What is price discrimination?

Price discrimination is a pricing strategy where one business charges consumers different prices for identical goods and services in different markets. In essence, businesses use price discrimination to ensure they maximize the revenue that is made from each customer. Price discrimination is a pricing strategy where identical or near-identical products and services are sold at different prices in different markets by the same supplier.

Understanding price discrimination

The price of movie tickets is one example of price discrimination at work, with separate prices for children, adults, families, and seniors. Movie ticket prices also vary according to the time of day and whether the movie is a blockbuster new release or a timeless old classic.

Three types of price discrimination

There are three general types of price discrimination, with each consisting of various pricing strategies businesses use. An explanation of each of these is provided below.

First degree

First degree price discrimination is also known as perfect price discrimination and this perfection makes it difficult to implement in practice.

Nevertheless, it involves the business charging the maximum price consumers are willing to pay for each unit of product or service sold. This allows the business to capture all the consumer surplus in the market, which can be defined as the difference in price between what the consumer actually pays and what they are prepared to pay.

Second degree

Second degree price discrimination is perhaps the most recognizable and involves the business charging a different amount according to the amount or quantity consumed. Frequent flyer programs, for example, reward customers with cheaper tickets the more they fly with an airline. Phone and internet data also tends to be cheaper the more data that is consumed.

Second-degree price discrimination is sometimes referred to as indirect price discrimination since companies allow consumers to choose what price they will ultimately pay. Some choices which appear more cost-effective on the surface are only affordable because the business imposes an extra cost on the consumer. This includes pricing that is influenced by coupon collecting and bulk purchases, among other factors.

Third degree

Third degree price discrimination is the strategy that movie theatres employ where different prices are charged to different groups of people such as:

  • Students.
  • Seniors.
  • Emergency services personnel.
  • Veterans.
  • Men or women.

This form of price discrimination is also often used by utility, parking lot, and gym businesses to charge one price for peak usage and another for off-peak usage. 

What are the necessary conditions for effective price discrimination?

For price discrimination to be effective, a few conditions must be met:

  1. The company must be a price maker – that is, it must operate in an imperfect market with a demand curve that slopes downwards. The company should also possess some degree of monopoly power.
  2. The ability to separate markets – the company must also be able to prevent the resale of its products and services to consumers who would otherwise have to pay a higher price. A children’s movie ticket, for instance, would need to be distinguishable from an adult’s ticket. Microsoft Office for university students must also be kept separate from home or workplace users. Online, eCommerce companies use dynamic pricing where prices vary from second to second according to real-time demand and other metrics.
  3. Elasticity of demand – there must also be different elasticities of demand within the same market for price discrimination to be effective. Lower-income individuals tend to be more elastic to the cost of an airline ticket than business travelers. This means the airline can sell cheaper “red-eye” flights or those without meals to target this segment.

Key takeaways:

  • Price discrimination is a pricing strategy where identical or near-identical products and services are sold at different prices in different markets by the same supplier.
  • There are three types of price discrimination: first degree, second degree, and third degree. Each type has a selection of unique price discrimination strategies.
  • To be effective, price discrimination must be carried out by a company operating in an imperfect market with the ability to segment its products. There must also be varying elasticity of demand within the market itself.

Read Next: Pricing Strategies, Dynamic Pricing.

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