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what is price discrimination?
where firm sells same product at different prices to different customers
what is the aim of price discrimination?
to further maximise profits by extracting some or all of consumer surplus
what are the types of price discrimination?
first degree
second degree
third degree
first degree price discrimination
where firm charges each and every customer the max price they are willing to pay;
attempting to extract ALL consumer surplus and turn it into producer surplus
D curve becomes MR curve
evaluation of first degree price discrimination
this is unlikely to happen as cost of finding out every individual’s price preferences would be well in excess of any potential profits gained
second degree price discrimination
firm seeks at profit maximising output then sells any excess capacity cheaply
typically where FC are very high
so any marginal output - even sold at MC - will bring in some additional outcome (something is better than nothing)
an example of second degree price discrimination
AIRLINE INDUSTRY
very high fixed costs
standard pricing strategy will cover these fixed costs and all related marginal costs.
however, any unsold seats will be sold off last minute at a discount, as long as the price simply covers the marginal cost.
third degree price discrimination
firm splits market into diff customer groups
charge a diff price to each sub group
illustrated through 3 panel diagram
evaluation for third degree price determination
the cost of separating the market into sub groups must not exceed the increase in profits gained
what conditions are necessary for price determination to succeed?
Firm must have some degree of market power
Downward sloping AR curve
hence the firm can vary prices
Identifiable market segments, each with a different PED
Charge lower price in elastic market
Higher price in inelastic market
No possibility of arbitrage
i.e. where customers buy the product in the low-price market and resell it in the high-price market
This would take away the firm's high-price market
Thus the firm would have no more incentive to practise
costs of price discrimination
allocative inefficiency
inequalities
anti-competitive pricing
Price discrimination operates mainly in the interests of producers as they extract consumer surplus and turn it into extra profit
Can be used as a pricing tactic to reduce competition and reinforce the market dominance of leading firms
May lead to manipulation of groups with a price inelastic demand, not all of whom are on high incomes
Can be perceived as unfair or inequitable to certain groups e.g. alleged gender pricing
Exploitation of the consumer - the majority of consumer still pay more than marginal cost
Extraction of consumer surplus turned into higher producer surplus / supernormal profit
Possible use of discrimination as a limit pricing tactic / and a barrier to entry to rival firms
Ultimately, if successful, it reinforces the monopoly power / dominance of existing firms
benefits of price discrimination
dynamic efficiency
economies of scale
some consumers benefit
cross subsidisation
Makes better use of spare capacity leading to less waste and unsold stock. There are potential environmental benefits from this strategy.
Helps generate cash flow for businesses which can ensure their survival during a recession / tough economic times
Can help fund the cross-subsidy of goods and services e.g. premium prices for some can fund discounts for other groups
Higher monopoly profits can finance research which drives improved dynamic efficiency and can lead to important social benefits
social benefits i.e. charging much lower prices for drugs in lower & middle-income countries
making better use of spare capacity - this can have environmental benefits - e.g. less waste
It brings new consumers into market - who would otherwise excluded by a 'normal' higher price
Use of monopoly profit for research - this is a stimulus to innovation / dynamic efficiency gains
the welfare case against price targeting
exploitation of the consumer - the majority of consumer still pay more than marginal cost
extraction of consumer surplus turned into higher producer surplus / supernormal profit
possible use of discrimination as a limit pricing tactic / and a barrier to entry to rival firms
ultimately, if successful, it reinforces the monopoly power / dominance of existing firms
arguments in support of price targeting
potential for cross subsidy of activities that bring social benefits i.e. charging much lower prices for drugs in lower & middle-income countries
making better use of spare capacity - this can have environmental benefits - less waste etc
it brings new consumers into market - who would otherwise excluded by a 'normal' higher price
use of monopoly profit for research - this is a stimulus to innovation / dynamic efficiency gains
other pricing strategies
cost-plus pricing
predatory pricing
limit pricing
cost-plus pricing
AKA ‘mark-up’ pricing
where firm sets its price as:
AC + desired profit margin
without any reference to D curve
e.g. if AC =10
desired profit margin without any reference = 20%
price = £12
advantages of cost-plus pricing
easy to calculate, low cost of computation
pricing decisions can be made at a relatively junior level in a business based on formulas
Price increases can be justified when costs rise
Price stability may arise if competitors take the same approach (and if they have similar costs) - reduces the costs of price
pricing stability gives consumers confidence in a business as price increases can be deemed as profiteering and decreases as the actions of a struggling business
disadvantages of cost-plus pricing
not necessarily profit max (MC = MR)
however, over time the mark up may be changed based on attempting to maximise profits based on the level of competition and other factors
fluctuations in prices
rises viewed as profiteering
falls viewed as sign of weakness / poor market performance
predatory pricing
a short-run strategy where a firm
sets price below AVC (i.e. P < AVC)
in order to force existing rivals out of the market..
...to achieve market dominance and greater SNP in the long run
how is the firm able to make a loss and still survive using predatory pricing?
in the short-run
cross-subsidisation of losses
in the long-run (once competitors have left the market):
raise price above previous competitive levels...
in order to recoup any losses incurred during the period when P < AVC
examples of predatory pricing
Esso and Shell face allegations of 'predatory pricing' over fuel cost (2013)
Wal-Mart convicted in 3 cases in Germany and USA of essential items e.g. Milk (2000)
Newspaper group (subsidiary of Daily Mail group was fined by the OFT for predatory pricing (free advertising space) and trying to eliminate its main competitor. Aberdeen Journals were fined £1.3million.
Debatable: Microsoft's decision to offer its web browser (Internet Explorer) helped to make it very difficult for its main competitor (Netscape) who was also forced to offer its web browser for free.
limit pricing
where price is set below the AC of potential rivals, in order to prevent new competitors entering the market
incumbent firm will
have the benefit of economies of scale and therefore a lower AC curve
thus can reduce price to just above its own АС..
..and guarantee that any small new entrant will make a loss
a powerful disincentive for new firms to enter the market
Limit-pricing is therefore a man-made entry barrier
