Meaning
Price discrimination is the microeconomic pricing strategy adopted by the monopolist to offer the same product to different consumers or markets at different prices. Price discrimination is a common phenomenon in the real market scenario.
Consumers are charged differently either on the basis of the number of products they purchase or on the basis of the general elasticity of the market or on the basis of willingness to pay.
Price discrimination is prevalent since antiquity. The consumer who buys a product in bulk obviously gets the product at a lower price than the one who purchases less quantity of product.
Moreover, producers set different prices for the different markets for the same product on the basis of price sensitivity. Thus, price discrimination is ubiquitous.
Reasons
Why is price discrimination ubiquitous in the global market? Why firms or companies discriminate price?
These are some prominent questions that strike our mind. The main reasons for price discrimination are as follows:
- Firms discriminate price to increase the sales
Price discrimination is an efficient strategy to increase the sales of the product. If the product is priced high, then the higher income group can only afford the product. Consequently, the product is purchased by the high-income group only.
But, if the firm charges different prices to different consumers or the market, then the lower income group can also afford the product. Hence, the sales of the product increase.
For example, Kaspersky charges $39 to $79 for its range of security suites in the developed economies; but in Nepal, one of the underdeveloped economies, its cost ranges from $10 to $28. Due to lower pricing in the Nepalese marketplace, Kaspersky is affordable for Nepalese customers and has a significant market share in the Nepalese market.
- Firms focus on profit maximization
Price discrimination is a tool to increase profit. The profit increases drastically with the application of price discrimination. Price discrimination certainly increases quantity sales; consequently, increases sales revenue.
Eventually, the profit rises with an increase in sales revenue. The logic behind the rise in profit can be attributed to a rising in producer’s surplus, as the producer can capture both consumer surplus and some part of the deadweight loss.
- Firms capture deadweight loss through price discrimination
Firms capture deadweight loss through price discrimination in the sense that a firm can increase its consumer base.
The loss in quantity sales due to a higher price (price above the marginal cost) can be reduced by setting a lower price (price equal or just above marginal cost) in some price-sensitive market segments.
For example: if Kaspersky sets global pricing of $39 to $79, then Nepalese customers cannot afford the security suite. Hence, there exists a deadweight loss. But, by offering the product at a lower price, Kaspersky is able to reduce the deadweight loss.
- Firms can enjoy the larger customer base
A firm that sticks with the global pricing strategy suffers due to the heterogeneity of the market. A firm focusing on a larger customer base generally set prices based on the characteristics of the market.
Think globally, and act locally is the famous slogan of today’s business world. For instance, if Kaspersky sticks to a global pricing strategy, then definitely its consumer base will constitute those of high-income economies.
But, due to regional pricing strategy, it is able to expand the consumer base as it is able to capture the consumers of middle-income economies.
Conditions
In what circumstances price discrimination can be applied? What are the prerequisites for the implementation of price discrimination? Which type of firm can enjoy price discrimination?
These are some of the common questions that arise in our minds. So, some of the basic conditions for the implementation of price discrimination are as follows:
- Imperfect market
Price discrimination is impossible in perfect competition. A firm must have a monopoly power to implement price discrimination.
Without a differentiated product, a firm cannot place its product differently in the market; and discriminatory prices are unattainable in case of homogeneous products.
Moreover, in the imperfect market, consumers lack perfect information about the product.
Thus, due to the monopoly power of the firm and lack of perfect information about the product to the consumers, it is easy for firms to set different prices in a different market.
- Markets should be located in distant places
The market should be located in distant places reflects that the product must be available in a specific market, and the markets are far from each other.
If the product is available elsewhere, then it is difficult for producers or firms to discriminate price as the consumer can easily buy the product from another market at a relatively lower price.
Hence, the market must be located in distant places
- The difference in price elasticity of demand exists
Price elasticity of demand reveals the responsiveness of quantity demanded to the change in price. Simply, price elasticity of demand reflects alertness towards change in price.
Generally, low-income groups are sensitive to change in price; they readily substitute the high priced product with low priced products.
Hence, firms tend to set different prices for high-income economies (G7 nations), upper-middle-income economies (BRICS nations), and lower-middle-income economies (LDCs).
- Heterogeneity of market
Heterogeneity of the market is one of the major requirements for price discrimination. Price discrimination inhomogeneous market is unthinkable.
The market must be different with respect to either standard of living of people or geography or price sensitivity, and so on.
There must be some basis for discrimination. The basis can be either income or psychology or geography and so on.
- Reselling of products is strictly forbidden
Strictly forbidding of reselling of products is the fundamental criterion for the successful implementation of price discrimination.
If reselling of product is allowed, then arbitrage will occurs which completely ruins the motive of price discrimination.
Arbitrage is the simultaneous buying and selling of a product or securities or assets in different markets (buying from low priced market and selling to market with high price). Arbitrage will eventually equalize the price of a product in both markets.
The most relevant example of preventing an arbitrage, Rohm, and Haas produced a plastic (MM) used in industry and in dentistry. MM for industrial uses sold at 85 cents per pound; a slightly different version for dentures sold at $22 per pound.
To reduce arbitrage, Rohm and Haas spread a rumor that industrial MM contained poison.
Degrees or Kinds or Forms or Types of Price discrimination
1. First-degree price discrimination
First-degree price discrimination is a situation where a monopolist charges different prices to different consumers on the basis of his or her willingness to pay.
The firms are considered an all-knowing firm. The firm changes each person his or her reservation price. A monopolist is so clever, cunning, and efficient that he or she will be able to derive an individual demand curve of each consumer and charge accordingly.
The firm knows exactly how much each consumer is willing to pay for each unit of a good and it can prevent resale. This is taking it or leave it price discrimination. First-degree price discrimination is called Perfect Price Discrimination.
In the figure, OX and OY measure output and price/cost respectively. MC is marginal cost, and AR and MR are Average Revenue and Marginal Revenue respectively.
E is the equilibrium of monopoly. For a simple monopoly, OQe and OPe are equilibrium quantity and price respectively.
In first-degree price discrimination monopolist charges on the basis of individual demand of the consumers where the minimum price is OPe and maximum quantity is OQe. Thus the range in AR from A to B is the representative demand curve of an individual consumer.
For different quantity and consumers, there are different prices like P1 for Q1, P2 for Q2 …, Pn for Qn. If one consumer wants to purchase X1 quantity, he has to pay the P1 price and several other prices for the respective quantity.
This shows the price on the basis of ability to pay. This there is no consumer surplus remaining to the consumer which is exploited by the monopolist himself or herself.
Thus, the first-degree price discrimination is known as take it or leave it situation.
2. Second – degree price discrimination
Second – degree price discrimination is one of the types of price discrimination in which a monopolist charges the different prices to the different consumers on the basis of quantities consumed.
Investopedia (2018) defines “second-degree price discrimination occurs when a company charges a different price for different quantities consumed.” [1]
The second-degree price discrimination is associated with bulk purchase at a lower price. Quantity discount is the most prominent example of second-degree price discrimination.
Second-Degree price discrimination is more common in the real market scenario. Buy 2 and get 1 free is also one of the examples of second-degree price discrimination.
For a simple, monopoly, Pn is the minimum price and Xn is the maximum output. According to second-degree price discrimination, a monopolist divides the number of consumers into ‘n’ groups on the basis of quantity consumed and charge accordingly.
Similarly, when a consumer consumes X1 quantity, he has to pay P1 price and for X2, X3, X4 … Xn, he has to pay P2, P3m P4 … Pn prices respectively.
In this case, a consumer can enjoy some portion of consumer surplus as shown in the shaded portion in figure 2 and some are exploited by a monopolist.
This shows monopolists can maximize profit in comparison to simple monopoly.
3. Third-degree price discrimination
Third-degree price discrimination is the form of price discrimination in which the producer segregates the market on the basis of price elasticity of demand and charge them accordingly.
The monopolist set price well above the marginal cost in the inelastic market segment, and set price equal to or just above the marginal cost in the elastic market segment. Hence, the price elasticity of demand is the basis for third-degree price discrimination.
According to Koutsoyiannis (2005), “If price elasticities differ price will be higher in the market whose demand is less elastic” [2].
For example, Kaspersky charges $39 to $79 for its range of security suites in the developed economies; but in Nepal, one of the underdeveloped economies, its cost ranges from $10 to $28. Hence, Kaspersky implemented third-degree price competition.
Similarly, figure 3 (b) evinces market B with elastic demand where the x-axis measures quantity and price respectively. AR2 and MR2 are the average revenue and marginal revenue curves of market B.
Figure 3 (c) represents the equilibrium of the monopolist. The kinked AR and MR curves represent the average revenue and marginal revenue of the monopolist and are the horizontal summation of AR and MR of market A and market B. The upward sloping curve is the marginal cost curve.
Point 'e' is a point of equilibrium as it is the point of intersection between the rising marginal cost curve and falling marginal revenue curve. For a simple monopoly, OPe is minimum price and OQe is the maximum quantity. So, the area of rectangle OXeOPe represents total revenue.
For a discriminating monopoly, equilibrium in the respective market can be determined by the intersection of the Marginal revenue curve and a horizontal line drawn from e. So, e1 and e2 represent equilibrium in market 1 and market 2 respectively.
Accordingly, OX1 and OX2 are equilibrium quantity to be sold in the inelastic and elastic market respectively. Moreover, OP1 and OP2 are the equilibrium price in the inelastic market and elastic market respectively.
The total revenue generated from market 1 equals to an area of rectangle OP1CX1 and total revenue earned from market 2 equals an area of rectangle OP2BX2.
Clearly, the total earned from market 1 and market 2 is greater than the total revenue earned from simple monopoly.
That is,
Total revenue of market 1 + Total revenue of market 2 > Total revenue of simple monopoly
OP1CX1 + OP2BX2 > OXeOPe
Welfare aspect of price discrimination
Price discrimination is the monopolists’ strategy to charge a different price to different consumers. Some consumers are in a better off situation while consumers paying the higher price are in worse off. Consumers falling under low-income groups can also afford the product.
For example, the HIV AIDS drug, Combivir, cost $22 in American and European markets, and the same drug is available at $12 in the African market. The majority of poor African people die of AIDS if the drug was not available at affordable prices.
From the point of producer, the producer can increase the sales and consequently increase the profit by capturing some part of deadweight loss. Hence, both producers and consumers are at a better off situation.
Some argue that American and European consumers are at worse off condition, but it is not true in the sense that American and European consumers have a higher capacity to pay in comparison to African consumers.
Price discrimination can also be the basis of the survival of the firm. The firms earning just a normal profit can earn excess profit through discriminatory pricing.
For example, the rail operator generally charges higher train fare during peak hours. Both the train operator and train passengers are in a win-win situation. The train operator earns higher revenue, while the passengers in rush can take less congested train travel.
In case the fare was equal in the whole day, the passengers who are not in the rush also take the train increasing the congestion.
References
[1] Investopedia. (2018). Price discrimination definition. Retrieved from https://www.investopedia.com/terms/p/price_discrimination.asp/[2] Kutosoyiannis, A. (1979). Modern Microeconomics. Houndsmill: Macmillan Press Ltd.
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Suggested Readings:
Ahuja. H.L. (1970). Advanced Economic Analysis: Microeconomic Analysis. New Delhi: S. Chand & Company Pvt. Ltd.Kutosoyiannis, A. (1979). Modern Microeconomics. Houndsmill: Macmillan Press Ltd.
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