Price discrimination - example
Price discrimination is common in transport services and utilities, such as gas and energy supply.
Taking rail services between a city and its outskirts, peak travel will occur in the mornings and evenings as commuters head to work and back home.
However, there is a second category of rail passenger – the casual traveller who is not travelling to work but, innstead, is going into the city for a variety of reasons, including visiting sores, musuems, or the theatre. These can be identified as off-peak travellers.
The issue for the train operating firm is whether to have a flat rate charge for a return fair, or wheher to charge commuters and casual travellers a different rate.
In the table below, demand by commuters and casual traveller is shown for a range of prices of return tickets.
Demand by commuters is much less elestic than for casual travellers. Different price elasticity of demand for different submarkets is a key requirement for a successful policy of price discrimination.
Graphs to show demand for rail travel
Here we can see that the two submarkets have different elasticities.
The issue for the rail operator is whether to set one price for all return journeys, or to price disciminate. If price discrimination is possible (which it certainly is for rail travel) then two prices can be set in contrast to setting only one price only if the two submarkets are combined into one.
To assess the effectiveness of price discrimination we need to consider whether profits will be greater than with no discrimination.
To find the profit maximising position we apply the profit maximising rule, marginal cost equals marginal revenue. In the diagram below we show a simplified scenario where marginal cost (MC) is assumed constant and equal to average cost (AC). The marginal revenue (MR) curve is also added, and this falls at twice the rate of average revenue (AR), as shown.
In this case profit maximisation in the two sub-markets can be seen at the prices P1 and P2 (with profit areas profits1 and profits2.) This can be contrasted with the single price P3 and the profit level profit3 when the market is combined.
If profit area P1 plus P2 is greater than profit area P3, then price discimination will increase profits. In our example it is clearly the case that price discrimination will be a profit maximising strategy.
The key assumption to analyse is the extent to which marginal cost remains constant when markets are separated. Factoring in costs of separation, such as the increased cost of printing tickets, and any extra costs in policing the trains, the profits from price discimination may fall.