By: Andrew McCashland


Price Discrimination is the practice of charging different prices to consumers for the same good or service.
Price discrimination is a tool that firms use to extract additional surplus from consumers. The three types of discrimination that firms use to extract surplus depend upon the information that the firm contains. First degree price discriminations is when firms charge consumers the maximum price that they are willing to pay for each unit. Second degree price discrimiation is when firms post a discrete schedule of decling prices for different ranges of quantites.Third degree price discrimination is when firms charge different prices to different groups for the product.



First degree price discrimination is where firms would like to charge the maximum amount that the consumer would be willing to pay. For firms this is basically the best situation they can reach. This type of prices discrimination gives them the best opportunity to extract surplus from the consumer. By engaging in this price discrimination is allows them to earn the most profit, and it takes away all deadweight loss to society. Because this gives the firm the most profit it also requires that the firms know exactly how much each consumer is willing to pay. This makes it extremely difficult to implement because the firm must have perfect information which is very difficult to have. Even though it is difficult to implement there are still businesses that can implement this style. These firms include car dealerships, doctors, lawyers, and mechanics. The graph below gives an example of how this discrimination works.


external image priced1.gif
Graph UKeconomics.com

By looking at the graph you can see how much more revenue the firm can bring in. If the firm were to set a single price like on the graph the light blue section the firm only sells a quantity of five at that price. But with a first degree price discrimination the graph shows that at each quantity the firm can charge a price for that quantity. So by looking at the graph at a quanity of zero the firm can charge the highest price. At Quantity one they can charge the next highest prices and so on down the demand curve. This will lead to higher profits and more products sold. Which also gives all surplus to the firm and none to the consumer.


Second degree price discrimination is setting a discrete schedule of declining prices for a different range of quantities. This also allows the firm to gain more surplus instead of charging a single price. This lets firms sell their product at a higher price for a scheduled time, and then the price would lower to reach another group of consumers. This practice allows the firm to charge higher prices to different groups of individuals even though it doesn’t know the maximum amount that each consumer is willing to pay. In this price discrimination the firms let consumers sort themselves into the groups and price that they are willing to pay. This practice is commonly used in the electric utility industry where firms will charge higher rates for the first set amount of electric usage and then lower the price depending on the schedule they have set. Other examples in the market are in the movie industry where they charge different prices due to the time, whether it is a matinee or night movie. Also at shopping stores where they have end of season sales, to reduce the inventory they have going from summer to winter.

external image priced2.gif
Graph UKeconomics.com

Looking at the graph it shows where the firm sells it product at one price P1 and at quantity Qa that is point X. With a second degree price discrimination they will also charge a second price on a discrete schedule they had set up. To gain more profits they will charge a price P2 and Qa at Point Y. So they can sell more quantity of their product at a cost that the consumer’s who were not willing to pay at the higher price are now willing to pay at the lower price.


Third degree price discrimination is when firms recognize that the demand for their product is different for each group of consumers. Firms know that charge different prices to different groups for the same product. So firms will offer discounts to groups, like students or senior citizens. This pricing strategy can only exist when firms have some price setting power. They must be able to differentiate between consumer segments and be able to put them in groups based upon income or geography. They also must be able to differentiate between elasticity of demand for consumers. This allows firms to price discriminate between groups and make more profits when they don’t have complete or all the information needed to do the two other types of discrimination. This will give them the knowledge they require to determine which groups they can charge the higher prices to and to what groups to give the discounts.


external image priced3.gif
Graph UKeconomics.com

This graph shows two different markets where their prices and quantities are different but in third degree price discrimination they can sell to both markets by offering discounts to the groups that are not willing to pay the higher price for the product. For certain groups they can charge the higher price, but for consumers such as students or senior citizens they will not be willing to pay the higher price. So for firms they will give discounts to these groups in order to get them to purchase the product as well. So if they charge a price of say 60 dollars for regular consumers, but the students will only buy at a price of 50. Then firms can price discriminate and give a ten dollar discount to students. Examples of this is at movie theatres. They will charge a price but then give students a discount.


These are the three types of price discrimination that firms are able to use to maximize their surplus and profits. In order for these to work the consumer must not be able to resell their products to other individuals. If this was allowed consumers could purchase products at lower prices and sell them to the people who are in the groups being charged the higher prices.
In this situation the consumers who could buy at the lower price would buy the product then turn around and resale it to the individuals who are willing to pay a higher price. But they could resell it at a lower price then what the firms are trying to sell to those individuals, but at a higher price then what they paid. Then takes the consumer surplus away from the firms and back to the individuals. This example is why price discrimination can not work, so that is why firms must not let individuals resell their product.



1. Which groups of business’s can take part in first degree price discrimination?
a. Lawyers
b. Auto Mechanics
c. Car salesman
d. All of the above.

2. What is type of information is needed to first degree price discriminate?
a. No Information.
b. Consumer elasticity
c. Consumer income,
d. Perfect Information

3. What situation in the market will not let any type of price discrimination work?
a. No information
b. Different income elasticity in consumers
c. Resell of products
d. Monopolistic Competition

4. Why do firms engage in price discrimination?
a. To differentiate market segments
b. To gain monopolistic power
c. Keep consumers demand low
d. To make greater profits

5. Which type of price discrimination includes using a discrete schedule of declining prices?
a. 1st degree price discrimination
b. 2nd degree price discrimination
c. 3rd degree price discrimination
d. No price discrimination strategy uses this strategy


Answers:
1. D. All groups because in a service related field such as what the lawyers and car salesmen are in they can charge prices determined by what the consumer needs. So they can discriminate based upon what service they are giving.
2. D. In order for firms to charge the maximum amount the consumer is willing to pay they must know all the information or have perfect information about the consumer.
3. C. If consumers were allowed to resale then consumers who could buy for lower prices would then stock up and then resale the products to the people that would be charged more. Thus taking away profit from the firms because the consumers would then buy from the other consumers then from them.
4. D. When firms engage in price discrimination they are trying to gain the most profit possible. In these cases each price discrimation tatic would give the firm a higher profit than if they were just charging one single price.
5. B. 2nd degree price discrimination uses the discrete schedule method. This is because they don't have perfect information, so this lets them charge higher prices and lets the consumers place themselves into groups.

References
1. Baye, Michael R., Managerial Economics and Business Strategy, Fifth Edition pg. 404-409
2. Types of Price discrimination Wikipedia.com "Author Unknown"
http://en.wikipedia.org/wiki/Price_discrimination
3. Price Discrimination Uk Economics.com "Author Unknown"
http://www.revisionguru.co.uk/economics/pricedis.htm
4. Third Degree Price Discrimination amosweb.com "Author Unknown"
http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=third-degree+price+discrimination
5. Micro Price Discrimination tutor2u.neteconomics "Author Unknown"
http://www.tutor2u.net/economics/revision-notes/a2-micro-price-discrimination.html
6. "Have They Got a Deal for You" WashingtonPost.com by Joseph Turow
http://www.washingtonpost.com/wp-dyn/content/article/2005/06/18/AR2005061800070_pf.html