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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- 1 Definition
- 2 Motivation behind price discrimination
- 3 Conditions for price discrimination
- 4 Alternative explanations for apparent price discrimination
- 5 Models of behavior and organization for price discrimination
- 6 Types of price discrimination
- 7 Costs and benefits of price discrimination
- 8 The political economy of price discrimination
- 9 Legal regulation of this strategy
- 10 References
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 money units per piece, and there is no competition. Buyer is willing to pay a maximum of units for the good, and buyer is willing to pay units for the good. In other words, the reservation prices of buyers and are and units respectively.We first consider the case where and . For instance .[SHOW MORE]
Note that although the term profit is used here, price discrimination may well be practiced in the same manner by institutions or firms that are not profit-making, including governmental institutions and private nonprofits.
Price discrimination practiced for non-economic reasons
Price discrimination may be practiced by governmental or private firms for social goals or for taste-based reasons.
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.
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 many 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
Further information: price discrimination requires difficulty of resale
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, in restaurants, 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 marketsConsider the example discussed earlier: a seller can produce a good at units per piece, and there are two buyers, each of whom has to decide whether to buy the good or not, and their reservation prices are and respectively, with and .[SHOW MORE]
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.
The political economy of price discrimination
Influence by market actors on politicians to convince them of price discrimination
Some market actors try to convince politicians that their competitors are practicing price discrimination. One self-interested motivation for doing this is if the competitors are in fact providing lower prices to certain segments of the market. In some of these cases, the real price discrimination story may be altogether opposite.Let us say there are two buyers and and two sellers and . [SHOW MORE]
Accusations of price discrimination are often made along with accusations of predatory pricing (lowering prices below production cost to drive out competitors and achieve market control) and other anti-competitive practices.
Confusion and conflation
Often, sellers are accused of using price discrimination for non-economic reasons, such as tastes for certain kinds of buyers, and this is considered unfair and worth acting against. The confusion/conflation could happen in many ways:
- Confusing something that isn't price discrimination for price discrimination, because of the end result that prices are different for different customers.
- Not appreciating the conceptual distinction between profit-based price discrimination and price discrimination for other reasons.
- Confusing price discrimination that is, in a specific instance, profit-based, with price discrimination practiced for taste-based reasons.
Alternatively, even without confusing these many issues, it may be argued that even if price discrimination is not discriminatory in intent and is purely profit-based, it is still immoral because of its greater impact (in terms of prices) on some individuals/groups compared to others, and hence must be acted.
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.
Online encyclopedia/dictionary references
- Search for "price+discrimination" on the Library of Economics
- Search for "price+discrimination" on the Marginal Revolution weblog
- The Economics of Price Discrimination by Louis Phlips, 10-digit ISBN 0521283949, 13-digit ISBN 978-0521283946More info
- Theory of Price by George J. StiglerMore info
- The Economics of Welfare by Alfred C. PigouMore info
- Book:HandbookofIndustrialOrganizationMore info, Chapter 10 (Price discrimination) by Hal Varian
- Beyond the many faces of price: an integration of pricing strategies by Gerard J. Tellis, Volume 50,Number 4, Page 146 - 160(October 1986): JSTOR linkMore info
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.