Price discrimination

1. Identifiable and Separable Market Segments: The firm must be able to identify different groups of customers with different price elasticities of demand. Furthermore, it must be possible to segment these customers and prevent them from easily moving between segments. This separation can be based on various factors such as:

   • Demographics: Age (student/senior discounts), location (regional pricing).
   • Time of Purchase: Peak vs. off-peak pricing (electricity, travel).
   • Purchase Quantity: Bulk discounts.
   • Product Versioning: Offering different features at different price points.
   • Willingness to Search/Bargain: Coupons, haggling.

2. Prevention of Arbitrage (No Resale): The firm must be able to prevent customers who buy the product at a lower price from reselling it to those who are willing to pay a higher price. If arbitrage is possible, the price difference cannot be sustained. Examples of preventing arbitrage include:

   • Services: Services are consumed directly and cannot be resold (haircuts, medical exams).
   • Perishable Goods: Difficult to resell over time.
   • Transaction Costs: The cost of reselling might outweigh the price difference.
   • Contractual Restrictions: Tickets that are non-transferable.
   • Product Differentiation: Slightly different versions of a product targeted at different segments.

In summary, price discrimination is a strategic pricing tactic employed by firms with market power to enhance profitability by capitalizing on differences in consumer willingness to pay, provided they can effectively segment their market and prevent resale.

Why Does Price Discrimination Occur?

Price discrimination occurs because firms aim to increase their profits by capturing more of the consumer surplus. Consumer surplus is the difference between what a consumer is willing to pay for a good or service and what they actually ¹ pay. By charging different prices to different customers based on their willingness to pay, a firm can extract more revenue than it would by charging a single price to everyone.  

Here's a breakdown of the motivations behind price discrimination:

• Profit Maximization: This is the primary driver. By tailoring prices to different segments of the market with varying price elasticities of demand, firms can sell more units and generate higher total revenue and profit. They charge higher prices to those with less elastic demand (who are less sensitive to price changes) and lower prices to those with more elastic demand (who are more price-sensitive).
• Capturing Consumer Surplus: As mentioned above, price discrimination allows firms to convert consumer surplus into producer surplus (profit). In perfect price discrimination (first-degree), the firm theoretically captures all consumer surplus.
• Reaching Different Market Segments: Price discrimination allows firms to serve a wider range of customers, including those who might not be able or willing to pay the "average" price. By offering lower prices to price-sensitive segments (e.g., students, seniors), firms can increase their overall sales volume.
• Utilizing Capacity: In industries with high fixed costs and low marginal costs (like airlines or movie theaters), price discrimination can help fill empty seats or off-peak times, increasing overall efficiency and revenue. Charging lower prices during off-peak times attracts customers who might not come at peak prices.
• Responding to Competition (Indirectly): While not the direct goal, price discrimination can be a way to compete more effectively by offering different value propositions at different price points, catering to various customer preferences.

Conditions That Must Be Present for Price Discrimination to Occur:

For a firm to successfully implement price discrimination, several conditions must be in place:

1. Market Power (Price-Setting Ability): The firm must have some degree of market power, meaning it is not a price-taker in a perfectly competitive market. It must have the ability to influence the price of its product. This often occurs in monopolies, oligopolies, or markets with differentiated products. If there are many close substitutes and firms are price-takers, any attempt to charge a higher price to some customers would lead them to buy from competitors.