2. Size-up-their-income: wealthier (individual) customers are expected to possess more inelastic demand and are charged more than less affluent consumers. Examples: legal and medical services.
3. Measure-the-use: customers who use a product more are charged a higher price that is not proportional to any difference in costs. Example: Xerox machine rental charges.
Group Discrimination
1. Dump-the-surplus: goods in excess supply are exported at reduced prices, to prevent depressing domestic monopoly prices. Example: export market dumping e.g. televisions, computer chips, etc.
2. Promote-new-customers: new customers are offered lower prices than existing customers to develop new brand loyalty. Examples: newspapers and magazines.
3. Keep-them-loyal: special discounts are given to high volume buyers or prized customers. Example: frequent flier programs.
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4. Sort-them-by-time-value: coupons which involve a time commitment for redemption are given to customers. Those who redeem these coupons are presumed to have a lower opportunity cost of time, which corresponds with a lower reservation price. Examples: mail-in rebates, and newspaper coupons.
5. Divide-them-by-elasticity: separating customers on the basis of belonging to a particular group, when there is an expectation that the demand elasticity or reservation price will vary among each group. Examples: business vs. tourist rates on travel, and student vs. general admission prices for entertainment.
Product Discrimination
1. Appeal-to-the-classes: pricing higher quality products to achieve larger markups than with lower quality products. Examples: cloth vs. paperbound books, and luxury vs. mid-size economy cars.
2. Make-them-pay-for-the-label: charging higher prices for (homogeneous) goods, based on name recognition. Examples: Name-brand vs. generic aspirin, salt, etc.
3. Clear-the-stock: clearance sale prices are charged on certain items when inventories need to be reduced, with the hope that these lower prices will induce purchases by customers with tight budgets. Example: Macy's, or other high-end store clearance sales.
4. Switch-them-to-off-peak-times: for goods and services with varying time-consumption patterns, lower prices are charged during off-peak periods. Examples: hotel and motel rates, and long distance telephone rates.
5. Skimming: setting high introductory prices that are designed to exploit customers eager to buy a new product. Example: introductory automobile prices
Price discrimination is categorized into three types:
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First degree price discrimination - charging what ever the market will bear,
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Second degree price discrimination - quantity discounts or versioning,
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Third degree price discrimination - separate markets and customer groups.
All these three types involve additional effort on the part of the firm to determine the preferences of different customers and their willingness to pay. These efforts are justified by a greater level of profits relative to which can be earned by charging a single price.
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First Degree Price Discrimination
The thought process behind the practice of first degree price discrimination is that the firm has enough accurate information about the consumer, and that products can be sold each time for the maximum amount that the consumer is willing to pay. This, of course, requires that the firm knows the actual demand for the good that it produces. The firm must divide its customers into distinct, independent groups based upon their respective demands for the good. The firm wants to first sell to the group who will pay the highest price for the new product. It then reduces the cost slightly and sells to another group with only a slightly less demand for the good. This process is copied on numerous occasions until the marginal revenue drops to equal marginal cost. The most significant difference here is that there are a virtually limitless number of possible prices that, if charges correctly, will lead to profit maximization in the end. The firm must, of course, be on the ball and must make constant changes of the demand, and the price for the good, at any given time, after the initial price is set, and a number of units are sold.
(Price discrimination /Askjeeves, 1998)
The firm will sell a quantity of output 'Q*' up to the point where the price of the last unit sold just covers the marginal costs of production. The difference between the price charged on each unit and the average costs of producing 'Q*' units of output will be the firm's profits.
Figure 1, First Degree Price Discrimination
Examples of first degree price discrimination include car sales at most dealerships where the customer rarely expects to pay full sticker price, scalpers of concert and sporting-event tickets, and road-side sellers of fruit and produce.
In all the above examples the discounts are given to the customers in accordance to his ability to buy. A wealthier customer might be charged a higher price for a car or by a road side seller who notices the customer can afford the same at a higher price.
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Second Degree Price Discrimination
The second type of price discrimination involves the establishment of a pricing structure for a particular good based on the number of units sold. Quantity discounts are a common example. In this case the seller charges a higher per-unit price for fewer units sold and a lower per-unit price for larger quantities purchased. In this case the seller is attempting to extract some of the consumer's surplus value as profits with residual surplus remaining with the consumer over and above the actual price paid. Second degree price discrimination yields itself well to a process called "product bundling". Product bundling is more common in the personal computer industry. System packages are bundled together with the most popular software and hardware, and this reduces possible arguing over certain items. No one can argue about the value of not including a CD-ROM or video card. Like the case of first degree price discrimination, the firm will produce a level of output where the price charged just covers the marginal costs of production.
In the diagram below, we find an example of a firm charging three different prices for the same product. The price P0 is charged per unit if the buyer chooses to buy Q0 units of the good. A lower price P1 is charged for a greater quantity Q1 and the
price P2 is charged for the quantity Q*2 (the level of output such that P2 = MC -- the marginal costs of production):
Figure 3, Second Degree Price Discrimination
Examples of second degree price discrimination include quantity discounts for energy use; the variations in price for different sizes of boxed cereal, packaged paper products; and sodas and French fries at fast food outlets.
Third Degree Price Discrimination
Third degree price discrimination deals with separating customers into distinct groups based upon their difference in elasticity of demand. Based upon this elasticity, you then charge a higher price to the group whose demand is less elastic. Marginal revenue is the
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change in the total revenue that is the result of a small change in the sales of the good in question.
'P1' and selling a level of output 'Q1' in the first market and a lower price 'P2' selling a level of output 'Q2' in the second market; profits are greater than in that firm charged a single price 'P* ' (P2 < P* < P1 ) for all units sold. Specifically, the firm will attempt third degree price discrimination if:
P1Q1 + P2Q2 > P*Q* (Q* = Q1 + Q2 ,Total Costs are the same in either case)
In order for this type of price discrimination to be effective, the firm must be able to prevent a third party from engaging in arbitrage (buying in the second market
at a price slightly above P2 and selling in the first market at a price slightly below
P1 forcing both prices towards P*) and profiting from the price differences. The markets must be kept separate!
Examples of third degree price discrimination include: business vs. tourist airfares, business vs. residential telephone service, and senior discounts.
Conditions Under Which Price Discrimination Is Possible
- The buyers or the groups of buyers (markets) must be separable. It must be possible to identify and keep the two or more buyers or markets separate in order to prevent arbitrage selling from the lower price to the higher price buyer or market. In other words, a seller can practice price discrimination only when he is selling in different markets which are divided in such a way that the product sold by him in the lower price market can not be resold in the higher price market. Services are less easily resold than commodities; goods that require installation by the manufacturer like heavy equipment are less easily resold than the movable commodities like household appliances. Transportation cost, tariff barriers or import quotas serve separate classes of buyers and make discrimination
- The markets must be characterized by a lack of price competition from rival firms, in order to prevent price levels being eroded from profit maximizing levels in each market. Price discrimination is most likely to work well in a monopoly situation, where there are no rivals to worry about, but it is feasible in oligopoly markets too where the firms coordinate to determine their pricing strategies in one way or another. In a perfect competitive market it is not possible as there are a large numbers of firms selling a homogenous product in the market. The seller by charging a higher price from the buyers will loose its customers.
How Price Discrimination Is Profitable
Price discrimination is a significant and influential practice on the market in the modern economic world. It aids in a firm's profit maximization scheme, it allows certain consumers with more scarce resources the opportunity to purchase goods or services that would otherwise be usable, and it aids firms in balancing what is and what is not sold.
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Price discrimination is an effective means by which a firm can sell a higher quantity of goods, make a higher profit margin on the goods it sells, and builds a broader consumer base due to differing price elasticity of demand for given goods and services. Price discrimination ultimately equalizes price and value for both the consumer and the firm, creating a more ideal situation for both entities in terms of preference and opportunity cost.
Examples of Price Discrimination
Electricity cost:
Indeed, each kilowatt of energy is the same as the next - but the value in use of electricity is different. Most people prefer electric lighting in their homes. (Candles are nice for romantic dinners, but they are impractical for every day use.) The amount of electricity we use for lighting is relatively small, though. We can use electricity for heating our hot water heater (and this requires a lot of electricity), but gas is equally as convenient. Thus, to get us to use electricity for all our energy needs, the power company will have to set a low price for electricity; low enough for electricity to be competitive with the cost of gas. However, this means electricity users would gain a huge consumer surplus for their lighting needs! Electricity suppliers are discriminating monopolists. They can gain extra revenue, (and thus reduce the consumer surplus) by setting up a two price system. The value in use of electricity for lighting is higher than the value in use of electricity for heating. Since relatively little electricity is used for lighting, the first component of our electricity bill reflects this usage; the second component of the bill reflects the heating cost. Some of the consumer surplus is transferred to the power company as extra revenue.
In the restaurants
When you were young, did you ever order from the childrens' menu in a restaurant? When a family with small children goes to a restaurant, they are often given a children's menu in addition to the regular menu. If they order two similar items, one from each menu, they will find that the item ordered from the children's menu will be a bit smaller, but its price will be much smaller. In fact, it would often be worthwhile for the entire family to order from the children's menu, but they cannot. Restaurants usually only allow children to order from it.1
Why do restaurants use children's menus? Economists doubt that restaurant owners have a special love for children; they suspect that the owners find offering children's menus to be profitable. It can be profitable if adults who come to restaurants with children are, on
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the average, more sensitive to prices on menus than adults who come to restaurants without children.
Children often do not appreciate restaurant food and service, and often waste a large part of their food. Parents know this, and do not want to pay a lot for their child's meal. If restaurants treat children like adults, the restaurants may lose customers as families switch to fast-food restaurants. If this explanation is correct, then restaurants price discriminate.2
In the airfares
Economic theory suggests that a monopolist can price discriminate more successfully than can a perfectly competitive firm. Most real-life markets, however, fall somewhere in between the two extremes. What happens as the market becomes more competitive: Does price discrimination increase or decrease? This paper examines how price discrimination changes with market concentration in the airline market. The paper uses data on prices and ticket restrictions across various routes within the United States, controlling for distances and airport gate restrictions. Price discrimination is found to increase as the markets become more competitive.
DEMAND GRAPH OF AIRLINES
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TOTAL REVENUE GRAPH
MARGINAL REVENUE GRAPH
LADIES GIVEN DISCOUNTS IN NIGHT CLUBS.
This means that during ladies night at the local bar, it costs more for men to have a beer than women simply because these bars find it o.k. to charge females less, as a way to draw more females to the business on a specific night.
Movie theaters, magazines, computer software companies, and thousands of other businesses have discounted prices for students, children, or the elderly
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Copyright holders on digital media demand new rights and privileges constantly. They push laws like DMCA through the United States Congress, and enforce their privileges worldwide through such treaties as the Berne Convention. Perhaps they want a pay-per-view society where every reading of a book or playing of a song costs a fee, payable to them. They want to control, not only the copying of a book, movie, or song, but the use thereof - where and how many times it may be viewed, what persons may use it. This would enable what economists call price discrimination - they could charge each customer as much as they're willing to pay.
Another area where price discrimination commonly occurs in the publishing industry. A hardcover book doesn't cost all that much more to produce than a paperback book ($1 to $2 more), and yet hardcover books are generally 2 to 3 times as expensive as paperback books. This seems to be a way to discriminate based on time preferences. Those people who need to read the new Stephen King novel the moment it hits bookstores are subsidizing the lower cost of his novels for those of us who wait for the paperback version.