Price discrimination is the practice of charging a different price for the same good or service. There are three types of price discrimination – first-degree, second-degree, and third-degree price discrimination.
First degreediscrimination, alternatively known as perfect price discrimination, occurs when a firm charges a different price for every unit consumed.
The firm is able to charge the maximum possible price for each unit which enables the firm to capture all available consumer surplus for itself. In practice, first-degree discrimination is rare.
Second-degree price discrimination means charging a different price for different quantities, such as quantity discounts for bulk purchases.
Third-degree price discrimination means charging a different price to different consumer groups. For example, rail and tube travellers can be subdivided into commuter and casual travellers, and cinema goers can be subdivide into adults and children. Splitting the market into peak and off peak use is very common and occurs with gas, electricity, and telephone supply, as well as gym membership and parking charges. Third-degree discrimination is the commonest type.
Necessary conditions for successful discrimination
Price discrimination can only occur if certain conditions are met.
The firm must be able to identify different market segments, such as domestic users and industrial users.
Different segments must have different price elasticities (PEDs).
Markets must be kept separate, either by time, physical distance and nature of use, such as Microsoft Office ‘Schools’ edition which is only available to educational institutions, at a lower price.
There must be no seepage between the two markets, which means that a consumer cannot purchase at the low price in the elastic sub-market, and then re-sell to other consumers in the inelastic sub-market, at a higher price.
The firm must have some degree of monopoly power.
Diagram for price discrimination
If we assume marginal cost (MC) is constant across all markets, whether or not the market is divided, it will equal average total cost (ATC). Profit maximisation will occur at the price and output where MC = MR. If the market can be separated, the price and output in the relatively inelastic sub-market will be P and Q and P1 and Q1 in the relatively elastic sub-market.
When the markets are separated, profits will be the area MC, P,X,Y + MC1,P1,X1,Y1. If the market cannot be separated, and the two submarkets are combined, profits will be the area MC2,P2,X2,Y2.
If the profit from separating the sub-markets is greater than for combining the sub-markets, then the rational profit maximizing monopolist will price discriminate.
Market separation and elasticity
Discrimination is only worth undertaking if the profit from separating the markets is greater than from keeping the markets combined, and this will depend upon the relative elasticities of demand in the sub-markets. Consumers in the relatively inelastic sub-market will be charged the higher price, and those in the relatively elastic sub-market will be charged the lower price.
In the above example we are assuming that the price at which consumers in the relatively elastic sub-market (students, for example, looking to travel into a major city) are prepared to enter the market is lower than those in the relatively inelastic sub-market (commuters, for example). This gives the combined demand (AR) curve an outward kink, and the combined MR curve a discontinuous portion (indicated by the vertical dotted line.) If, however, both types of consumer are prepared to enter the market at the higher price then the combined demand (AR) curve is simply shifted further to the right, and will not have the kink. This is illustrated in the diagram below:
In all cases it should be noted that that profit maximisation must occur where MC = MR. This means that profit maximising equilibrium for the discriminating monopolist must occur where MR is positive, which means that, irrespective of the gradient of the demand curves in the submarkets, the price will always be set in the elastic portion of the demand curve (individually, and when combined).