How Can Firms Practice Effective Price Discrimination?
Price discrimination is commonly defined as a practice of one and the same product or service having different prices when sold to different groups of people. Despite the sometimes negative connotation that it can have, price discrimination can be beneficial both for companies and consumers. Using it, companies can increase their profits, and social welfare improves because of the increased output. This research will discuss different types of price discrimination, as well as various effects that it can have both on the firms that implement this policy and on their consumers.
A firm operating in a perfectly competitive market does not have power over the price; it is forced to sell the entire volume of output at the price offered by the market. In a market of imperfect competition, however, the individual firm acquires a certain degree of power over the price, raising it over the competitive level in order to maximize profits. If the firm uses price discrimination, its profits will rise. As mentioned above, price discrimination occurs when a firm sets different prices for the same product for different groups of consumers (Poort and Zuiderveen Borgesius). At the same time, the differences in price are not due to differences in costs or quality of the product. The motive for using a price discrimination system is the desire of the firm with monopolistic power in the market to maximize profits. Setting a single price for all buyers, the seller loses potential profit by leaving consumers in the market whose maximum willingness to pay exceeds the marginal cost of production.
There is a number of conditions necessary for price discrimination to be implemented. First of all, a manufacturer has to be a monopolistic firm, because the ability to influence the market price of the product plays a significant role in price discrimination policies. Another condition is that the company should be able to identify and classify different groups of consumers who are “willing to pay different prices” (Poort and Zuiderveen Borgesius). Finally, the firm has to be able to “prevent arbitrage”, or resale of goods by consumers who buy them at a lower price to those buying them at a higher price (Church and Ware 159). To prevent this from happening, the firm must create artificial barriers between market sectors. Such barriers can arise due to the number of factors, among which are the following:
- High transaction costs of resale prevent arbitrage: what the economic agent can gain from the difference in prices, he loses on transaction costs.
- Special qualities of products: to exclude arbitrage, the manufacturer may give the goods special characteristics that reduce the possibility of finding potential buyers for resale.
- A special type of product: a service, unlike a product, cannot be resold. This enables service providers to discriminate more actively than product suppliers.
- Special forms of sales contracts: a monopolist manufacturer selling products in sufficiently large batches may not sell the goods themselves, but a warrant – a security that certifies the buyer’s right to the corresponding batch of the product.
The goal of any price discrimination policy is to translate consumer surplus into firm profits, and the higher the profit, the better. Perfect price discrimination occurs when a firm manages to set prices so that it acquires the entire consumer surplus of a given market (Li and Shuai). This can be achieved in the following way: suppose that the price is set by the successive procedures of the English auction. Each consumer gets the opportunity to pay for a product as much as they really value it. Then, each consumer has to pay the price indicated by the product’s place on the aggregate demand curve for the given market. The firm will sell the product until the unit sold to the additional consumer has a price equal to its marginal cost of production. The last consumer ready to buy the given product will pay the price of the competitive market for it. At the same time, the volume of the market supply appears to be equal to the volume of the competitive supply, although the entire consumer surplus now goes to the firm conducting price discrimination.
Another way of perfect price discrimination, as opposed to setting different prices for each unit of product sold, is the two-part tariff system. Suppose a monopoly firm knows the individual demand functions of all consumers and can eliminate arbitrage between them. Payment for goods consists of two parts: a lump-sum payment for the right to purchase goods and prices for each additional unit of goods (Poort and Zuiderveen Borgesius). The profit-maximizing monopolist sets the price at the level of the marginal cost of production of the goods and a lump-sum fixed contribution equal to the amount of consumer surplus received by the buyer (Church and Ware). A two-part tariff can be applied when pricing two complementary goods, one of which is assigned a high price equal to the consumer surplus, and the other is relatively low in terms of marginal costs of production.
The second type of price discrimination involves setting different prices to products goods when purchasing different quantities of those products. As a rule, large volumes of purchases are cheaper per unit of goods for the consumer. A classic example of price discrimination of the second type is the block tariff: the consumer pays for the first few units of the product (the first block) at a slightly higher price than the subsequent blocks. Obviously, with this payment scheme, how low the price is depends on how high the volume of goods purchased is (Poort and Zuiderveen Borgesius). Another example of price discrimination of the second type is wholesales versus retail sales: when buying bulk quantities of a product, the consumer pays a lower unit price than in retail. In addition to a “decrease in the price of goods with an increase in the volume of purchases”, a characteristic feature of price discrimination of the second degree is the independent selection of consumers (Church and Ware 167). The firm does not know exactly the individual demand function of each type of consumer (therefore, it is not able to appropriate the entire consumer gain). It also does not need a mechanism to differentiate between two groups of consumers.
Some firms cannot accurately establish the marginal value of their product for all groups of consumers and, therefore, cannot pursue a price discrimination policy of the first type. In this case, it is possible to divide the aggregate demand into groups of consumers with the same marginal value of the product. Because of the impossibility of arbitrage, the firm can set different prices for different groups of consumers, which is referred to as the third degree of price discrimination (Church and Ware). This type is applied in practice when conducting a policy of stimulating demand by issuing coupons for the purchase of goods at a discount. Another example is the practice of setting initially higher prices for goods from catalogues and price lists.
Another type of price discrimination is selling two or more goods together as a package, which is commonly known as bundling. Bundling occurs when a product is sold on the condition that another product is purchased (Church and Ware). For example, the purchase of a VCR may be accompanied by the purchase of warranty repairs only in the workshops of this company. Bundling is a special type of price discrimination because it allows the firm to make higher profits than when using single sales by requiring the buyer to purchase additional items at a higher price (Li and Shuai). In addition, bundling can be used as a way to provide price discounts for certain groups of customers.
It can be concluded that price discrimination is much more common that some people tend to think, because the majority of large firms use it in their policies and strategies. To be able to use price discrimination, the company needs to have certain amount of power over the market, and, therefore, influence the market price. Other conditions include the firm’s ability to prevent arbitrage and select groups of consumers willing to pay different prices. There are certain factors that help to prevent resale, which include high transaction costs and manufacturers giving their goods special characteristics that prevent arbitrage. There are several types of price discrimination, such as two-part tariff and bundling. However, the general goal of all these strategies is to gain profit, and price discrimination, when wisely managed, has proved to be an efficient way to do it.
Church, Jeffrey, and Roger Ware. Industrial Organization: A Strategic Approach. Richard d Irwin, 2000.
Li, Youping, and Jie Shuai. “Monopolistic competition, price discrimination and welfare.” Economics Letters, vol. 174, 2019, pp. 114-117.
Poort, Joost, and Frederik J. Zuiderveen Borgesius. “Does everyone have a price? Understanding people’s attitude towards online and offline price discrimination.” Internet Policy Review, vol. 8, no. 1, 2019.