Price DiscriminationIB Economics

Ch 11

Learning ObjectivesAt the end of this chapter you will be able to

Define and explain price discriminationDefine, illustrate, give examples of, and distinguish between first degree, second degree, and third degree price discrimination

Conditions needed to discriminateAn example would be an airline selling a child’s ticket to fly from Vienna to Toronto which may cost $500 while his mother’s ticket costs $700 – the product is exactly the same but the price is different and it is not to do with the cost of supplyThere are 3 conditions necessary for discrimination

1. Producer must have price setting abilitymost often found in monopoly and oligopoly marketsNot possible in perfect competition

2. Consumers must have different elasticities of demand for the product If the PED is more inelastic they will be more willing to pay a higher price

Price Discrimination: Where a firm sells identical products at different prices to different buyers for reasons other than differing cost of supply

Conditions needed to discriminate3.Producer must be able to separate consumers so they cannot buy and sell onVarious ways they can separate

Time – e.g. people travelling on trains at different times – those needing to get to work in the morning will have an inelastic demand compared to those going out shopping who can alter their time of travel

Age – children are charged a lower price at the cinema because their demand is more elastic having lower income

Gender – a football club in Sweden charges lower prices for female supporters than for male supporters (apparently they are not as keen and therefore have a more elastic demand)

Conditions needed to discriminateMore ways they can separate

Income – lawyers will often charge higher prices to wealthy clients who have a relatively inelastic demand for legal services

Geographical distance – this is only possible if the cost of transferring is greater than the difference in the price CDs are sold for a lower price in the USA than

they are in the EU (there are different elasticities in the 2 countries)

Types of consumer – different users buy the service at different prices – electricity companies often charge different rates to industrial and domestic users

If the 3 conditions don’t exist the price discrimination will not happenBe careful not to confuse promotion with price discrimination

Letting girls into a night club free is not price discrimination because the PED is not different – this is just promotion

Not price discrimination (promotion)

Three degrees/Levels of discriminationFirst degree price discriminationEach consumer pays exactly the price that he /she is prepared to payThis is how traders in a souk or market operate when they bargain to get the highest price they canIn this diagram a trader is selling world cup t-shirts to tourists in a marketThe trader bargains with each touristIf the trader is successful he will sell one shirt at $14, one at $13, one and $12 and so onIf the trader did not discriminate the total revenue (p x q) would be the shaded pale blue rectangleBecause he does he eliminates the consumer surplus and gets the dark blue triangle as wellBecause the extra revenue received from each shirt (MR) is equal to the price D=MR

First Degree Discrimination – selling each good at highest possible price to each individual buyer (perfect)

Three degrees/Levels of discriminationSecond degree price discriminationA firm charge different prices to consumers depending on how much they purchaseElectric and Gas companies do thisThey charge a high price for the first number of units (the essential ones) and a lower price for extra units consumedMobile phone companies do the sameIn this diagram the first 50 messages are charged at a rate of 30 cents each and any messages over this number are charged at a reduced rate of 20 cents

Second Degree Discrimination – the firm charges different prices depending on how much they purchase

Three degrees/Levels of discriminationThird degree price discriminationConsumers are identified in different market segmentsA separate price is charged in each market segmentThere are different price elasticities in each segmentThis is the most common type of discriminationThis diagram show a typical exampleCinema management has identified 2 market segments (adults and students)

Third Degree Discrimination – a separate price is charged in each market segment

Three degrees/Levels of discriminationStudents have a more elastic demand because they have lower incomesManagement will have to charge a lower price for students than adultsThey can separate the segments because students will have to show some proof of status e.g. student cardThis diagram shows the situation for a week

Three degrees/Levels of discriminationThe demand curve D(S) is more elastic than D(A)The marginal revenue curves are twice as steepWe assume that they are maximising profitsWe use the diagram on the left to show total salesThis has the marginal cost curve for the whole cinemaThe MR is the total of both MR(S) and MR(A)That is why it is kinked

Three degrees/Levels of discriminationThe cinema will profit maximise where MC=MRIt will serve 700 customers per week and the marginal cost will be $5We can then transfer the marginal cost to each market position to find out the profit maximising position in eachStudent segment = 375 students for a price of $7.5Adult segment = 325 adults at $10.25

Three degrees/Levels of discriminationIn third degree discrimination a market may be broken up into more than two segments but the principle will still be the sameIt is just simpler to only draw 2 segments

EvaluationPrice discrimination can be a good and a bad thingIt depends upon the situation and who the stakeholder isAdvantages to the firm:The firm can get a higher level of revenue from a given amount of salesThe producer can produce more and get economies of scale

Both the firm and the consumer can benefit if lower average costs are achieved and prices are lowered accordingly

A firm can drive competitors out of the more elastic segment

Profits gained from the inelastic market segment can be used to lower prices in the elastic segment

If a firm has a strong brand in its home country it can use those profits to be aggressive in new elastic foreign markets (however, if can be proved to sell below production costs this is illegal according to the rules of the WTO

EvaluationAdvantages to the consumer:The consumer may be able to purchase a good or service that otherwise they could not afford

Lawyers often charge high prices to wealthy clients and lower prices to low income clients

Some people will be able to purchase the product at a lower price than they would have had to pay if the producer could not charge a higher price to others

Many universities charge foreign students higher tuition fees than for domestic students

Price discrimination usually increases total output so the product is available to more consumersEconomies of scale may equal lower pricesThe disadvantages to the consumer are:Consumer surplus is lostSome consumers will pay more than the price that would have been charged in a single, non-discriminated market

Time for you to do some work!!Read the case study on P137Create a presentation for the Examination Qs on P138