Price Discrimination – What is it and How Does It Work

Price discrimination

Price discrimination is when the business charges different prices to different groups of people. The business may define different groups based on the attribution/characteristics of the customers within a certain group.

The price discrimination is carried out based on the expectation of the business from the seller that how much value they perceive from the product/services provided by the business.

Price discrimination can be categorized in three degrees depending on the fact that how discrimination is carried.

First degree price discrimination

The first degree of price discrimination/perfect discrimination is when the business charges different prices for every unit consumed. The business would like to sell the units at the maximum price to get the highest profit from a sale. The business will get the entire market surplus it could be possible for it to achieve.

However, the first degree of price discrimination seems to be unrealistic as demand is elastic and the information is available to the consumer that a reduction in their interest to buy the product could lead to a decrease in the price. Hence, it’s rare to be able to exercise the first degree of price discrimination in the real world.

First degree price discrimination example

The first degree of price discrimination is when the business-used car dealer tries to negotiate a maximum price from the buyer of a car.

It’s up to the competence of the seller to charge the highest possible amount from the buyers. Hence, there is no fixed price and the price is different for each unit of the sales.

Second degree price discrimination

It happens when the business charges different prices based on the quantity of the purchase by the customer. If the quantity of purchase is higher the business charges a lower amount from the customer. On the contrary, if the quantity of the purchase is lower the business charges higher rates from the customer.

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Quantity-wise discrimination of the price encourages the customers to buy more as they want to purchase the goods at a lower price, it’s the same as economies of scale.

Second degree price discrimination example

Consider a business where pulses are sold at USD 4 per kg. However, the price will be USD 3.5 per kg if the customer orders at least 10,000 kg of the pulses.

Hence, there is an incentive for a customer to purchase the increased quantity of the goods and get discounts on their overall purchases. Second-degree price discrimination intends to increase the sale of the quantity although the business has to discount for some amount.

Third degree price discrimination

The third degree of price discrimination is when the business charges different prices for the same goods/services to a different group of consumers. The group of consumers may be people affiliated with different subsets of society.

Third-degree price discrimination might be used by the business to ease some specific group of people as they might be naturally weak or the business perceives some specific group of consumers as their ethical responsibility to be discounted.

Third degree price discrimination example

Third-degree price discrimination is when the theatre charges differently from the students, professionals, and senior citizens. The same goes with the air industry where the price of the ticket is less when booking is made in advance and the prices are higher if the ticket is booked at the last minute.

Third-degree price discrimination perfectly works to encourage early sales and build up brand loyalty among the people.

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Price discrimination under monopoly

In a monopoly environment of the business, there is a single supplier that can control the pricing, production, and demand of the product in the economy.

The monopolist business can control the supply and demand of the specific market and charge the prices to the consumer on their terms. In other words, being a monopolist enables the business to be in a position to discriminate in price.

Conditions of price discrimination

Not each business can discriminate the prices of the products. To discriminate the prices the business must have sort of monopolistic power and control over the market.

If there is perfect competition in the market with information symmetry the business will not be able to charge discriminated prices from the customers.

Further, the market for the product needs to be divided into different segments. In other words, the business needs to identify separate groups of consumers to discriminate the price.

In addition to this, if the price discrimination is carried based on the geographical distribution the buyers from low price areas should not be able to access the buyers in the high price area else they might carry out the sales transaction and leave the business at loss technically.

Finally, one of the geographical markets/segments identified should not be price sensitive or the elasticity of demand should be lower to enable the business to discriminate the price.

Basis of the price discrimination

The business can discriminate the price depending on different factors that include but are not limited to persons, geographical distribution, the basis of the users, etc. Let’s discuss these aspects in detail.

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The business may decide to charge different prices from different people. The difference in people may be due to their level of income, or any other reasons.

For instance, the physician may set higher prices for the rich people and lower prices for the poor people while maintaining the level of service for both the patients.

Geographical distribution

Alternatively, the business may opt to discriminate the price based on the location. There may be a different price for the same product in two different areas, regions, or countries.

The decision may be taken by the business as there may be competition in one area leading the business to charge low prices and the business may be monopolist on other geographic locations enabling it to charge higher prices.

Basis of the use

The basis of the use refers to how the buyer is using the product of the company. If the buyer consumes the product the business may consider charging the customer a lower price. On the contrary, if the buyer makes commercial use of the product, the business may be able to charge higher prices.

For instance, an electricity supply company charges a higher rate for the residential consumer and higher for the commercial consumer.