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What’s it: First-degree price discrimination is a type of price discrimination in which producers charge each customer the highest price they are willing and able to pay. We also call this perfect price discrimination.
Types of price discrimination
Before getting into any further, let’s take a quick look at price discrimination. Price discrimination is when producers charge different prices for the same product to different customers. Economists divide them into the following three categories:
- First-degree price discrimination
- Second-degree price discrimination
- Third-degree price discrimination
Price discrimination works when consumers have different preferences and reservation prices. The reservation price is the highest price they are willing to pay. By charging different prices, firms get more profit than charging single prices.
First-degree price discrimination
In this strategy, the company sets the price according to the reservation price of each consumer. The main objective of first-degree price discrimination is to take all consumer surplus from its customers as the company’s profit.
Second-degree price discrimination
Under second-degree price discrimination, firms use purchasing volume to indicate consumer preference and willingness to buy. When they like and choose a product, consumers will be willing to pay a higher price and buy a larger quantity. Conversely, if they don’t like it, they are likely to buy a small amount. The company then uses such information to assign a different price to each customer.
An example of second-degree price discrimination is volume discounts. However, it works oppositely. In this case, the company rewards customers who buy in bulk by providing a price discount. And, the firm charges a higher price per unit for the lower volume of purchases.
Third-degree price discrimination
Under third-degree discrimination, firms set prices differently by segmenting consumers based on geographic or other non-volume variables.
Some of these segments may have inelastic demand, so they are less sensitive to price increases. Meanwhile, demand in other segments tends to be elastic, so price increases can lead to a more significant decrease in sales volume.
From this information, the company then charges a different price for each segment. For example, for a segment with inelastic demand, firms charge a higher price. Because demand is inelastic, the effect of an increased price is higher than the effect of a decreased sales volume. Thus, the total revenue will increase. And because the company sells lower volumes, the total costs will also go down. That implies increased profitability.
Conditions for first-degree price discrimination
The success of first-degree discrimination depends on the following factors:
First, the company operates in a monopoly market. It controls supply and has absolute market power.
When there are multiple players, a manufacturer finds it challenging to price first-degree discrimination. If they sell at the reservation price, the consumer will switch to another player.
Likewise, monopoly markets have high entry barriers. Also, the product has no substitutes. Thus, the threat from new entrants and product substitutes is low. And therefore, consumers have no alternative to divert purchases.
Second, the company knows the reservation price of each consumer. That way, the company can maximize profits by assigning different prices to each customer according to their reservation price.
If companies do not have this information, the price may be higher or lower than the reservation price. When the price is higher, consumers will not buy. Conversely, when prices are lower, profits are less maximized.
Third, companies can prevent arbitrage. I mean, the company can prevent the resale of products from one buyer to another.
Conversely, if arbitrage occurs, firms cannot extract the entire consumer surplus in the market. Consumers who buy at lower prices seek to capture profits by reselling products to consumers with a higher reservation price. Ultimately, it is the consumers who capture the profits, not the companies.
Fourth, demand has a different price elasticity for the product. In other words, each consumer varies in their responsiveness to price changes, reflecting different reservation prices and preferences. That way, the company can sell products to each consumer according to the reservation price and demand volume.
An example of first-degree price discrimination
Let me take an example to explain first-degree price discrimination.
Assume the monopolist has 3 buyers, each with the following detailed reservation prices:
- 1st buyer: $10
- 2nd buyer: $7
- 3rd buyer: $5
To maximize profit, firms produce output when marginal income equals marginal cost. Assume the profit-maximizing output is 4 units. At this level of output, the firm sets a price of $3.
The company will not produce more than 4 units because the loss due to marginal cost is higher than the marginal income. Conversely, by producing less than 4 units, the company’s profits are less than optimal.
In the above case, the company should have set a market price of $3. But, being the sole producer, it can increase profits by setting price discrimination.
Say, the company knows the price of each buyer’s reservation. In this case, first-degree price discrimination occurs when the company charges $10, $7, and $5 to each buyer.
If there is no price discrimination, the first buyer’s consumer surplus is $7. It represents the difference between the reservation price and the market price, which is $10-$3. In other words, a surplus arises because the market price is lower than the reservation price.
Due to price discrimination, the company charges $10 to the first buyer. As a result, a surplus of $7 was lost, and he could not enjoy the lower market price. On the other hand, the surplus becomes the company’s profit.
Likewise, the second and third buyers’ consumer surpluses are $4 ($7-$3) and $2 ($5-$3, respectively). However, due to price discrimination, neither of them enjoyed a surplus. The company extracts them into profit.
From this example, we know that perfect price discrimination works when the monopolist knows each reservation’s price.
Also, the company must ensure that buyers do not resell products to other buyers. If it can’t do this, the first buyer will most likely buy from the second or third buyer because it is lower. Likewise, for example, a second or third buyer could profit by selling the product to the first buyer slightly lower than the market price, say $9.
A closer example of first-degree discrimination is online auction like eBay. An auction occurs when consumers bid up to the maximum amount they are willing to pay.
Is first-degree price discrimination efficient?
First-degree price discrimination is efficient. It does not result in deadweight losses, so no economic welfare is lost.
Manufacturers charge each according to their reservation price. In other words, the firm charges its prices at points along the demand curve.
By doing so, producers extract consumer surplus into producer surplus. Since the total surplus remains the same (that is, as large as the producer surplus), first-degree price discrimination is efficient.
Although Pareto is efficient, however, of course, the practice is unfair to consumers. They have to pay a higher price than when it is under a competitive market.
First-degree price discrimination issues
The practice of first-degree discrimination is difficult. The reason is, firms generally do not have sufficient information about the reservation price of each customer. Despite this information, they find it challenging to prevent arbitrage.
Also, the company bears administrative costs for implementing the discrimination strategy. They need resources and incur costs to prevent arbitration and collect reservation price information.
Furthermore, some consumers have to pay higher prices. When their reservation price is higher than the market price (competitive price), they have to spend more money than they should. Conversely, when the reservation price is lower, some other consumers pay less, and of course, it benefits them.
And conceptually, if successful, first-degree discrimination is a form of cross-subsidy. Consumers who pay higher prices “subsidize” those who pay lower prices. However, it does not make sense for companies to set selling prices below competitive prices.
