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Price Discrimination

A pricing strategy that charges consumers different prices for the identical good or service

What is Price Discrimination?

Price discrimination refers to a pricing strategy that charges consumers different prices for the identical good or service.

 

Price Discrimination

 

Different Types of Price Discrimination

 

1. First Degree Price Discrimination

Also known as perfect price discrimination, first-degree price discrimination involves charging consumers the maximum price that they are willing to pay for a good or service. Here, consumer surplus is entirely captured by the firm. In practice, a consumer’s maximum willingness to pay is difficult to determine. Therefore, such pricing strategy is rarely employed.

 

2. Second Degree Price Discrimination

Second-degree price discrimination involves charging consumers a different price for the amount of quantity consumed. Examples include:

  • A phone plan that charges a higher rate after a determined amount of minutes are used
  • Reward cards that provide frequent shoppers with a discount on future products
  • Quantity discounts for consumers that purchase a determined number of more of a certain good

 

3. Third Degree Price Discrimination

Also known as group price discrimination, third-degree price discrimination involves charging different prices depending on a particular market segment or consumer group. It is commonly seen in the entertainment industry.

For example, when an individual wants to see a movie, prices for the same screening are different depending on if you are a minor, adult, or senior.

 

Primary Requirements for a Successful Price Discrimination

For a firm to employ the pricing strategy, there are certain conditions that must be met:

 

#1 Imperfect competition

The firm must be a price maker (i.e., operate in imperfect competition). Therefore, there must be a degree of monopoly power to be able to employ price discrimination. If the company was in perfect competition, the pricing strategy would not be possible as there would be no ability to influence prices.

 

#2 Prevention of resale

The firm must be able to prevent resale. In other words, consumers who already purchased a good or service at a lower price must not be able to re-sell it to other consumers who would’ve otherwise paid a higher price for the same good or service.

 

#3 Elasticity of demand

Consumer groups must demonstrate varying elasticities of demand (i.e., low-income individuals being more elastic to airplane tickets compared to business travelers). If consumers all show the same elasticity of demand, the pricing strategy will not work.

 

Example of Price Discrimination: Cineplex

Canadian entertainment company Cineplex is a classic example of a firm using the pricing strategy. Depending on the age demographic, tickets for the same movie are at different prices. In addition, Cineplex charges different prices on different days (Tuesday being the cheapest and weekends being the most expensive). The following is a diagram from Cineplex for a movie screening on a Monday.

 

Price Discrimination - Cineplex

 

As indicated in the diagram above, different age demographics face a different price for the same screening. It would be an example of third-degree price discrimination.

 

Price Discrimination in Increasing a Firm’s Profitability

Consider a firm that charges a single price for an apple: $9. In such a case, it would lead to one sale and total revenue of $5:

 

Price Discrimination - Example Chart 1

 

Now, consider a firm that is able to charge a different price to each customer. For example:

  • $5 for the first consumer
  • $4 for the second consumer
  • $3 for the third consumer, and so on.

 

In such a situation, the firm is able to increase its profit and sell to customers that were originally not going to purchase by offering price = each customer’s willingness to pay. It would lead to five sales and a total revenue of $5+$4+$3+$2+1 = $15.

 

Price Discrimination - Example Chart 2

 

As indicated above, price discrimination allows a firm to reap additional profits and convert consumer surplus into producer surplus.

 

Advantages of Price Discrimination

Advantages of the pricing strategy can be viewed from the perspective of the firm and the consumer:

 

The Firm

  • Profit maximization: The firm is able to turn consumer surplus into producer surplus. In a first-degree price discrimination strategy, all consumer surplus is turned into producer surplus. It also ties into survivability, as smaller firms are able to better survive if they are able to offer different prices in times of greater and lower demand.
  • Economies of scale: By charging different prices, sales volume is likely to increase. As a result, firms can benefit from increasing their production towards capacity and utilizing economies of scale.

 

The Consumer

  • Lower prices: Although not all consumers are winners, consumers that are highly elastic may gain consumer surplus from the lower prices due to price discrimination. For example, at a movie theatre, tickets for seniors and children are typically priced at a discount on adult tickets.

 

Disadvantages of Price Discrimination

  • Higher prices: As indicated above, some consumers will face lower prices while others will face higher prices. Consumers that face higher prices (i.e., consumers who purchase airline tickets during peak season) are disadvantaged.
  • Reduction in consumer surplus: The pricing strategy reduces consumer surplus and transfers money from consumers to product, leading to inequality.

 

Related Readings

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

  • Brand Equity
  • Beachhead Strategy
  • Cost of Goods Sold
  • Economies of Scope

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