Barry Haworth
University of Louisville
Department of Economics
Economics 442

Price Discrimination: A Summary

Discussions of firm pricing behavior often assume that a firm will charge the same price to all consumers. In reality, we find examples like theatres who charge different prices to students, the general public, seniors, etc. - even though the cost of supplying "entertainment" to each of these consumer types is the same. This corresponds with a practice known as price discrimination.

What is price discrimination? The standard discussion of price discrimination centers on the following brief definition: "Price discrimination is the sale (or purchase) of different units of a good or service at price differentials not directly corresponding to differences in supply cost." (Scherer and Ross, 1990)

How do firms conduct price discrimination? Price discrimination is founded on a firm's ability to distinguish amongst buyers, based on their varying demand characteristics for a particular product. The more a firm is able to do so, the more perfect the degree of price discrimination.

Three conditions must exist to enable a firm to profitably price discriminate: (a) the firm must have market power, (b) the firm must be able to distinguish among buyers on the basis of their demand-related characteristics (e.g. demand elasticity or reservation price), and (c) the firm must be able to constrain resale between buyers with high and low reservation prices (or demand elasticities).

There are three degrees of price discrimination (illustrated below): (a) first degree (perfect), where firms charge each consumer their reservation price for the good; (b) second degree, where firms charge "blocks" of consumers their reservation price for the good; and (c) third degree, where firms divide consumers into two or more submarkets, each with its own demand curve, and independently maximize profits in each submarket.

What types of price discrimination are found in practice? There are three main classes, each with differing intra-type examples: personal discrimination, which is based on differences among individual consumers; group discrimination, where intergroup differences are the distinguishing factor; and product discrimination, where different products are priced in a discriminating manner.

Here are some examples of each type of price discrimination (from Scherer and Ross, 1990):

Personal Discrimination
1. Haggle-every-time: each transaction is a separately negociated bargain. Examples: Middle Eastern bazaars, and new/used car sales.

2. Size-up-their-income: wealthier (individual) customers are expected to possess more inelastic demand and are charged more than less affluent consumers. Examples: legal and medical services.

3. Measure-the-use: customers who use a product more are charged a higher price that is not proportional to any difference in costs. Example: Xerox machine rental charges.

Group Discrimination
1. Dump-the-surplus: goods in excess supply are exported at reduced prices, to prevent depressing domestic monopoly prices. Example: export market dumping (e.g. televisions, computer chips, etc.)

2. Promote-new-customers: new customers are offered lower prices than existing customers to develop new brand loyalty. Examples: newspapers and magazines.

3. Keep-them-loyal: special discounts are given to high volume buyers or prized customers. Example: frequent flier programs.

4. Sort-them-by-time-value: coupons which involve a time commitment for redemption are given to customers. Those who redeem these coupons are presumed to have a lower opportunity cost of time, which corresponds with a lower reservation price. Examples: mail-in rebates, and newspaper coupons.

5. Divide-them-by-elasticity: separating customers on the basis of belonging to a particular group, when there is an expectation that the demand elasticity or reservation price will vary among each group. Examples: business vs. tourist rates on travel, and student vs. general admission prices for entertainment.

Product Discrimination
1. Appeal-to-the-classes: pricing higher quality products to achieve larger markups than with lower quality products. Examples: cloth vs. paperbound books, and luxury vs. mid-size economy cars.

2. Make-them-pay-for-the-label: charging higher prices for (homogeneous) goods, based on name recognition. Examples: Name-brand vs. generic aspirin, salt, etc.

3. Clear-the-stock: clearance sale prices are charged on certain items when inventories need to be reduced, with the hope that these lower prices will induce purchases by customers with tight budgets. Example: Macy's, or other high-end store clearance sales.

4. Switch-them-to-off-peak-times: for goods and services with varying time-consumption patterns, lower prices are charged during off-peak periods. Examples: hotel and motel rates, and long distance telephone rates.

5. Skimming: setting high introductory prices that are designed to exploit customers eager to buy a new product. Example: introductory automobile prices.