Price Discrimination

Price Discrimination

Racial discrimination is defined as a situation where a certain race is discriminated against for no other reason than the fact that they are a different race. Price discrimination is a situation where certain consumers are discriminated against. Whereas in perfect competition, all firms charge exactly the same price, a monopolist (or a firm with monopolistic power) can charge different prices to different consumers even though the cost to the firm is exactly the same.

Examples fall into three categories. First, those associated with different times (e.g. different phone charges and rail tickets prices at peak and off-peak times). Secondly, those associated with different locations (e.g. car prices are higher, in general, in the UK compared with the rest of the European Union). Finally, those associated with different incomes (e.g. the lower prices paid by the young, old, unemployed and students at cinemas and hairdressers).

In a slightly more subtle way, price discrimination is also happening if a good has the same price for everybody, even if the costs vary between consumers (e.g. the price of a first class stamp is the same for everybody however far the letter has to travel in the UK).

Note that price discrimination should not be confused with price differentiation. This is where prices do differ, but they reflect different costs of production. As we shall see shortly, air travel is an example of price discrimination. First class passengers pay a much higher price. Obviously the cost of this service is also much higher, but given that the price can be up to 10 times higher, do you think that the costs are 10 times higher?

  1. The firm in question must have some market power. This does not mean that the firm must be a monopolist, but an element of monopolistic power would be useful.
  2. The firm must be able to separate the market. Phone companies can do this easily. If you make a call after 6pm then it is off-peak. At 5.55pm you are charged at a higher rate. It is easy for them to keep 'peak' and 'off-peak' separate. Other markets are more difficult to separate. Everyone knows that Levi's 501 jeans are cheaper in America than in the UK. The markets are separate, though, because most people will not spend £200 on a return flight to New York to save £20 on a pair of jeans. A couple of years ago, though, Asda managed to get a consignment of jeans at a reduced price, and started to undercut the regular fashion shops in the UK. The markets were no longer separate!
  3. The buyers in the different, separated, sub-markets must have different elasticity's of demand. Also, they should be identifiable by the firm at a reasonable cost. You will see why this is so important in the diagrams below.
  4. The firm must be able to prevent resale of the good or service. Obviously the Levi company failed to do this in the 'Asda' example above.

The following set of diagrams helps to explain why it can be profitable for a firm to price discriminate. It is quite difficult to draw these diagrams accurately so you should practise, especially as this is quite a popular essay question with examiners.

The secret is to draw the 'total market' diagram, and then draw horizontal lines to signify the industry's average cost and marginal cost before you start the other two diagrams.

These lines should then act as a guide to make sure that the inelastic sub-market has a big profit box and the elastic sub-market has a much smaller profit box.

Click on the next button, you will see the set of diagrams appear in the order that you should draw them:

Copyright S-cool

Another important point to note when drawing these diagrams: always draw the AR curve before you draw the MR curve when doing the sub-markets. This way, you can cheat a bit and makes sure that you draw the MR curve just where it needs to be to give you the right size of profit (small in the elastic sub-market, large in the inelastic sub-market).

Anyway, what these diagrams are trying to show is that the profit gained through the division of the market (the sum of the green and blue boxes) is higher than if the monopolist stuck with one large market (the red box). Note that Q1 = Q2 + Q3 (theoretically, at least) and Q2 > Q1, but Q3 < Q1. Also, P2 < P1, but P3 > P1.

Taking the example of airline flights, the elastic sub-market is economy class and the inelastic sub-market is business class. With economy class, output is high (Q2), but at a relatively low price (P2). With business class, output is low (Q3), but the price is very high (P3).

Businessmen's demand for air travel is very inelastic. Apart from the fact that the company pays, so they don't care how high the price is, they need the extra comfort because they may have an important meeting for which they cannot be tired. Those of us looking for a flight for a holiday have a much more elastic demand. Price is all-important. It is a relatively big purchase for most households; so most people will be very price sensitive and shop around. Quality of service is not such a big factor in the choice of airline.

If the airline offered one service at price P1, there would be no shortage of business customers, but most of them will use the better service at price P3 anyway. There would, though be a significant decline in the number of 'normal' passengers using the airline. By splitting the markets the firm should make more profit overall.

Finally, it should be noted that the increased profit must cover the cost of separating the market, and keeping it separate, otherwise there is no point in price discriminating. In other words,

Blue box + Green box > Red box + cost of market separation

for price discrimination to be profitable.