Price discrimination is the practice of charging different prices for the same or similar product/service to different consumers where the price differences do not reflect the differences in cost of supply.
Reasons for price discrimination
Price discrimination is carried out primarily to increase the profits of the discriminating firms. It occurs where different consumers are charged different prices in different markets for the same product or service, or where the same consumer is charged different prices for the same product, where the different prices are not due to differences in supply costs.
Necessary conditions for price discrimination
There must be some imperfection of the market. If there were perfect competition, price discrimination would be impossible since the individual producer could have no influence on price. At least some degree of monopoly power is therefore necessary so that producers have some ability to make rather than take the market price.
The discriminating supplier must be able to split the market into separate sections and keep them separate, such that it is difficult to transfer the seller's product from one sector to another i.e. there must be no 'seepage' between markets in the sense that goods can be bought in the cheaper market and re-sold in the dearer.
Barriers between markets may be:
- Geographical in that customers are separated by distance e.g. the international dumping of cheap goods, where goods are sold overseas at prices below those in the home market, and often below the cost of production e.g. the East European Communist block countries used to sell their exports to the West at lower prices than those prevailing in domestic markets to earn hard foreign currency.
- Temporal in that customers are separated by time e.g. it may be cheaper to travel by train after 9.30am than before 9.30 am, and the two markets can be kept separate as ticket office staff will not sell the cheaper tickets until after this time
- According to customer type so that customers are separated according to some easily identified feature of the customers themselves e.g. age, sex, income or occupation; examples of this would include cheaper theatre tickets for children, old age pensioners and the unemployed, reduced price rail travel for students and higher private physician consultation fees for those who are perceived as being able to pay more.
The two conditions discussed so far would make price discrimination possible, but for it to also be profitable a third condition must also be satisfied:
Price elasticity of demand in each market must be different; if this were the case , the discriminating supplier would increase price in the market with an inelastic demand curve, and reduce price where demand is elastic in order to increase total revenue and profits. If the elasticity of demand in each market was the same at each and every price, a common price would be charged in both markets as this price would represent the profit maximising price in each market where MC = MR. You might wish to refer back at this stage to where we discussed the relationship between price elasticity of demand and total revenue.
Equilibrium of the discriminating monopolist
In figure 1 there are two distinct markets, Market A and Market B. A third market, Market C, which is the combined market, is obtained by the horizontal summation of the individual AR and MR curves from A and B. Market A has an inelastic demand curve, whilst Market B has a more elastic demand curve. The gradient of the combined market demand curve will lie between that of A and B.
In the combined market, MC is equated with MR to give a single profit maximising price of OPc with an output of OQc, and a total profit equal to the shaded area z is earned. With a single price, this is the maximum profit that could be earned as the charging of a higher price would reduce demand and the area of profit, z.
However, total profits can be increased through price discrimination, with the total output OQc being sold at different prices in markets A and B. Price will always be higher in the market with a more inelastic demand as consumers will be less responsive to price changes.
As price discrimination only occurs where the differences in price are not associated with any cost differences, the combined market MC curve will also apply to markets A and B, and the output of each sub-market is therefore determined by equating MR in each market with the marginal cost of producing OQc units of output. Thus in figure 1, it can be seen that the marginal cost of production, OM, is projected back from the combined market as a horizontal line to enable the monopolist to find the equilibrium points Ea and Eb where MC = MR in each of the individual markets, A and B. Similarly the average cost of production, OC, is projected back from the combined market to determine the area of profit in markets A and B. As the level of profit is denoted by the amount by which AR exceeds AC, the areas x and y will represent the total profit for A and B respectively.
From the producer's standpoint, price discrimination will be a success if total profits increase as a result. In the diagram, it can be seen that Area x + Area y is greater than Area z, so the producer has succeeded.
Advantages and disadvantages of price discrimination
The main disadvantage will be experienced by consumers, particularly those having to pay the higher prices who may object to the discrimination against them e.g. users of peak time public transport. It could be argued that price discrimination represents a transfer of welfare from consumers to producers and is a way in which producers gain at the expense of consumers through the extraction of consumer surplus. In the extreme case of perfect or first degree price discrimination, no consumer receives any consumer surplus at all.
In more general terms, the higher profits earned through price discrimination could be viewed as an unjustifiable redistribution of income in favour of profit takers with higher prices reducing consumers' real incomes.
- Producers of course benefit from the higher profits as previously shown. It could also be argued that if such profits are re-invested, consumers might derive long run benefits in terms of increased efficiency and lower costs and prices.
- Those consumers paying the lower price may be able to obtain a good or service that they might not otherwise have been able to afford e.g. half price tickets for children at football matches.
- Consumer and producer alike may gain if a loss making firm is turned into a profitable one. This is illustrated in figure 2 below.
In figure 2, the producer's best output, where MC = MR is at OQe, but the price of OPe does not cover the average cost of OC, and a loss, equivalent to the rectangular area x, is made. However, a loss can be transformed into a profit by charging those consumers who are prepared to pay, a higher price of OPe1. The shaded area y shows the additional revenue that accrues to the firm from charging a two-part tariff. As area y exceeds that of x, the loss making firm is now able to make a profit at the current output level.
In the absence of price discrimination, this good would probably not be supplied in the long run, which would particularly represent a loss to society if it were one which generated positive externalities e.g. a doctor in a remote area charging wealthier patients more than the less affluent ones.