Price discrimination refers to the practice of charging different prices to different buyers for the same product. Even though the quality and cost of production are the same, the company tries to take advantage of various market needs, for example, in terms of willingness to buy and purchase volume.
To be able to discriminate prices, companies must have market power. As a consequence, a perfectly competitive market does not allow companies to discriminate prices because no one company has it. And, this practice usually takes place in oligopoly and monopoly markets, where producers have the ability and opportunity to do so.
Some industries that often adopt price discrimination strategies are the pharmaceutical, textbook publishers, and the travel industries. Some strategic sectors, such as utilities and electricity – which are usually controlled by one company – also often apply discrimination strategies.
In addition to differentiating prices, companies also often complement discriminatory practices with related marketing features, including age discounts, job discounts, coupons, age-based prices, and so on.
Three types of price discrimination are:
- First-degree price discrimination
- Second-degree price discrimination
- Third-degree price discrimination
First-degree price discrimination
First-degree price discrimination or perfect price discrimination occurs when a company can charge each individual the highest price that he is willing and able to pay.
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Take the case, customer A is willing to pay Rp30, and customer B is willing to pay Rp50. Then the company will charge IDR 30 to customer A and IDR 50 to customer B. That way; the company will get the maximum profit.
Because it imposes the highest price that a customer is willing to pay, the consumer surplus of each individual is zero. And, in total, perfect price discrimination allows producers to convert the total consumer surplus into a producer surplus.
Two criteria must be met for the company to impose perfect discrimination. First, companies must measure and know for sure the maximum price that each individual is willing to pay. Second, the company can prevent the resale of goods between individuals. In the example above, the company prevents customer A (who buys at a low price) from selling to customer B (who buys at a higher price). Presumably, both of these requirements are difficult to fulfill. Therefore, perfect price discrimination is impractical in the real world.
Second-degree price discrimination
In this type of discrimination, the company uses the purchase volume as an indicator of willingness to buy. The purchase volume also represents how a customer values a product. When purchasing large quantities, the customer is considered valuing the product highly and are, therefore, willing to pay a higher price per unit.
The company uses this information to differentiate the prices of each customer. The company will sell small quantities at marginal prices and large amounts at higher prices.
Third-degree price discrimination
This discrimination can occur if a company can group customers into various segments based on geographical variables or other non-volume variables. The company then charges a higher price to one group of customers while charges a lower price to another group.
Take, for example, the imposition of airline fares. Companies charge higher rates for one-way round-trip tickets because they are more likely to be bought by businessmen.
Success of discrimination
Discrimination is successful when companies can prevent the transfer of goods from cheaper markets to more expensive markets. Or avoid the resale of products from individuals who buy cheaper to individuals who buy more expensive. In this case, transportation costs are essential.
High transportation costs reduce the profit margins obtained from the resale of goods, supporting the success of price discrimination. Not surprisingly, discriminatory practices are more successful in different foreign markets because they involve long distances, thus increasing transportation costs.
Its success also depends on switching costs. When it is easy for consumers to switch to a substitute product or competitor’s product, it is difficult for a company to discriminate against prices.
Companies must also be able to control supply. Besides that, inter-markets have different elasticity prices for the same product.
Effect of market structure
Price discrimination is impossible in perfect competition. Because market demand in each market is perfectly elastic, the company takes the market price as the selling price of its products. In the long run, there is no opportunity for companies to charge prices higher than the market price.
Discriminatory practices are more likely in imperfectly competitive markets, especially in monopoly markets. Because there is only one producer in the market, the monopolist has absolute control over the pricing, supply, and quality of the product. Monopolists can sell their products in some situations in two or more markets with different prices to maximize profits.