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Should Firms Price Discriminate? Why or Why Not?

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Published: Fri, 24 Nov 2017

Price discrimination is a practice firms employ when they charge consumers different prices for the same good in order to earn higher profits. Price discrimination is made possible because of varying utility derived from the consumption of the same good and varying price elasticity of demand1. There are 3 types of price discrimination, namely: first-degree price discrimination (perfect price discrimination), second-degree price discrimination and third-degree price discrimination. In this essay, we will look at how the different types of price discrimination affect both consumers and producers, and whether or not firms are justified to employ that type of price discrimination.

A firm is said to have practised first-degree price discrimination when it charges each consumer a different price. Each different price corresponds to the value each individual consumer places on the good.

Figure 1)

As seen in Figure 1 above, the firm charges different prices to different consumers according to how much consumers value the good, thus the marginal revenue curve is equal to the demand curve. So, all consumer surplus is captured by the firm. Output of the firm is at Q2, where marginal cost (MC) incurred by the firm is equal to marginal revenue (MR) of the firm. Profit earned by the firm is given by the green shaded area (A).

In reality however, it is difficult to ascertain the value consumers place on the good offered by firms. The closest example is the case of Amazon2 charging different consumer different prices by tracking their online shopping behaviour. From there, Amazon can gauge the price sensitivity of a consumer. For consumers that are assessed to have relatively high price sensitivity, Amazon will charge them lower prices for the same good compared to other consumers with relatively lower price sensitivity.

Firms should practise perfect price discrimination because they produce at a socially optimum level. This also allows more customers (who previously could not afford the good) to consume the good. More consumers who previously were priced out of the market are able to afford the good3 now.

Figure 2)

When a firm does not practise perfect price discrimination, it fixes price at P1 and produces at an output of Q1. Profits earned by these firms will be given by the green shaded rectangle (B). Comparing Figure 1 and 2, it can be seen that firms earn more profits when it practises perfect price discrimination. Furthermore, firms that practise perfect price discrimination produces more of the good for consumers (Q2 > Q1). Lastly, there is a deadweight loss, given by the shaded brown triangle (D), when a firm does not practise perfect price discrimination.

However, when firms do not practise price discrimination, consumer surplus increases from 0 in Figure 1 to the black shaded area (C) in Figure 2. Furthermore, the issue of fairness crops up2: some consumers pay more for the same good because of their assessed consumption pattern. There is also a moral issue involved when firms go past the line by infringing on consumers “privacy” while ascertaining their price sensitivity, as illustrated by Amazon.

While there are good reasons on both sides as to whether firms should practise price discrimination, one must pause to ponder about the social and moral issues that crop up. How far can a firm go in assessing their consumers’ online behaviour? Is it fair that while firms charge more to other groups of consumers, they are at the same time allowing lower income groups of customers to consume the good? The fact that the practise of perfect price discrimination (or attempted replications of it) is ubiquitous and has long been used, suggest that such pricing strategy is ultimately beneficial to society3.

Second-degree price discrimination occurs when firms charge lower per unit prices as quantity purchase by consumers increases. For example, in Manchester, the Sugden Sports Centre charges students £165 for 9 months gym membership, £195 for 12 months gym membership and £5 per entry to the gym for students without the membership. Say a student would like to frequent the gym (workout twice a week) and continues going for the rest of the year. He is better off buying the 12 months membership because £195 < £5 x 2 x 4 x 12 = £480. Say another student (overseas student) would like to frequent the gym (workout twice a week) and continues going for 9 months (Length of academic year). He is better off buying the 9 months membership because £165 < £195 < £5 x 2 x 4 x 9 = £360. Lastly, say another student(Infrequent) who is not committed to working out in the gym but goes to the gym twice a month is better off not buying any gym membership.

The above examples have shown that if Sugden Sports Centre sets a single price, say £195 for 12 months gym membership and no per entry fee, overseas students and infrequent students will not sign up for the gym and Sugden Sports Centre loses potential revenue. However, if Sugden Sports Centre were to charge a £5 per entry fee regardless of frequency of usage of the gym, frequent users will not go to the gym at Sugden Sports Centre. Thus, by practising second degree price discrimination through offering different prices to consumers who purchase different quantities of good, Sugden Sports Centre allows different groups of students(consumers) to use the gym(consume the good). So instead of just obtaining revenue from one group of consumers, a firm can now obtain revenue from the few groups, thereby maximising profits.

Figure 3)

Figure 3 above shows the graphical representation of Sugden Sports Centre’s practice of second degree price discrimination. We assume that students who buy the 12 months and 9 months membership go to the gym twice a week every month. Therefore, at the end of their membership, students who subscribed to the 12 month membership would have gone to the gym 96 times and students who subscribed to the 9 month membership, 64 times. £2.57 is the calculated per visit entry fee for students who subscribed to the 12 month membership and £2.03 is the calculated per visit entry fee for the 9 month membership subscribers. Figure 3 clearly shows the falling per unit price as quantity of good or service consumed increases.

Firms should practise second degree price discrimination because the good or service offered will be made more available to different groups of consumers. The above example shows that if the firm were to set a single price, some groups of consumers will be priced out. Hence, practising second degree price discrimination will result in a win-win situation for producers and consumers as producers earn higher profits while more consumers can enjoy the good3. However, in some cases where a monopoly operates in the market, the firm may charge a very high price for the first few quantities of good and seemingly relatively low price for larger quantities of the good. It is still unfair and being dishonest to consumers because the monopoly intends to mislead consumers into buying larger quantities of good and hence earn more profits.

Third-degree price discrimination is practised when a firm charges different prices to different identifiable groups for the same good or service. These groups are identifiable based on, for example, age or sex4.Three requirements must be met before a firm can practise third-degree price discrimination: there must be varying sensitivity to price among the different groups, firms must identify the different groups explicitly and no resale of goods can be made among the groups themselves.

For example in Singapore, a typical bus ride will cost students a fix fare of S$0.55 but it will cost an adult S$1.00. The bus company is able to charge different prices because the above three conditions are met. A student is more price sensitive to adults because adults are drawing income and thus have higher purchasing power. A student and an adult are easily identifiable through identification cards and for obvious reasons. And a student bus ticket cannot be used by an adult.

Figure 4) Figure 5)

As seen in both figures, demand for bus rides by students is more price elastic than demand for bus rides by adults, hence the demand curve for students is less steep. At profit maximising output, students are charged S$0.55 per bus ride and adults are charged S$1.00 per bus ride. Thus, we can see that the firm charges different prices for different groups of consumers.

In this case, it is justifiable for the bus company to practise third-degree price discrimination as the profits earned from adults taking the bus might be used to cover the costs incurred from charging a lower price for students. However, in some cases like events held in nightclubs- charging men a fee of say £20 while women can enter for free. The answer to whether a firm should practise third-degree price discrimination is now highly subjective.

The practice of price discrimination remains a double edged sword. On one hand, it may seem beneficial because more consumers who otherwise might be priced out from previous higher price can now consumer the good3.But on the other hand, social and moral issues like unfairness and privacy may entail2. There are also many other sound justifications as to why firms should or should not price discriminate: able to identify consumers who are willing to pay more3 and the issue of the loss of consumer surplus. Whether or not firms should price discriminate is highly subjective and varies from case to case because of varying benefits and costs to society.

1) Riley, Geoff. “Price discrimination.”tutor2u. tutor2u, 23 Sept 2012. Web. 23 Nov 2013. <http://tutor2u.net/economics/revision-notes/a2-micro-price-discrimination.html>.

2) Krugman, Paul. “What Price Fairness?.”Econ tepper. N.p., 30 Nov 2009. Web. 23 Nov 2013. <http://econ.tepper.cmu.edu/ecommerce/amazon_pricing.htm>.

3) Smith, Tim. “The Case for Price Discrimination.”wiglafjournal. N.p., 30 Nov 2009. Web. 23 Nov 2013. <http://www.wiglafjournal.com/pricing/2004/03/the-case-for-price-discrimination/>.

4) Web, Amos. “third-degree price discrimination.”AmosWeb Encyclonomic. Amos Web, 25 11 2013. Web. 25 Nov 2013. <http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=third-degree price discrimination>.


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