Explanation
Sales
revenue without and with Price DiscriminationIn economic terms, the purpose of
price discrimination is to capture the market's consumer surplus. This surplus
arises because, in a market with a single clearing price, some customers (the
very low price elasticity segment) would have been prepared to pay more than the
single market price. Price discrimination transfers some of this surplus from
the consumer to the producer/marketer.
It
can be proved mathematically, that a firm facing a downward sloping demand curve
that is convex to the origin will always obtain higher revenues under price discrimination
than under a single price strategy. This can also be shown diagramatically.
In
the top diagram, a single price (P) is available to all customers. The amount
of revenue is represented by area P,A,Q,O. The consumer surplus is the area above
line segment P,A but below the demand curve (D).
With
price discrimination, (the bottom diagram), the demand curve is divided into two
segments (D1 and D2). A higher price (P1) is charged to the low elasticity segment,
and a lower price (P2) is charged to the high elasticity segment. The total revenue
from the first segment is equal to the area P1,B,Q1,O. The total revenue from
the second segment is equal to the area E,C,Q2,Q1. The sum of these areas will
always be greater than the area without discrimination assuming the demand curve
resembles a rectangular hyperbola with unitary elasticity. The more prices that
are introduced, the greater the sum of the revenue areas, and the more of the
consumer surplus is captured by the producer.
Note
that the above requires both first and second degree price discrimination: the
right segment corresponds partly to different people than the left segment, partly
to the same people, willing to buy more if the product is cheaper.
It
is very useful for the price discriminator to determine the optimum prices in
each market segment. This is done in the next diagram where each segment is considered
as a separate market with its own demand curve. As usual, the profit maximizing
output (Qt) is determined by the intersection of the marginal cost curve (MC)
with the marginal revenue curve for the total market (MRt).
(Multiple
Market Price Determination) The firm decides what amount of the total output
to sell in each market. This is determined from the marginal revenue curves in
each market. The intersection of the total market price with the marginal revenue
curves in each market yields optimum outputs of Qa and Qb. From the demand curve
in each market we can determine the profit maximizing prices of Pa and Pb.
Examples
of price discrimination
Travel
industry
Airlines
and other travel companies use differentiated pricing regularly, as they sell
travel products and services simultaneously to different market segments. This
is often done by assigning capacity to various booking classes, which sell for
different prices and which may be linked to fare restrictions. The restrictions
or "fences" help insure that market segments buy in the booking class
range that has been established for them. For example, schedule-sensitive business
passengers who are willing to pay say, $300 for a seat from city A to city B,
cannot purchase a $150 ticket because the $150 booking class contains are requirement
for a Saturday night stay, or a 15-day advance purchase, or other fare rule that
effectively prevents a sale to business passengers.
Notice
also that even in this simple example, the "seat" is not the same product.
That is, the business person who purchases the $300 ticket may be willing to do
so in return for a seat on a high-demand morning flight, for full refundability
if the ticket is not used, and for the ability to upgrade to first class if space
is available for a nominal fee. On the same flight are price-sensitive passengers
who are not willing to pay $300, but who are willing to fly on a lower-demand
flight (say one leaving an hour earlier), or via a connection city (not a non-stop
flight), and who are willing to forego refundability.
Since
airlines often fly multi-leg flights, and since no-show rates vary by segment,
competition for the seat has to take in the spatial dynamics of the product. Someone
trying to fly A-B is competing with people trying to fly A-C through city B on
the same airplane. This is one reason airlines use yield management technology
to determine how many seats to allot for A-B passengers, B-C passengers, and A-B-C
passengers, at their varying fares and with varying demands and no-show rates.
With
the rise of the Internet and the growth of low fare airlines, airfare pricing
transparency became far more pronounced. Passengers discovered it quite easy to
compare fares across different flights or different airlines. This helped put
pressure on airlines to lower fares. Meanwhile, in the recession following the
September 11, 2001 attacks on the U.S., business travelers and corporate buyers
made it clear to airlines that they were not going to be buying air travel at
rates high enough to subsidize lower fares for non-business travelers. This prediction
has come true, as vast numbers of business travelers are buying airfares only
in coach class for business travel.
As
to the absolute level of airfares, they continue their 35-year downward trend
line. Whereas following World War II it took an Australian the equivalent of a
year's wages to fly from Sydney to London, today that can be done for approximately
two days' average Australian wages, and on a far faster and more comfortable journey.
The same trends are true in all deregulated areas of the world, including the
U.S., inter-E.U. flights, and U.K.
Retail
incentives
A
variety of incentive techniques may be used to increase market share or revenues
at the retail level. These include discount coupons, rebates, bulk and quantity
pricing, seasonal discounts, and frequent buyer discounts.
Incentives
for industrial buyers
Many
methods exist to incentivize wholesale or industrial buyers. These may be quite
targeted, as they are designed to generate specific activity, such as buying more
frequently, buying more regularly, buying in bigger quantities, buying new products
with established ones, and so on. Thus, there are bulk discounts, special pricing
for long-term commitments, non-peak discounts, discounts on high-demand goods
to incentivize buying lower-demand goods, rebates, and many others.
"Ladies'
night"
Many
U.S. nightclubs feature a "ladies' night" in which women are offered
discount or free drinks, or are absolved from payment of cover charges. This differs
from conventional price discrimination in that the primary motive is not, usually,
to increase revenue at the expense of consumer surplus. Rather, establishments
benefit by maintaining an equitable gender balance; if the clientele of an establishment
is primarily male, it will lose popularity with both men and women, and therefore
it is better for the establishment to lower its prices for women if they show
less demand.
Financial
aid in education
Financial
aid as offered by U.S. colleges and universities is a form of price discrimination
that is widely accepted, and completely legal.
While
tuition is set according to cost-recovery formulas for universities (which are
non-profit organizations), increasing costs mean inevitably that tuition costs
rise. (This is true even after legislatures, which control tuition rates at state
schools, try to hold down tuition rates.)
Despite
this, middle- and lower-income students are often afforded discounts in the form
of tuition waivers, scholarships, work-study programs that pay partly in free
course hours, and government guaranteed loans.
Little
objection is given to this version of price discrimination, because of the well-established
funding mechanism which does a good job of allocating positions to members of
all income classes in the US.
Dry
cleaning
In
some communities, some dry cleaners would charge higher prices for the laundering
of women's clothes than for mens', despite no difference in the costs of providing
the service. Even though this involves minor amounts of money (unlike say, college
tuition), this has provoked immediate reactdion in some US communities, who often
outlawed the practice. They also do this at some hair salons.
"Haggling"
Many
cultures involve "haggling" in market transactions-- inflated prices
are posted, but the customer can negotiate with the vendor. In the United States,
haggling is rare if not nonexistent in grocery stores and with retailers, but
common when automobiles and homes are sold. (The Saturn company is an exception.)
Negotiation often requires knowledge, confidence, and a confrontational personality,
and vendors know that many customers will pay higher prices in order to avoid
haggling.
Because
dealers will usually offer more concessions to men, it is not uncommon for women
to send male friends or relatives to purchase automobiles and homes for them.
International
price discrimination
Price
discrimination also occurs on an international level. For example, prescription
drugs may cost considerably less in Canada than in the US, because of governmental
price controls in place in Canada. Similar government price controls exist for
fuels (India, among others) and tobacco products (Indonesia).
Governments
can also use tax policy to increase prices in order to limit consumption, such
as automobile prices, which incur a 100% tax in many 3rd world countries.
Academic
pricing
Companies
will often offer discounted software to students and faculty at K-12 and university
levels. These may be labeled as academic versions, but perform the same as the
full price retail software. Academic versions of the most expensive software suites
may be priced as little as one fifth or less of retail price. Some academic software
may have differing licences than retail versions, usually disallowing their use
in for profit activities. Companies that offer academic pricing include Microsoft,
Adobe Systems and Apple Computer.
Dual
pricing
Even
within a country, differentiated pricing may be established to ensure that citizens
receive lower prices than non-citizens; this is known as dual pricing. This is
particularly common for goods that are subsidized or otherwise provided by the
state (and hence paid by taxpayers). Thus Finns, Thais, and Indians (among others)
may purchase special fare tickets for public transportation that are only available
to citizens. Many countries also maintain separate admission charges for museums,
national parks and similar facilities, the usually professed rationale being that
citizens should be able to educate themselves and enjoy the country's natural
wonders cheaply, but other visitors should pay the market rate.
Universal
pricing
"Universal"
pricing is the opposite of price discrimination-- one price is offered for the
good or service. This is usually preferred by consumers over tiered pricing. For
example, the European Union is currently making efforts to set a single-price
protocol for automobile sales.
Related
topics
Pricing
Marketing
Microeconomics
Price
Production,
costs, and pricing
Scalping
Economics,
Banking & Finance
