Understanding Three Types of Price Discrimination

In this post, I will discuss three common types of price discrimination. Brifely, price discrimination means that some commodity is sold at different prices to different customers. Here, different prices indicate different ratios to marginal costs. Price discrimination is often used by monopolists or oligopolists to drive profit maximization.

There are three conditions for price discrimination to be available:

1. The firm must have some market power.
   • Market power is the ability of a firm to raise its price above the competitive level by reducing output.
   • Barriers to entry (natural advantages, control resources, tech superiority, network externality, patent protection, etc.) can induce market power.
2. The firm must have the ability to sort consumers.
   • The market can be categorized simply by age, gender, location, etc.
   • The customers can self-selected into appropriate categories.
3. The firm must be able to prevent resale.
   • Resale can lead to arbitrage that reduces a firm’s profit.
   • Set barriers to resale, add transaction cost/tax for resaling, etc.

What types of price discrimination should be encouraged or disencouraged? In general, there are three different types:

1. First-degree price discrimination
2. Second-degree price discrimination
3. Third-degree price discrimination

First-degree price discrimination

First-degree price discrimination is also called perfect price discrimination. It says that a different price is charged for each unit of the good brought. In pursuing profit maximization, the seller sells each unit of the good at the maximum price that anyone is willing to pay for that unit of the good. Alternatively, it sometimes defined as occurring when the seller makes a single take-it-or-leave-it offer to each consumer that extracts the maximum amount possible from the market.

It may sound impossible to charge each unit of the good brought a different price. Another way around is to impose two-part tariffs that first set the price equal to the marginal cost of producing the good, then set the entrance fee that extracts all of the consumer’s surplus. This result is equalivent to reaching Pareto welfare optimality.

Second-degree price discrimination

Second-degree price discrimination, or nonlinear price discrimination, says that different prices are charged depending on the number of units of the good brought. Quantity discounts or coupons in supermarket/grocery stores are common examples of second-degree price discrimination.

For simplicity, assume there are two types of consumers. Low demand type consumers have a marginal value of the good larger than the marginal cost, thus, they consume an inefficiently smaller amount of the good. Higher demand type consumers have a marginal willingness-to-pay equal to marginal cost, thus, they consume the socially correct amount. Therefore, higher demanders pay a lower per-unit price than low demanders.

Third-degree price discrimination

Third-degree price discrimination says that different consumers are charged different prices, but each consumer faces a constant price for all units of the good purchased. Student discounts in bookstores, or beverage happy hour in pubs are common examples of third-degree price discrimination.

If the seller can seperate the consumers in the market by their elasticity of demand, then, consumers with more elastic demand (more price sensitive) is usually charged the lower prices. If the seller can choose the division of the market, the optimal division threshold is set where the profits earned from charging marginal consumer the higher price must equal the profits earned from charging the lower price. Social welfare will always increase by shifting the breakpoint in the direction of the lower prices. This is why we often see limited happy hour offer, or limited urgent flight sales.

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Reference:

1. “Price Discrimination”. Hal R. Varian. Handbook of Industrial Organization, Chapter 10, Vol. 1, by Schmalensee R. and Willig R.