Applying Price Discrimination

Idea

Price discrimination — charging different consumer groups different prices for the same good — lets a firm raise its total revenue and profit, but only where three conditions hold. The 9570 focus is the third-degree case.

Mechanism

For (third-degree) price discrimination to be effective:

1. Price-setting power. The firm must be able to set price — that is, it must have a degree of monopoly power. A firm with little market power cannot discriminate, because consumers would simply buy a substitute from a rival.

2. Separable markets with no seepage. The firm must be able to keep the groups apart — by geography, age, gender or similar — so that it is impossible or prohibitively costly for a consumer to buy in the low-priced market and resell in the high-priced one.

3. Different price elasticities of demand. The groups must differ in price elasticity of demand. The firm then charges the higher price to the group with the more price-inelastic demand (quantity demanded falls less than proportionately) and the lower price to the group with the more price-elastic demand (quantity demanded rises more than proportionately). Charging each group according to its elasticity raises total revenue above what a single price would yield.

Considerations

The welfare effects cut both ways, and supply ready evaluation. Price discrimination transfers surplus from consumers to the firm: the firm gains producer surplus, while consumers in the inelastic market lose consumer surplus by paying more. Yet consumers in the elastic market — often lower-income — may now afford a good they otherwise could not, gaining consumer surplus and arguably improving equity. Whether the practice is judged harmful or beneficial therefore depends on which group’s effect is weighted more heavily.