Not every customer is willing to pay the same price for the same product. So how is a seller to set prices to maximise business? The answer is the world of price discrimination. When Apple Computer priced its new Power Macintosh line of computers in 1994, it grossly under estimated the level of demand and was consequently unable to supply enough computers and parts. Modi Telstra (now Hutchinson Max) in Kolkata offered a promotion in 1998 allowing free incoming calls when these were not ‘free’ in India. The promotion backfired when the response was so large that many customers were unable to gain access to the network. The question “How should a product be priced?” is of enormous importance to businesses, and most companies allocate substantial budgets to market research, both before launching a new product and, once launched, through the different stages of the product’s life cycle.
Economists argue that the level of demand for a product at any price is the sum of what all individual consumers in the market would be willing to purchase. This demand or willingness to pay, for any product is affected by three key factors:
- Individual consumers’ preferences for the different characteristics of the product.
- The price of close substitutes to the product and the price of goods that must be used in conjunction with it.
- The level of each individual consumer’s income.
This will apply to any product, be it cans of cola, automobiles or computers. This unit will examine the common pricing strategies adopted by firms including price discrimination.
PRICE DISCRIMINATION TYPES
In economic jargon, price discrimination is usually termed monopoly price discrimination. This label is appropriate because price discrimination cannot happen in a perfectly competitive industry in equilibrium. Monopoly power must be present in a market for price discrimination to exist. This seems a trivial point, when you understand, the definition of price discrimination; the practice of charging different prices to various consumers for a given product. In a competitive market, consumers would simply buy from the cheapest seller, and producers would sell to the highest bidders, and that would be that.
With monopoly power, however, the opportunity may exist for the firm to offer different terms (of which price is only one component) to different purchasers, thus dividing the market–a practice known as market segmentation. Price discrimination refers to the situation where a monopoly firm charges different prices for exactly the same product. The monopoly firm (a single seller in the market) can discriminate between different buyers by charging them different prices because it has the power to control price by changing its output. The buyers of its product have no choice but to buy from it as the product has no close substitutes.
There are three types of price discrimination – First Degree price discrimination, Second Degree price discrimination, and Third Degree price discrimination. First degree price discrimination refers to a situation where the monopolist charges a different price for different units of output according to the willingness to pay of the consumer. For example, a doctor who is the only super specialist in the town may charge different fee for conducting surgery from different patients based on their ability to pay. Second degree price discrimination refers to a situation where the monopolist charges different prices for different set of units of the same product. For example, the electricity charges per unit of the first 100 Kwh of power consumption may be different from the rate charged for the additional 100 Kwhs. Another example is railway passenger fares; the per kilometre fare is higher for the first few kilometers, which declines as the distance increases. Thus the discrimination is based on volume of purchases. When the monopolist firm divides the market (for its product) into two or more markets (groups of buyers or
segments) and charges different price in each market, it is known as third degree price discrimination. Airline tickets are a common example of this form of price discrimination. For example, lower rates are applicable to senior citizens than business travellers, electricity rates applicable to residential users are lower than those applied to commercial establishments and so on.
a) First Degree Price Discrimination
Monopolists engage in price discrimination when they can increase their profits by doing so. Even if sellers know the maximum amount that different customers are willing to pay, developing a pricing scheme that makes each customer pay that amount, a practice known as first degree price discrimination, can be difficult. Under first degree price discrimination, the full benefit from the trade between buyer and seller accrues to the seller. One strategy to achieve first degree price discrimination is to sell to the highest bidders through sealed bid auctions. The auction approach is best suited for situations where the volume of sales are low (usually due to scarcity of the product), where there are many potential buyers who are unable to co-operate among themselves and where buyers all have access to the same information about the product’s characteristics. The auction approach would enable to seller to identify those buyers with the highest willingness to pay and would yield the highest possible revenues for the same production costs. This is a common strategy for the sale of very special types of products such as art objects, antique furniture or the rights to the mining and exploration of plots of land. It is not suitable for most bulk-produced products such as cans of cola or computers. Perfect, or first degree price discrimination can occur when a firm knows the maximum price the individual is willing to pay for each successive unit. The firm could then charge that highest price for each successive unit and capture the entire consumer surplus. Remember that all forms of price discrimination involve some monopoly power, but perfect price discrimination involves a degree of monopoly power rarely found in the real world.
b) Second Degree Price Discrimination
Where the auction approach is not feasible, the company must do its best to approximate the first degree outcome using its pricing structure. This is based on the notion that an individual consumer derives diminishing satisfaction from each successive unit of any product consumed.
This form of price discrimination, which is based on the volume of consumer purchases, is very common and is known as second degree price discrimination. Other forms of second degree price discrimination include two-tier tariffs, i.e. prices where the consumer must pay a flat fee for access and then a separate fee (which may be zero) for usage. This is typical of many clubs, amusement parks and transport facilities offering monthly or annual passes.
The idea in the case of travel pass, for example, is that the traveller who travels infrequently pays on average, a higher price per trip because the fixed access cost is spread over fewer trips. On the other hand, the high volume user spreads this fixed cost over so many trips that he or she may actually sit next to the infrequent traveller, consume the exact same services (meals, fuel and so on), but end up paying a lower average price for any given trip.
Second-degree price discrimination is also referred to as multipart pricing. It is a block, or step, type of pricing, in which the first set of units is sold at one price, a second set at a lower price, a third set at a still lower price, and so on. Note that this is different from a quantity discount in which the lower (discounted) price applies to all units purchased. In second-degree price discrimination, the lower price applies only to units purchased in that block. The buyer must have already paid the higher price for the earlier units. Some familiar examples should make this clear:
- Electricity: In many parts of the developed world residential electricity users are billed at different rates for different blocks of consumption. For example, the first 100 kilowatt-hours may be priced at $0.62 per kilowatt-hour, the next 100 kilowatt-hours may be priced at $.59 per kilowatt-hour, and everything over 200 kilowatt-hours may be priced at $.57 per kilowatt-hour. This is an example of three-block second degree price discrimination. You cannot buy the second 100 kilowatt-hours at the lower price until you have already purchased the first 100 at the higher price.
- Long-distance phone calls: When you make a long-distance phone call, you are usually charged a higher rate for the first three minutes than for subsequent time. It is impossible to buy just the second three minutes of a phone call. You must first have used the initial three minutes. This is also an example of second degree price discrimination.
Now, let’s look at second-degree price discrimination in a more formal graphic model. In figure -1, the seller faces the demand curve (D) of one typical consumer. Although the cost function is not shown in the figure, assume that marginal revenue and marginal cost intersect and lead to an optimal price of P*. The consumer would choose to buy the quantity Q* at this price. The shaded area of the figure represents the consumer’s surplus. It may be, however, that the firm uses multipart pricing to capture a portion of this surplus. Suppose that the firm sets a price of P1 for the first Q1 units purchased and that additional units sell for P2 (a two-stage pricing scheme). The consumer buys Q1 units at price P1 and Q2 units at price P2. That portion of the consumer surplus labeled P1BCP2 is now captured by the firm rather than by the consumer. This still leaves a rather large portion of the consumer surplus still in the consumer’s hands. The firm’s management would prefer to capture it all, and could do so by using more parts in a multipart pricing strategy. However, to do so, management needs to know a great deal about the consumer’s demand.
In this example of second-degree price discrimination, or multipart pricing, the first block of units (Q1 units) is sold at the price P1, and the second block (Q2 units) is sold at the price P2. This allows the seller to capture that part of the consumer’s surplus represented by the area P1BCP2.
c) Third Degree Price Discrimination
Pricing based on what type of consumer is doing the purchasing rather than the volume of purchase is an approach known as third degree price discrimination. This is very common in the sales of air and rail travel, movie tickets and other products where consumers can be segmented into different groups, who are likely to differ greatly in their willingness to pay based on certain easily identifiable attributes. Thus, third-degree price discrimination, or market segmentation, requires that the seller be able to (1) segment, or separate, the market so that goods sold in one market cannot be resold by the buyers in another; and (2) identify distinct demand curves with different price elasticities for each market segment.
Students are one of the main beneficiaries of third degree price discriminations schemes, since their demand is more sensitive than the population at large. Other often identified groups include senior citizens and the young, both of whom also tend to be more price sensitive, and business purchasers, who are often less price sensitive and may be willing to pay a lot for small quality improvements. Suppose, for example, there are only two types of travellers; students and businessmen. Students pay for their travel out of their own pockets, while businessmen charge their travel to their employers who in turn deduct these expenses from their taxable income. Since a typical student is likely to be willing to pay less for a travel ticket, all else being equal, than a typical businessmen, it makes sense for the company selling travel services to price higher to the businessman and lower to the tourist to get the largest possible volume of business out of each customer group.
AN ALGEBRAIC EXAMPLE OF THIRD DEGREE PRICE DISCRIMINATION
Third degree price discrimination is the most common in actual practice in the real world, so it makes some sense to examine a detailed (and realistic) example of how it works. Consider a mathematical formulation of third degree price discrimination because it is the most common type. We shall limit our discussion to the case of two submarkets, but the technique is entirely general and can be applied to any number of submarkets.
Consider a monopolist facing the following demand and cost curves.
P = 100 – 4Q, C = 50 + 20Q
Suppose the firm is able to separate its customers in two distinct markets with the following demand functions.
P1 = 80 – 5Q1, P2 = 180 – 20Q2
It can be easily verified that the aggregate demand curve remains unchanged at
P = 100 – 4 Q
The two demand equations can be written in terms of quantities.
Besides, the combined marginal revenue (CMR) must also equal MC. The price and quantities in the respective markets can be seen as:
Market = 1 : P1 = 50, Q1 = 6
Market = 2 : P2 = 100, Q2 = 4
The typical discriminating monopolist is depicted in Figure 14.2. The total market MR curve is plotted by adding the respective MR curves horizontally.
The maximum profit is calculated as
p = TR – TC = P1*Q1 + P2*Q2 – (50+20Q)
=300 + 400 – (50+20*10)
= 700 – 250
Now, let us see what would happen if the firm were to face just one market. The MR equation in this case, is given by 100 – 8Q, the MC = 20 and hence profit maximising combination is P = 60, Q = 10. or
Profit = TR -TC = P*Q -TC = 600 – 250 = 350
or Profit is only 350.
Why has this happened? Let us compute the elasticities of demand at the equilibrium outputs in the two markets to understand the improvement in profit in the first case. The market which faces a demand curve P1 = 80 – 5Q exhibits an elasticity of demand which is 1.67 at Q1 = 6 and the other market has only 1.25 at Q2 = 4. This means the price is lower and the quantity higher in the market with greater demand elasticity. We can prove this by applying the principle that only if the two marginal revenues are equal in the two markets.. Recall that marginal revenue equals P(1+1/e), where P is price and e is the price elasticity of demand. Therefore, if marginal revenue is the same in the two classes, P1(1+1/e1) = P2(1+1/e2). Hence P1/P2 = (1+1/e2)/(1+1/e1). As the following table also shows that price is higher in the market where elasticity of demand is lower. If the marginal revenues in the two markets are equal, the ratio of the price in the first class to the price in the second class will equal
P1/P2 = (1+1/e2)/(1+1/e1)
Where e1 is the price elasticity of demand in the first class, and e2 is the price elasticity of demand in the second class. Thus, it will not pay to discriminate if the two price elasticities are equal. Moreover, if discrimination does pay, the price will be higher in the class in which demand is less elastic.
Pricing schemes can be quite complex and may combine elements of second and third degree price discrimination: for example, discounted travel passes for students and pensioners. In any case, the main danger to the seller is that customers have an incentive to get together and trade among themselves to benefit from existing price differentials.
Thus, a student may try to purchase a ticket s/he does not plan to use for the express purpose of selling it to a business traveller and sharing the difference between the prices. Or, a holder of a travel pass may offer the pass to a friend to use, enabling the friend to benefit from the high volume of the holder’s travel. If this were allowed to happen, the seller would lose the business of the high-price paying customer and would be better off offering a single profit-maximising price. The seller engaging in price discrimination must therefore take measures such as passport checks at the departure gate and photos on rail passes to make sure consumers are not able to engage in arbitrage, i.e. profit from their access to a lower price by selling to someone to whom such access is precluded. The other danger the price discriminating seller faces is that a rival firm may enter with a single price that undercuts the incumbent’s higher price. Then the rival will draw away the most profitable market segments and the original company will only be left with the low-margin discount buyers. That is why price discrimination is only possible in imperfectly competitive markets, where direct competition by rivals is made difficult by entry barriers such as established brand names (computers), differentiated products (magazines), scale economies in production (air and rail travel), technology patents (pharmaceuticals) for where access to a key input is limited (fine art).
PEAK LOAD PRICING
Peak load pricing is a type of third-degree price discrimination in which the discrimination base is temporal. We single out this particular form of price discrimination in part because of its widespread use. But remember that all forms of third-degree price discrimination, including peak load pricing, involve a seller attempting to capitalize on the fact that buyers’ demand elasticities vary. In the case of peak load pricing, customer demand elasticities vary with time. Very few, if any, business economic activities are characterized by an absolutely constant demand during all seasons of the year and at all times of day. For many, the variations, or fluctuations, are not large enough to be of concern; but for some activities, fluctuations in demand are significant. These variations are sometimes relatively stable and predictable. Telephone calls provide one good example. Telephone companies and their competitors use a pricing scheme for long-distance calls that encourages people to make such calls at slack times when equipment and personnel are less busy. Prices are the highest between 8:00 a.m. and 5:00 p.m., reduced between 5:00 p.m. and 11:00 p.m., and reduced still further from 11:00 p.m. to 8:00 a.m. The highest prices are charged during peak demand periods, and lower prices are charged at other times. This is an example of peak-load pricing. Consumers are encouraged to shift demand from peak to slack periods through the price mechanism, and those who use the phone system for long-distance calls during peak periods pay a relatively greater share of the cost of providing and maintaining the phone system. Whenever price discrimination is based on time differentials, the object of the selling firm is to charge a higher price for the product during the more inelastic period and a lower price during the more elastic interval.