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Third degree price discrimination
Price discrimination is charging different prices to different people for the same good.
The Edexcel A syllabus focuses on third degree price discrimination. This is where different consumer groups face different prices for the same good.
Real world examples of price discrimination
What are some examples of price discrimination?
Uber
- Uber provides ride-hailing services and engages in “surge pricing”, adjusting prices based on demand.
- This often includes higher prices at peak times.
- There have been reports of a surge in Uber taxi prices during a rainstorm in New York that shut down the subway.
Train tickets
- For train tickets, National Railcards for those aged 16 to 25 can give one third off for off-peak and super-off-peak train tickets.
- This also means higher prices at peak times.
- However firms may use the revenue from peak times to cover other train routes that may be loss-making.
Price discrimination can also happen on a global level, such as with Apple iPhones. Consumers in different countries are charged different prices for the same goods.
You will see other examples of price discrimination in supermarkets (loyalty discounts), theme parks or cinemas.
What are the necessary conditions for price discrimination?
For price discrimination to increase firm profits, the following conditions must hold:
1) No seepage – the firm must be able to separate the markets. In other words, the firm needs to be able to tell which consumer belongs to which group. This is so that people cannot falsely claim discounts by changing which group they belong to.
2) The firm is a price maker. This means the firm has the power to set the price, instead of taking the market price as given.
3) Different price elasticities of demand for two different consumer groups. This makes it optimal to set different prices for the two different groups.
4) Low admin costs associated with the price discrimination. This could include the costs of providing discount cards and the costs of enforcing the separation of markets. These admin costs must be lower than the revenue gain from price discrimination, in order for firms to undertake price discrimination.
The price discrimination diagram
Below is the diagram for price discrimination with explanations:
The left diagram shows the whole market (all consumers), assuming there is no price discrimination.
In the centre, the diagram is for the consumer group with price-inelastic demand.
- There, the MR and AR curves are steeper.
- For this consumer group, the firm increases the price from p to p1
- The higher price leads to an increase in revenue, as the output level only falls by a little.
- However the higher price does reduce consumer surplus for this group.
The right diagram is for the consumer group with price-elastic demand.
- In this case, the MR and AR curves are flatter.
- The firm lowers the price for these consumers from p to p2 .
- The lower price leads to an increase in revenue, as the output level increases significantly.
- Also the lower price increases consumer surplus for this group.
Note we assume one horizontal MC = AC line for these diagrams for simplicity.
Who benefits and who loses out from price discrimination?
Here is a summary of the key effects of price discrimination for firms and consumers (where CS = consumer surplus). Explanations are below the table.
Firms:
- Higher revenues from both the price-inelastic and price-elastic consumer groups.
- This increases the level of supernormal profit for the firm.
- This may prevent a firm from shutting down.
- Manage capacity / make use of spare capacity such as on trains and airplanes. By moving consumers away from peak times to off peak times, this ensures the spare capacity at off peak times is used, while overcrowding at peak times can be prevented. This makes more efficient use of firms’ available capacity.
- The firm can invest profits into improving the quality of the service.
- Alternatively the firm can allocate extra profits towards shareholder dividends, making shareholders better off.
- Administrative costs involved in setting different prices and enforcing price discrimination, e.g. by making sure a consumer from one group does not buy a cheaper ticket intended for another group of consumers.
Consumers:
- The consumer group with price-elastic demand benefits from lower prices and higher output, increasing consumer surplus.
- The consumer group with price-inelastic demand is worse off from higher prices and lower output. This decreases consumer surplus.
- As firms have higher profits, they may invest more in improving the quality of the service. This may benefit consumers.
- Reducing demand at peak times, while increasing demand at off-peak times, may help to manage capacity and prevent overcrowding.
- Price discrimination can reduce inequality if the group with price-elastic demand is a lower income group. However it can increase inequality if the reverse is true.
- Firms can use higher profits to fund (or ‘cross-subsidise’) routes that make a loss, preventing their closure. For example rural bus routes.
Further evaluation points for price discrimination
The effects of price discrimination depend on:
- How firms allocate extra profits made from price discrimination. Do profits go towards shareholder dividends or firm investment?
- Whether firms can separate the different consumers. This includes whether the admin costs of enforcement to prevent seepage exceed the increase in revenue from price discrimination.
- The extent of the firm’s price-making power. A firm may face competition within or outside the market. For instance, if a train company raises prices too far, other train competitors may enter the market or people may switch to other alternatives such as buses. This would reduce the revenue gain from raising prices for some consumer groups.
- The extent of regulation, for example competition regulators could put in place a price cap on train ticket prices. This would reduce the extent to which train companies can increase prices for peak consumers.
Generally for evaluating price discrimination, you can also think about whether the necessary conditions for price discrimination will always hold.
The level of regulation is another great evaluation point when discussing the effects of market power or mergers.
Practice question on price discrimination
This is a practice question written in the style of Edexcel Economics A. It features a short text, followed by a question.
Some companies have faced criticism for price discrimination. Surge pricing increases prices temporarily at peak times and can be used for private taxis, plane tickets or tickets to sports events.
Question: Discuss the benefits of price discrimination. (25 marks)
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