6.1.10

Price Discrimination

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Price Discrimination

Firms use price discrimination to capture consumer surplus (the difference between someone's willingness to pay and the price they pay).

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Conditions needed for price discrimination

  • The groups being discriminated between must have a different price elasticity of demand.
  • There must be a way of stopping arbitrage opportunities that arise from consumers buying cheap, and selling to those who have been charged a higher price.
  • The firm discriminating must be a price-setter.
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First degree price discrimination

  • First degree price discrimination involves a complete transfer of consumer surplus (the disparity between the price the consumer is willing to pay and the actual product price) to the producer.
  • This is because each customer is charged the very maximum they are happy and able to pay for a good or service.
  • This method is rarely used because of asymmetric information, and the difficulty of gathering information on every customer.
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Second degree price discrimination

  • Second degree price discrimination involves charging different prices based on the quantity purchased.
  • The more you purchase, the cheaper the product.
  • This generates revenue from part of the consumer surplus that has been transferred.
  • It also rewards customers for making larger orders.
    • Bulk buying from a wholesaler like Costco may lead to cheaper prices. This is second degree price discrimination.
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Third degree price discrimination

  • This charges different prices to customers based on which segment they are in - different age groups, geographies and industries.
    • Software companies like Balsamiq charge different prices for non-profits.
  • This is based on the idea that different segments of a market will have different price elasticity of demands. Profits are maximised when the price is set where marginal cost is equal to marginal revenue for each particular segment.
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The impact of third degree price discrimination

  • Consumers with more inelastic demand will be charged a higher price of Pa. They will receive less consumer surplus than if a firm could not segregate the two groups.

Advantages and Disadvantages of Price Discrimination

There are a number of advantages and disadvantages associated with the three types of price discrimination.

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Advantages of price discrimination

  • Price discrimination will lead to increased revenue for the firm. Higher profits could be reinvested and improve dynamic efficiency.
  • Price discrimination often means that those with higher incomes pay more for a good or service than those with lower incomes. This may help cross-subsidise products so that poorer people can afford them.
    • E.g Google Chromebooks in schools.
    • To decide whether this is fair and improves equality or not, we need to make a value judgement.
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Disadvantages of price discrimination

  • Price discrimination isn't allocatively efficient.
    • This is because the price is greater than marginal cost.
  • Some may argue that consumers paying a different price for the same good or service is unfair. This is more of a moral or normative judgement though.

Jump to other topics

1Introduction to Markets

2Market Failure

3The UK Macroeconomy

4The UK Economy - Policies

5Business Behaviour

6Market Structures

7A Global Perspective

8Finance & Inequality

9Examples of Global Policy

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