Essay title
Consider the following market structures essay question:
Price discrimination appears in several markets, from airlines, trains and taxis to leisure, entertainment and technology.
Question: Evaluate whether price discrimination is beneficial (25 marks).
Below I have written out a model answer, split into one subsection for each paragraph.
Model answer
Brief introduction
Price discrimination means setting different prices to different consumers for the same good. For train tickets from Chiltern Railways, there can be different prices for students vs commuters. This is an example of third-degree price discrimination, where different consumer groups face different prices for the same good.
Analysis point 1
Price discrimination benefits sellers such as train companies. For example, railcards for UK train rides for groups such as 26-30 year olds offer a discount of a third on certain trains. Because of the option to charge different prices for different consumer groups, they can increase their profits. For example suppose there are two groups of consumers, the group with the more elastic price elasticity of demand (PED) with flatter MR/AR curves in the diagram and the group with the more inelastic PED with the more vertical AR/MR curves. In each submarket the firm will set the quantity so that MR=MC in that particular market, so profit for the submarket is maximised. For train companies, commuters may have more price-inelastic demand as they have to get to work by a certain time. Students may be more flexible about when and how they travel, so their demand for train tickets may be more elastic. To increase the revenue received from the price-elastic group, the firm can reduce its price from p to p2. To increase revenue received from the price-inelastic group, the firm can increase its price from p to p1, increasing total revenue and also total profits. These profits could make shareholders better off or lead to higher pay for key workers in the firm such as the CEO.
Evaluation point 1
This depends on the necessary conditions for price discrimination holding. Specifically firms need to be able to separate the submarkets otherwise cannot charge different prices. Specifically the firm needs to prevent seepage, i.e. commuters pretending to be students to get a cheaper price. The process of separation and enforcement costs money could be more than extra revenue made from price discrimination, for example if producing student ID cards and hiring security guards to check tickets could be costly.
Analysis point 2
The group with the more elastic PED benefits from lower prices and higher quantity sold, so their consumer surplus increases. A decrease in price from p to p1 results in an increase in quantity from q to q1 and consumer surplus increases by the orange shaded area. The inelastic group is worse off from higher prices and reduced quantity, so their consumer surplus does fall. If the group who has the more elastic PED is poorer, then price discrimination may improve inequality, as the poorer elastic group experiences lower prices and the richer elastic group experiences higher prices. This could apply in the case of train tickets where students are likely poorer (and have more elastic PED, as tickets are a larger percentage of their income) than the commuters who may be earning higher incomes in for example the City of London.
Evaluation point 2
However this depends on whether the elastic group is richer or poorer. For train tickets, suppose the elastic group consists of pensioners (who often receive reduced rates for train tickets). The inelastic group consists of lower income workers who do not have cars to commute. For example Trainline offers one third off train tickets for those aged 60 and over in the form of the Senior Rail Card. Then price discrimination means a higher price for the inelastic group and a lower price for the elastic group and hence may worsen inequality. Overall the consequences of price discrimination for inequality are unclear.
Analysis point 3
Price discrimination leads to higher profits as mentioned before. This leads to dynamic efficiency – efficiency over time. It means that firms have the supernormal profits to reinvest in reducing costs or improving quality of the product. Higher product quality for trains could include more comfortable seats or more legroom, increasing the welfare of consumers in both the elastic and inelastic groups. For example, Avanti has invested in its new Evero trains, which have more USB sockets, improved Wifi and more legroom than previous trains. Alternatively the reduced costs could be investing in energy efficiency so the trains can run on less energy. Lower costs could be passed on to the consumers in the form of lower prices, increasing consumer surplus. Profits could also cross-subsidise loss-making services such as rural train services, increasing access to public transport to those in isolated areas. Without the extra profit, these services may not have run.
Evaluation point 3
These effects depend on how the price-discriminating firm allocates its profits. If profits go to dividends for shareholders instead of investment, this may reduce the extent of dynamic efficiency benefits. Apple conducts price discrimination by charging different prices to consumers in different locations. Apple also allocates 25% of its profits to dividends, which is a relatively high share, reducing the amount available to invest in quality improvement or cost reduction. The firm also may not decide to subsidise loss-making services if its goal is solely to maximise profits.
Conclusion
Overall price discrimination is likely to be beneficial. It benefits firms through higher profits. It is also very likely to benefit the elastic group of consumers through lower prices. But the effect on the inelastic group of consumers is less clear and depends on how the firms use their profits and their objectives. If firms want to maximise profit to maximise shareholder returns, there will be less reinvestment of profit. However, aiming for a satisficing objective with a minimum profit level could allow for greater reinvestment of profit to satisfy other stakeholders, improving product quality for consumers. Regulation to prevent significant price rises or to guarantee quality of service may help make price discrimination more beneficial. Also price discrimination may be particularly helpful where there is fixed capacity. On trains for example, at peak times there may be less overcrowding, as some consumers switch to cheaper off-peak tickets.
Comments on the answer
This answer meets all the criteria for a top level answer:
- Chains of analysis are well explained, including effective use of the price discrimination diagram.
- Lots of real world examples, including in each analysis paragraph.
- This answer has focussed on the rail industry but you could pick other examples. For example, airplanes, cinemas, leisure activities such as gyms or swimming pools or technology products.
- The evaluation points are explained clearly and are relevant to the question.
- For price discrimination, this includes questioning whether the conditions required for price discrimination hold, how firms use their profits, the role of regulation and so on.
- The conclusion answers the question and gives justification. It also brings in one new evaluation point that the conclusion may depend on.
Therefore, this answer is likely to score full marks or close to it.
Other possible points include, but are not limited to:
- Second or first degree price discrimination and diagrams.
- More on the necessary conditions for price discrimination, such as the two groups each having a different price elasticity of demand or firms having price making power.
- Firm objectives may not just be to maximise profits – this is somewhat mentioned above but other examples of objectives could be considered and analysed.
- Unfairness of price discrimination.
Other essay structures are also possible.
- For example, an essay with an introduction, two long analysis paragraphs, two evaluation paragraphs and an extended conclusion can also be effective.
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