Price Discrimination IB Economics Ch 11

At the end of this chapter you will be able to Learning Objectives At the end of this chapter you will be able to Define and explain price discrimination Define, illustrate, give examples of, and distinguish between first degree, second degree, and third degree price discrimination

Conditions needed to discriminate An example would be an airline selling a child’s ticket to fly from Vienna to Toronto which may cost $500 while his mother’s ticket costs $700 – the product is exactly the same but the price is different and it is not to do with the cost of supply There are 3 conditions necessary for discrimination Producer must have price setting ability most often found in monopoly and oligopoly markets Not possible in perfect competition Consumers must have different elasticities of demand for the product If the PED is more inelastic they will be more willing to pay a higher price Price Discrimination: Where a firm sells identical products at different prices to different buyers for reasons other than differing cost of supply

Conditions needed to discriminate Producer must be able to separate consumers so they cannot buy and sell on Various ways they can separate Time – e.g. people travelling on trains at different times – those needing to get to work in the morning will have an inelastic demand compared to those going out shopping who can alter their time of travel Age – children are charged a lower price at the cinema because their demand is more elastic having lower income Gender – a football club in Sweden charges lower prices for female supporters than for male supporters (apparently they are not as keen and therefore have a more elastic demand)

Conditions needed to discriminate More ways they can separate Income – lawyers will often charge higher prices to wealthy clients who have a relatively inelastic demand for legal services Geographical distance – this is only possible if the cost of transferring is greater than the difference in the price CDs are sold for a lower price in the USA than they are in the EU (there are different elasticities in the 2 countries) Types of consumer – different users buy the service at different prices – electricity companies often charge different rates to industrial and domestic users If the 3 conditions don’t exist the price discrimination will not happen Be careful not to confuse promotion with price discrimination Letting girls into a night club free is not price discrimination because the PED is not different – this is just promotion Not price discrimination (promotion)

Three degrees/Levels of discrimination First degree price discrimination Each consumer pays exactly the price that he /she is prepared to pay This is how traders in a souk or market operate when they bargain to get the highest price they can In this diagram a trader is selling world cup t-shirts to tourists in a market The trader bargains with each tourist If the trader is successful he will sell one shirt at $14, one at $13, one and $12 and so on If the trader did not discriminate the total revenue (p x q) would be the shaded pale blue rectangle Because he does he eliminates the consumer surplus and gets the dark blue triangle as well Because the extra revenue received from each shirt (MR) is equal to the price D=MR First Degree Discrimination – selling each good at highest possible price to each individual buyer (perfect)

Three degrees/Levels of discrimination Second degree price discrimination A firm charge different prices to consumers depending on how much they purchase Electric and Gas companies do this They charge a high price for the first number of units (the essential ones) and a lower price for extra units consumed Mobile phone companies do the same In this diagram the first 50 messages are charged at a rate of 30 cents each and any messages over this number are charged at a reduced rate of 20 cents Second Degree Discrimination – the firm charges different prices depending on how much they purchase

Three degrees/Levels of discrimination Third degree price discrimination Consumers are identified in different market segments A separate price is charged in each market segment There are different price elasticities in each segment This is the most common type of discrimination This diagram show a typical example Cinema management has identified 2 market segments (adults and students) Third Degree Discrimination – a separate price is charged in each market segment

Three degrees/Levels of discrimination Students have a more elastic demand because they have lower incomes Management will have to charge a lower price for students than adults They can separate the segments because students will have to show some proof of status e.g. student card This diagram shows the situation for a week

Three degrees/Levels of discrimination The demand curve D(S) is more elastic than D(A) The marginal revenue curves are twice as steep We assume that they are maximising profits We use the diagram on the left to show total sales This has the marginal cost curve for the whole cinema The MR is the total of both MR(S) and MR(A) That is why it is kinked

Three degrees/Levels of discrimination The cinema will profit maximise where MC=MR It will serve 700 customers per week and the marginal cost will be $5 We can then transfer the marginal cost to each market position to find out the profit maximising position in each Student segment = 375 students for a price of $7.5 Adult segment = 325 adults at $10.25

Three degrees/Levels of discrimination In third degree discrimination a market may be broken up into more than two segments but the principle will still be the same It is just simpler to only draw 2 segments

Evaluation Price discrimination can be a good and a bad thing It depends upon the situation and who the stakeholder is Advantages to the firm: The firm can get a higher level of revenue from a given amount of sales The producer can produce more and get economies of scale Both the firm and the consumer can benefit if lower average costs are achieved and prices are lowered accordingly A firm can drive competitors out of the more elastic segment Profits gained from the inelastic market segment can be used to lower prices in the elastic segment If a firm has a strong brand in its home country it can use those profits to be aggressive in new elastic foreign markets (however, if can be proved to sell below production costs this is illegal according to the rules of the WTO

Evaluation Advantages to the consumer: The consumer may be able to purchase a good or service that otherwise they could not afford Lawyers often charge high prices to wealthy clients and lower prices to low income clients Some people will be able to purchase the product at a lower price than they would have had to pay if the producer could not charge a higher price to others Many universities charge foreign students higher tuition fees than for domestic students Price discrimination usually increases total output so the product is available to more consumers Economies of scale may equal lower prices The disadvantages to the consumer are: Consumer surplus is lost Some consumers will pay more than the price that would have been charged in a single, non-discriminated market

Time for you to do some work!! Read the case study on P137 Create a presentation for the Examination Qs on P138