Price discrimination refers to a pricing strategy normally adopted by businesses where different consumers are charged different prices for the same product or service. In the most basic form of price discrimination, a business will charge individual consumers the highest price that they are willing to pay for a product or service. In most cases, however, price discrimination will entail the classification of consumers into groups based on particular attributes and each group is allocated different pricing.
Price discrimination has been categorized into three classes as illustrated below.
- First Degree: This is the first type of price discrimination; First Degree Price Discrimination, is based on the business’s ability to accurately predict how much each individual consumer is willing to pay for a product or a service. Different consumers will have varying preferences as well as varying purchasing power capacities, therefore, the price they would be willing to adhere to for a product or service will normally surpass a single competitive price. The difference between the price that a particular consumer is willing to adhere to and the amount that they actually pay is known as the consumer’s surplus. Hence, a business that engages in First Degree Price Discrimination is usually seeking to draw all consumer surpluses and claim them as profits.
- Second Degree: Second Degree Price Discrimination entails the installation of a pricing structure for a specific product or service based on the amount of sales that it attracts. An example of Second Degree Price Discrimination is; Quantity Discounts. In terms of quantity discounts, the business charges a higher per-unit price for a minimal amount of units sold and a lower per-unit price for a larger amount of units sold. In such incidence, the business is seeking to draw the consumers’ surplus and claim them as profits with residuals being accorded to the consumer above the actual amount paid for the product or service in question. Similar to First Degree Price Discrimination, the business produces an output level in which the price charged on products covers the marginal production costs.
- Third Degree: Third Degree Price Discrimination prevails where a business places different prices on products for two or more consumer groups bearing different elasticities in demand. These consumer groups are then differentiated dependent on attributes such as, age, sex, or location. An example of Third Degree Price Discrimination is the ‘children’s discount’ often offered by businesses. Families with children normally have low demand elasticities in comparison with those without when it comes to their inclination towards activities such as dining at restaurants or booking rooms in hotels.
Conditions Necessary for Price Discrimination
- The business must operate in an environment of imperfect competition. That is; the business must be a price-determiner in its market.
- The business must be in a position to set markets apart and curb resale activities. For example, by ensuring no adults use a children’s tickets to obtain products or services.
- Various consumer groups should have varying demand elasticities.
Benefits of Price Discrimination
- Businesses are able to increase their revenue; price discrimination enables some businesses to stay in the market in environments where they would have otherwise made losses.
- An increase in revenues can facilitate research and development that would be beneficial to the consumers.
- Some consumers benefit from lower rates, for example, where students benefit from lower transportation rates.
Limitations of Price Discrimination
- It leads to a decline in consumer surplus.
- Groups paying the highest prices for products and services may not be best suited for the privilege. For example, some adults may happen to be unemployed.
- Profits realized from price discrimination may be used for the facilitation of predatory pricing.
In a nutshell, product pricing arises in cases where some businesses have the capacity to place prices on their products or services that are consistent with the best interests of that business even where they are not characterized as monopolies. These price-determiners operate in extremely competitive markets but due to certain unique characteristics that they posses, either in the business itself or its products and services, they wind up having discretion over product pricing.