Have you ever gone to a museum with your family and noticed that you’re all being charged different admission fees?
This practice is called price discrimination. But how does it function, and what advantages does it offer to both the seller and the buyer?
Furthermore, what are the various forms of price discrimination?
Read on to find the answers to all these questions.
Price discrimination is a selling strategy in which sellers offer customers varying prices for the same good or service, depending on what they believe the buyer will accept. A merchant who practices pure price discrimination charges every customer the highest amount they are willing to pay. More prevalent types of price discrimination involve the seller classifying customers into groups according to specific criteria and charging a different price to each group.
Consumers’ preferences differ, as does their willingness to pay for a product. Price discrimination is the practice of a business targeting specific client groups based on their willingness to pay a higher price. As a result, the company does not use the cost of production as a basis for setting prices. By using pricing discrimination, the business is able to make more money than it otherwise would.
Price discrimination means that different consumers are charged different prices for identical products or services. It involves setting higher prices for those willing to pay more, while offering lower prices to price-sensitive individuals.
Example of Price Discrimination
For example, consider a signed t-shirt of a famous footballer like Lionel Messi. A devoted football fan might be willing to pay a premium price for it, while someone with no interest in football may not value it as highly. By charging the football enthusiast a higher price and the less interested individual a lower price, the seller maximizes their revenue.
Types of Price Discrimination
There are three types of price discrimination, including
- First-degree (Personalized Pricing)
- Second-degree (Product Versioning)
- Third-degree (Group Pricing)
1. First-Degree Price Discrimination (Perfect Price Discrimination):
First-degree price discrimination is the most comprehensive form of price discrimination. In this practice, a business sets a unique and maximum price for each unit or transaction based on what each individual consumer is willing to pay. This allows the company to capture the entire available consumer surplus for itself. First-degree price discrimination is often applied in service-based industries, where a company charges a different price for every unit or service it provides.
Example of First-Degree Price Discrimination
A pharmaceutical company that has developed a cure for a rare disease can charge a very high price for its product, as consumers affected by the ailment are often willing to pay any amount to obtain the cure.
2. Second-Degree Price Discrimination (Product Versioning)
Second-degree price discrimination occurs when a company varies its prices based on the quantity or volume of products or services consumed. For example, a company might offer quantity discounts for bulk purchases, encouraging consumers to buy more by offering reduced prices for larger quantities.
Example of Second-Degree Price Discrimination
A common example is phone services, where customers are billed different prices based on the number of minutes and mobile data they use.
3. Third-Degree Price Discrimination (Group Pricing)
Third-degree price discrimination involves charging different prices to distinct groups of consumers. For instance, a movie theater might categorize its patrons into groups like seniors, adults, and children, each paying different prices to watch the same movie. This form of discrimination is one of the most common and widely observed in various industries.
Example of Third-Degree Price Discrimination
Museums employ price discrimination by charging different rates for tickets based on the age and status of visitors, such as adults, children, students, and the elderly.
Requirements for price discrimination
- Monopoly Power: The company should possess enough market influence to act as a price maker rather than a price taker.
- Segmentation Ability: The company must be capable of dividing the market based on factors like customer needs, characteristics, timing, and location.
- Elasticity of Demand: Consumers should exhibit varying degrees of demand elasticity. For instance, lower-income individuals may have more price-sensitive demand, meaning they are less willing to purchase when prices rise compared to wealthier consumers.
- Resale Prevention: The company should have mechanisms in place to prevent its products from being resold by a different customer group.
Advantages and Disadvantages of Price Discrimination
A firm only considers price discrimination when the profit of separating the market is greater than keeping it whole.
Advantages of Price Discrimination
- Increased Revenues: Price discrimination provides firms with the opportunity to boost their profits compared to charging a uniform price for all customers. It can also help recover losses during peak seasons.
- Lower Prices for Specific Groups: Price discrimination can lead to reduced prices for certain customer groups, benefiting individuals such as older people or students.
- Demand Regulation: Companies can use lower pricing to stimulate purchases during off-peak seasons, helping manage crowd levels during peak times.
Disadvantages of Price Discrimination
- Reduced Consumer Surplus: Price discrimination shifts surplus from consumers to producers, diminishing the benefits consumers receive.
- Limited Product Choices: Some monopolies can exploit price discrimination to increase market share and create high barriers to entry, limiting product diversity and reducing overall economic welfare. Lower-income consumers may be unable to afford the high prices set by companies.
- Social Inequity: Customers paying higher prices may not necessarily be wealthier than those paying lower prices, leading to perceptions of unfairness. For instance, some working-class adults may have lower incomes than retired individuals.
- Administrative Costs: Implementing price discrimination incurs costs for businesses, including expenses related to preventing customers from reselling products to others.
Price discrimination is a strategy employed by businesses to capture additional consumer surplus and optimize their profits. It encompasses a range of approaches, including tailoring prices based on customers’ maximum willingness to pay, the quantities they buy, or even their age and gender.
Price discrimination often offers substantial advantages to specific customer segments, allowing them to access the same product or service at a reduced price. However, this practice can potentially introduce inequalities in society, and businesses may face significant administrative expenses as they work to prevent resale among customers.