price discrimination

Second-degree price discrimination, also called nonlinear pricing or volume-based price discrimination, describes a situation where the cost per unit is lower the greater the volume a buyer buys. Such price discrimination is useful if it is true that people who are willing to buy larger quantities are also the people who are less likely to be willing to pay higher unit prices. This is usually the case, since consumers buying larger quantities may well be more likely to search for better deals or cheaper alternatives, since more money is at stake. Alternatively, such price discrimination may be explained by the fact that the marginal utility of purchasing additional units of the product is decreasing. Hence, for a given buyer, the reservation price per unit for purchasing a larger quantity is lower.

Third-degree price discrimination

Further information: Third-degree price discrimination

Third-degree price discrimination uses group targeting. Here, prices are set at different levels based on region, demographic group, and other factors. Group targeting thus tries to exploit the different demand curves for different demographic groups. Such price discrimination may again be of two kinds: direct segmentation, where the segmentation is based on rules (such as age and geographic location) and indirect segmentation, which more covertly tries to attract high-paying customers to high-priced versions and low-paying customers to low-priced versions.

Costs and benefits of price discrimination

Price discrimination indicates the existence of sellers with market power, and this is bad news because sellers with market power may set prices and quantities to maximize their own surplus in a way that does not maximize the social surplus. However, the price discrimination itself may well be better than the other options for a seller with market power.

Price discrimination imposes costs of gathering information about reservation prices

Price discrimination imposes costs on sellers, since they need to determine the reservation prices of a larger number of buyers. These costs are highest for first-degree price discrimination, where the reservation price has to be determined for every individual potential buyer. For second-degree price discrimination and third-degree price discrimination, the costs are less.

Price discrimination is good when it expands available markets

Further information: Price discrimination is efficient when expanding available markets

Consider the example of a seller (with no competition) whose product cost per unit of a good is 5 units, and two buyers A and B, who value the good at 10 and 30 units respectively.

In the absence of price discrimination: The seller sets a price of 30 units. Buyer A does not buy, while buyer B buys. The seller has a producer surplus of 25 units.

For the seller, this is preferable to selling at a price of 10 units or less, because at that price, the seller's profits are limited to 2 (10 - 5) = 10.

In the presence of price discrimination: The seller sets a price of 30 units for buyer B and 10 units for buyer B. The producer surplus is now 25 units for buyer B and 5 units for buyer A. There is no consumer surplus. The total social surplus is 30 units, which is the maximum possible.

Thus, price discrimination increases the total social surplus generated. In this situation, price discrimination is preferable for society to the alternative single high price. Nonetheless, it is not preferable to a situation of perfect competition. Perfect competition not only maximizes social surplus but also gives consumers a larger fraction of it.

Price discrimination is inefficient when it redistributes resources among existing buyers

Further information: Price discrimination is inefficient when distributing limited resources

Price discrimination can be bad when it distributes limited resources from people who value them more (indicated by a willingness to pay more) to people who value them less. Examples are discounts for certain groups for seats in flights and trains. Such discounts may end up allowing people who derive relatively less benefit from traveling to travel in place of others who may have benefited more.

Legal regulation of this strategy

In the United States

Price discrimination, when intended to reduce competition among retailers, is regulated under the Robinson-Patman Act in the United States.


Textbook references

Journal references

Expository book references

  • The Armchair Economist by Steven E. Landsburg, 13-digit ISBN 9780029177761, 10-digit ISBN 0029177766 (paperback)More info, Page 157-167, Chapter 16 (Why popcorn costs more at the movies and why the obvious answer is wrong)
  • The Undercover Economist by Tim Harford, 10-digit ISBN 0345494016, 13-digit ISBN 978-0345494016 (paperback)More info, Page 31-59, Chapter 2 (What supermarkets don't want you to know)
  • Naked Economics: Undressing the Dismal Science by Charles Wheelan, 10-digit ISBN 0393324869, 13-digit ISBN 978-0393324860More info, Page 16-17, Chapter 1 (The Power of Markets: Who Feeds Paris?)
  • The Economic Naturalist: In Search of Explanations for Everyday Enigmas (paperback) by Robert H. Frank, 10-digit ISBN 0465003575, 13-digit ISBN 978-0465003570More info, Pages 41, 84, 153.