Microeconomics: Price Discrimination

Price discrimination in economics occurs where a firm sells different units of an output at different prices to different markets, and the price differentials are not based on the marginal costs of production (Wilkinson, 2005, pp 398). There are various forms in which price discrimination occurs, each determined by the degree and conditions under which it occurs. In order for price discrimination to occur, there must be more than one market segment, and the segments must be separated to avoid reselling from one segment to the other. The following paper aims to look at the three degrees of price discrimination and the relation of prices set by the monopolist to elasticity of demand.

First degree price discrimination

            First degree price discrimination is also known as perfect price discrimination. In this situation, the producer is expected to know all the market conditions, including how much each customer is prepared to pay for a unit of output. In this kind of discrimination, there is no consumer surplus because it is all transferred to the producer as revenue and profit (Wilkinson, 2005, pp 398). The monopolist takes advantage of the possession of knowledge concerning a consumer’s capability to buy, and therefore ensures they sell the output to the consumer at the highest price possible per unit. In prefect price discrimination, the monopolist can only operate in perfect knowledge of the market conditions. Each customer forms a market of their own, with their individual market forces and therefore determiners for their prices.

(First degree price discrimination from Whitney classes)

            The monopolist is comfortable selling to the last buyer as long as their purchase price for the output exceeds the marginal cost of production. This is because the producer is aware that they will make additional sales to other customers which will give him an additional profit (Charkravarty, 2009, pp 354). The monopolist therefore bases the price of the last buyer above the marginal cost of production, and the profit is maximized by the sales made additionally by the producer.

            Perfect price discrimination generates the maximum surplus for both the consumer and the producer. However, the consumer surplus is all transferred to the producer, which is just an alteration in the distribution of income. The monopolist therefore maximizes output, and the consumer gets the best value of a price they could possibly afford depending on their income, therefore maximizing the total sum of surplus in the market (Charkravarty, 2009, pp 356).

            An example of perfect price discrimination is in the example of medical services, such as gynecologists. A gynecologist may know the wealth status of clients, and therefore be able to charge each client differently for the same service, depending on how much they can afford. It is certain that the clients will most likely not ask each other how much they are charged, or sell services to each other. The clients of the gynecologists cannot treat each other, and therefore the gynecologist is assured that the services provided at particular prices cannot be resold at another price. The gynecologist is therefore able to form perfect price discrimination in the market.

Second degree price discrimination

            This kind of price discrimination is based on the concept of quantity of units purchased. The quantities may be split into clusters or group, where each group represents an amount and the price at which each unit in the cluster is purchased; that is a group q1-q2 may be sold at p1 while another group q3-q4 is sold at p2. It is important to note that in second degree price discrimination; the change in price is not usually linear, implying that price does not change proportionately to the number of units purchased. It is for this reason that second degree discrimination is known as non- linear pricing (Charkravaty, 2009, pp 355).

            A monopolist may apply this principle in the case of a wholesaler for any type of product. When goods exceeding say fifty units are purchased, they are sold at price P1. When goods sold are above a hundred units, they are sold at price p2, above two hundred units at price p3 and so on. The pricing of the one hundred goods is not necessarily half of p1, and therefore the understanding that the pricing is non linear. It is therefore important for the consumer to understand the segmentation of the monopolist so as to realize the number of units they can purchase.

            Second degree price discrimination also occurs when the concept of time is applied (Charkravarty, 2009, pp 354). A monopolist may sell the same units of output to the same market, but have distinct prices depending on the time of purchase. The change in prices is also not proportional to the change in time. For instance, when people enroll in a new institution, those who apply first may be charged less fee, and from a certain time period, a different amount is charged. This means that in our example, those who enrolled a week before others will not be charged half of those who enroll two weeks after.

Third degree price discrimination

            Third degree price discrimination is based not on individuals; rather it is based on segments created by the monopolist. The monopolist may find it impossible to know the actual purchasing potential of each customer, but then they may be able to classify the customers into the segments they belong (Wilkinson, 2005 , pp 398).  This degree of price discrimination may be disadvantageous in that it may wrongly classify some customers, such that they are totally locked out of the market due to the prices offered in the segment. The producer ends up losing potential consumers of a product as they felt unable to live up to the segment in which they were put.  

An example of third degree discrimination is that of the movie theatres. There are special prices for adults because they have less free time and therefore are more elastic. This is because the young viewers have a much more low elasticity of demand, and the monopolist has to create a more attractive price for adults. Should the price of movie tickets be too high, adults will be reluctant to watch them, but it is likely the youth will adjust to the new prices and still watch. The youth in this case are obviously much free to watch the movies, and any price increase exerted upon them will not change their preference to watch the movies.

The monopolist has to decide on the optimal price for the two groups of customers, which is done by equating the marginal cost to the marginal revenue; that is MR=MC (Charkravarty, 2009, pp 354).Determining the elasticity of demand then follows in the equation. The group with a higher elasticity will have a lower price, while the higher price will be set for the group with a lower elasticity of demand. This is given by:

P1(X1)/p1(X2) =1+ 1/e2/1+1/e1

Should elasticity in group 1(e1) exceed that of group 2 (e2), then it is expected that the group 1 will have lower prices for the units of output. e2 is less elastic and therefore the pricing set by the monopolist will be higher for the block (Charkravarty, 2009, pp 354).The monopolist will only exert price change in the segment where the elasticity of demand is high, as there lays less risk of a potential decline in purchasing of services.

(Third degree price discrimination from Economic Principles and Problems: Source http://faculty.oxy.edu/whitney/classes/ec250/handouts/images/vib2_pd1_h1_f1.gif)

The conditions for third degree price discrimination are that the price elasticity must differ for different segments. It must also be impossible for resale to occur between the various segments. Price discrimination is entirely based on the understanding of the monopolist concerning the particular market. The monopolist uses the knowledge concerning the consumers to make decisions on pricing. Third degree price discrimination is entirely based on the price elasticity of demand of the customer in question and the equalization of marginal cost and marginal revenue.

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