Price discrimination occurs when a business sells the same product at different prices even though there is no difference in the cost of production. The aim of price discrimination is to increase the monopolist’s revenue by extracting consumer surplus from the consumers. It ends up realising more sales revenue than if all the units were sold at the same price. More revenue can result in more profits for the monopolist as the cost of producing each unit has not increased even if he sells additional units at higher prices. A business with a huge fixed cost can cover part of its cost by reducing the prices of subsequent units if there is excess stock or capacity. For example, a football club could sell extra tickets at a reduced price if there would be a lot of empty seats after tickets were sold at the standard price. The costs incurred in organising the match remain the same irrespective of the number of people that bought the tickets. A price discriminating club can increase ticket sales and make more profit.
Types of price discrimination
First-degree price discrimination
First-degree price discrimination involves selling each unit of the product to a different consumer at a different price. The price charged for a unit is what each consumer is willing and able to pay. This is possible if the firm can determine the ability of the different consumers to pay with ease. The monopolist continues to sell at different prices as long as the marginal revenue exceeds the marginal cost. The consumer surplus extracted by the firm is the difference between the total revenue made with discrimination and the revenue that a firm could have made without discrimination. From Figure 1 below, a discriminating monopolist charges $60 for the first unit, $45 for the second, $30 for the third, $24 for the fourth and $18 for the fifth unit. The price for each unit is the highest the monopolist can receive for it. The total revenue made is $177 ($60+$45+$30+$24+$18). If there is no price discrimination, the monopolist would sell each unit for $15 and the total revenue would be $75 (5 x $15). Therefore, the monopolist made an extra revenue of $102 ($177-$75).
Figure 1: Demand curve showing price discrimination
A uniform price per unit is charged for a particular quantity of a product and a reduced price is charged for extra collection of the product. For example, a hotel might have a lot of unbooked rooms after selling at the standard price. It may later reduce its price for the spare rooms for them to be taken up by customers. This is an example of second-degree price discrimination. It can sell an extra batch of the product at a discounted price as long as marginal cost is covered. From Figure 1 above, if the monopolist decides to sell the first two units at $60 each and the next three units at $45 each, the total revenue would increase to $255, i.e. ($60 x 2) + ($45 x 3). The consumer surplus extracted by the monopolist will be $180 ($255-$75).
The monopolist charges different prices in different market segments. The market may be categorised as adults and children, peak and off-peak periods, female and male, low-income and high-income, etc. The segment of the market that has a higher elasticity (Figure 4 below) pays a lower price than the one with inelastic demand (Figure 3 below). Customers with relatively elastic demand are more responsive to a price change than those with relatively inelastic demand.
Figure 2: Cost and revenue diagram for the whole market
Figure 3: Cost and revenue diagram for the market segment with relatively inelastic demand
Figure 4: Cost and revenue diagram for the market segment with relatively elastic demand
Conditions necessary for price discrimination
Control over price
Price discrimination is only possible in a market where the seller has the power to alter the price. This is why it is impossible to discriminate in a perfectly competitive market where sellers are price takers.
The seller can prevent arbitrage by keeping the customer groups separate. The monopolist must be able to prevent a customer from purchasing at a lower price and reselling at a higher price in another market.
Price discrimination can be practised when there are no competitors that may undersell the business. It will be unsuccessful if there are many other firms that can sell the same product at different prices.
Different elasticity of demand
The demand elasticity in the different segments must be different. The segment with relatively inelastic demand is charged a higher price while the segment with relatively elastic demand is charged a lower price. If there is a uniform price elasticity of demand for all customer groups, then the business will be able to sell to all at the same price and there is no opportunity to benefit from price discrimination.