Do you ever drive to a different part of town and say to yourself, “Wow, gas is so much more expensive here!”?
Or maybe you’ve thought to wait to buy tickets to a sporting event in hopes that they’ll drop in price.
Both of these are common examples of price discrimination. In fact, price discrimination happens more often than you think, you just need to know the signs to look for.
What is price discrimination?
Price discrimination is a pricing strategy that charges customers varying prices for goods or services based on certain criteria or what the seller believes the customer will agree to pay.
What are the three types of price discrimination?
- First-degree price discrimination: the seller knows the maximum price a consumer is willing to pay
- Second-degree price discrimination: the price of the product varies based on demand
- Third-degree price discrimination: the price of the product varies based on attributes like age or sex
It’s important to remember that price discrimination charges customers a different price for the same product or service based on a specific bias toward a group of people or specific characteristics. For example, the product or service may be a different price for adults versus senior citizens or domestic buyers versus international buyers.
The point of doing so is so a seller can capture the consumer surplus. Their goal with price discrimination is to generate the most revenue possible for the product or service they are offering. It is most valuable for the seller to utilize price discrimination when there is a profit to be earned by when markets are separated.
When sellers go about price discrimination, they look at the type of market their product or service is in. For instance, if it's within an elastic market the price can change the demand of the product. But, if it's within an inelastic market, the demand won't change when the price changes.
For those who are visual learners, let's break it down.
If the marginal cost (MC) of a product or service is consistent across all market, whether or not it's divided, it will equal the average total cost (ATC). Maximum profit occurs at the price and output where MC is equal to marginal revenue (MR).
However, if the market is separated, then the price and output of a product in an inelastic market will be P and Q, while P1 and Q1 in an elastic sub-market.
Image Source: Economics Online
Types of price discrimination
There are three types of price discrimination that you can encounter: first-degree, second-degree, and third-degree. These degrees sometimes go by other names: personalized pricing, product versioning or menu pricing, and group pricing, respectively.
First-degree price discrimination
First-degree price discrimination, or perfect price discrimination, happens when a business charges the maximum possible price for each unit.
Since prices vary for each unit, the company selling will collect all consumer surplus, or economic surplus, for itself. In many industries, a company will commit first-degree price discrimination by determining the amount each customer is willing to pay for a specific product, and selling that product for that exact price. This can be done using market research strategies in addition to using budgeting and forecasting software.
Related: Interested in learning more about budgeting and financing software to plan for the future of your business? Read the reviews on some of your options!
Second-degree price discrimination
Second-degree price discrimination, otherwise known as product versioning or menu pricing, happens when a company charges a different price for varying quantities consumed, such as offering a discount on products purchased in bulk.
Third-degree price discrimination
Third-degree price discrimination, or group pricing, is when a company charges a different price to a specific consumer group. This is the most common type of price discrimination.
Price discrimination examples
There are many industries that use price discrimination.
For example, when a consumer purchases airline tickets several months in advance, they will typically pay less than a consumer who purchases a ticket for the same flight two days before. This is because when the demand for a particular flight is high, airlines raise the ticket prices as a response. Similarly, airlines will get passengers to pay more for added perks, like legroom.
Another example would be how movie theaters, restaurants, or amusement parks often offer senior discounts for those over a certain age, or student discounts for moviegoers with a school ID.
There’s also the example of warehouse retailers, like Costco, that sell bulk items at discounted prices, as well as loyalty or reward cards for frequent customers. And, any time there is a “Ladies Night” at a bar or club that offers a different price for women is also a unique form of price discrimination.
Some others examples that fall within price discrimination:
- Coupons: Retails assume that customers who collect coupons are ore sensitive to a higher price than those who don't. By offering coupons, a seller can charge a higher price to customers who don't use coupons while also providing a discount to those who do.
- Discounts on occupation: Many business offer reduced prices to those who are currently serving in the military. The same can be said during a promotion such as "Nurses Appreciation Week" to those who work in the nursing field.
- Premium pricing: A product that has premium pricing is being sold far beyond its marginal value. For instance, you may see a "premium cup of coffee" at your local coffee shop that is prices at $3.50, while a regular cup is only $2.
- Retail: Retail incentives include rebates, buying in bulk, and seasonal discounts. They are used to increase market share or revenue on specific products.
- Financial aid: When college students apply for financial aid, the amount they are offered is based on their parents economic and financial situation.
Advantages and disadvantages of price discrimination
Whether you're a seller or a consumer, there are advantages and disadvantages to price discrimination.
If you're a business looking to utilize price discrimination, some advantages include:
- Maximizing a profit: When a price is matched to a specific characteristic within the market, the profit is maximized and the business can utilize the consumer surplus within the market to their advantage.
- Economies of scale: Charging varying price of a product can increase sales, thanks to new consumers entering the market.
- Efficient use of space: When used correctly, price discrimination can clear existing stocks of products faster, creating a better use of the store, shop, or factory space.
- Understanding the flow of customers: When a business makes the most of "happy hours" or "early bird specials" it encourages customers to adjust their shopping times so that they're not waiting in long lines or shopping during busy hours.
On the other hand, price discrimination can result in some disadvantages, too, especially for the consumer. They include:
- Taking advantage of specific markets: If a consumer is living in an inelastic market, it is very easy for them to be exploited and overcharged. An example would be a consumer paying a high price for a plane ticket during the holiday season.
- Limitations: For consumers, there are always limitations that go hand-in-hand with price discrimination. For example, there can be limits to which different prices can be applied, how many coupons a consumer can use, if they fall into multiple groupings being discriminated against, and others.
You get what you pay for
And sometimes the price you pay is more than what someone else would pay. It’s more common than you think, and moving forward you will hopefully be able to spot price discrimination in action.
When you're done considering price, learn more about the four types of market segmentation, in addition to the most common mistakes.