Price discrimination occurs when firms charge individual customers (or groups of customers) different prices for the same goods or services. That means, instead of charging all consumers one single price, they set different prices for different customers, depending on the maximum amount these customers are willing to pay. This allows the firms to increase profits by skimming off consumer surplus.
This practice requires firms to have in-depth knowledge about their customers. Depending on the information available and the given circumstances, various degrees of discrimination can be applied. In the following paragraphs, we will look at the three most common types of price discrimination: first, second, and third-degree price discrimination.
First-Degree Price Discrimination
First-degree price discrimination occurs when a firm charges each customer the maximum amount they are willing to pay for a good or service. This practice can only be applied if the company knows the maximum willingness to pay for each individual customer. It describes the highest possible level of price discrimination which is why it’s sometimes also referred to as perfect price discrimination. When the required information is available, the firm can maximize profits and eliminate all consumer surplus.
To illustrate this, let’s look at an imaginary restaurant called Deli Pizza. Assume this restaurant knows each consumer’s maximum willingness to pay for a pizza. So instead of charging every customer the same price, everyone has to pay exactly as much as they are willing to. That means, if you are willing to pay USD 8.00 for a pizza, you pay USD 8.00. Meanwhile, your friend who is willing to pay USD 10.00 pays USD 10.00 and so on and so forth. As a result, Deli Pizza can maximize profits without reducing the total quantity sold and thereby eliminate consumer surplus.
Please note that first-degree price discrimination is mainly a theoretical construct. In practice, it’s virtually impossible for firms to assess each consumer’s maximum willingness to pay. This makes it almost impossible to implement this level of discrimination in reality.
Second-Degree Price Discrimination
Second-degree price discrimination occurs when firms offer different prices depending on the quantity purchased. This strategy can be applied when there are at least two groups with a different willingness to pay but the firms cannot identify which consumers belong to which group. The most common form of second-degree price discrimination is bulk discounts. This allows companies to extract some additional consumer surplus from customers with a higher demand by giving them a discount on larger quantities.
To illustrate this, let’s revisit our pizza example from above. Now, assume Deli Pizza does not know each customer’s maximum willingness to pay. Instead, the restaurant knows there are exactly two types of consumers: hungry and starving consumers. Hungry consumers are willing to pay USD 8.00 for a regular pizza. Meanwhile, starving consumers have a higher demand so they would be willing to buy more than a regular pizza at that price. Therefore Deli Pizza can create an additional extra-large pizza which is twice as large as a regular one but only costs USD 15.00. This encourages starving customers to buy the larger quantity and allow the restaurant to extract more of their consumer surplus.
Second-degree price discrimination is quite common in practice. It is much easier to implement than first-degree discrimination because it requires less information. However, unlike first-degree discrimination it only allows firms to extract some (but not all) consumer surplus.
Third-Degree Price Discrimination
Third-degree price discrimination occurs when firms charge different prices to different groups of customers. This form of discrimination can be applied when companies are able to identify at least two groups of consumers that have a similar willingness to pay (i.e. they know which consumers belong to which group). The most common forms of third-degree price discrimination are discounts based on demographic criteria (i.e. age, income, size of family), location or time.
For example, students don’t usually have a regular income. As a result, many of them won’t be willing to spend USD 8.00 for a pizza. Knowing this, Deli Pizza can create a special offer for students where they can get a pizza for USD 5.00. The only requirement is that they provide a valid student ID. This allows the restaurant to easily identify students while still charging regular prices for all other customers.
Third-degree price discrimination is the most common one in reality, especially in the service sector. The reason for this is that the companies must be able to prevent the resale of their products for this form of discrimination to work. Otherwise, the consumer groups who pay a lower price could simply buy the product and sell it at a higher price (below the regular price) for a profit.
In a Nutshell
Price discrimination allows firms to increase profits by charging individual customers (or groups of customers) different prices for the same goods or services. Depending on the information available and the given circumstances, three types (i.e. degrees) of price discrimination can be applied: first, second and third-degree. First-degree price discrimination occurs when companies charge each customer the maximum amount they are willing to pay for a good or service. Second-degree price discrimination occurs when firms offer different prices depending on the quantity purchased. And finally, third-degree price discrimination occurs when firms charge different prices to different groups of customers.