Price discrimination (old syllabus) HL

Introduction

This page focuses on the three different types of discrimination. Students will commonly confuse types one with third degree discrimination. The primary difference is that the first form of price discrimination does not consider that customers belong to different market segments where as the third type uses this as the basis for their discrimination. First degree discrimination is most commonly illustrated in an auction setting. It is presumed by some IB students that many firms will actively practise price discrimination when in reality it is not always possible. In order to utilise this pricing strategy certain conditions must be met which this page considers.

Enquiry question

What is price discrimination and what are the conditions required for price discrimination to take place.

Lesson notes

Lesson time: 70 minutes

Lesson objectives:

Describe the necessary conditions required for the practice of price discrimination to take place. Distinguish between price discrimination as the practice of charging different prices to different consumer groups for the same product, where the price difference is not justified by differences in cost and other forms of sales promotion or product differentiation.

Draw a diagram to illustrate how a firm maximises profit in third degree price discrimination, explaining why the higher price is set in the market with the relatively more inelastic demand.

Teacher notes:

1. Beginning activity - begin with the opening activity and allow 10 minutes for your classes to complete this.

2. Processes - technical Vocabulary - the students can learn the key concepts through the key terms and accompanying brief notes, which should take 10 minutes to go through and discuss.

3. Practise activities - included on the handout should take around 35 minutes. These are short answer exercises.

4. Reflection exercise - activity 6, having looked at the impact of price discrimination on both consumers and the profits of individual businesses, this activity considers the impact on social welfare as a whole. (15 minutes)

Beginning activity

You are on holiday with your friends in a different country - you do not speak the language and are unsure exactly of where you are going next. You have directions to your hotel but you are not sure exactly of the correct route or the regular price paid. You get into a local taxi and after what seems like a significant amount of time you arrive at your hotel. After a little haggling you pay the driver the agreed price. Later at the hotel you speak to the cashier and she informs you that you paid twice as much as the official (local) price.

Next you visit a bar on the seafront and you pay the entrance fee of £15. While at the bar you begin speaking to a group of local residents. They inform you that their entrance price was just £5. The two examples described are examples of price discrimination - charging different customers different prices just because they can. You may consider this to be unfair and you are probably correct. In reality however this is a practise which goes on throughout the world - in certain circumstances.

Key terms:

Price discrimination - involves a firm charging different prices to different groups of people for the same good or service. Examples of this include a cinema offering student discounts, or train companies offering off peak fares for a lower price than fares during peak times.

First degree price discrimination - involves charging each consumer the maximum price that they are willing and able to pay, such as in a closed auction process.

Second-degree price discrimination - involves charging different prices to consumers who purchase the product in larger quantities e.g. hotels offering discounts on the second week of a hotel stay.

Third degree discrimination - when firms charge different prices to different market segments,e.g. age, income, time of use e.t.c, based on their willingness and ability to pay for a good or service.

What is and what is not price discrimination?

While price discrimination involves separating their market into different segments and charging each a different price, it should not be confused with similar types of sales promotion. For example many nightclubs’ charge women lower prices for entry. This is not price discrimination because the motive here is to attract more boys into their nightclubs. In this example this is an example of sales promotion rather than price discrimination.

The activities on this page are available as a PDF file at: Price discrimination

Activities

1. Watch the following video and then identify whether the following situations are examples of price discrimination or not?

(a) An airline charging a higher price for a flexible ticket than a ticket with time restrictions.

No this is not an example of price discrimination because while technically they are selling the same seat at different prices the customer paying the higher price is technically getting a slightly differentiated product, as they are given greater flexibility to change or cancel their journey.

(b) An airline charging a higher price for customers who purchase their ticket less than 24 hours before they fly.

Yes this is an example of third degree discrimination because the airline is discriminating by time. Presumably the last minute customer is more desperate to fly and will therefore be more willing and able to pay the higher price for their ticket - i.e. their demand is price inelastic.

Yes this is an example of third degree discrimination by geographical location. Due to a lack of competition in Japan the Japanese customer is willing and able to pay a higher price than the American one.

(d) A health club charging lower prices for off peak members who only wish to use the facilities during off peak times.

No this is not an example of price discrimination because while technically the customer is using the same facilities the higher paying customer is getting a slightly differentiated product, as they are given greater flexibility on when they can use the facilities. In reality this is more likely to be working age people who have higher incomes and therefore less sensitive to paying a higher price.

(e) A company providing a bulk buying discount to customers ordering in large quantities.

This maybe discrimination depending on the costs involved. If the business providing the bulk buying discount is able to provide the larger amount at a lower unit cost and is then simply passing on this benefit to the customer then this is not price discrimination. However, if this is not the case and the larger customer is simply getting a lower unit price because of their market power then this would be an example of second degree price discrimination.

Activity 2

Suppose that you walk into a shop to purchase a television. The television is a luxury LCD with a curved screen and stereo sound. There is no price on the television so you go to the counter and ask for the price. The salesman asks if you are working full time or part time before quoting you a price of $ 1,500. How much would it be if I were a student or unemployed you ask and the cashier explains that students as well as those without paid work pay a much lower price to reflect their reduced financial circumstances. What action would you take in this scenario?

Unlike the example on the previous page you are unlikely to get caught as you were when you used an overseas taxi or visited a beach bar, without knowing the price. In this case you are likely to ask a friend or family member, who is without work to purchase the television on your behalf. This illustrates one of the conditions that must be met before a firm can actively discriminate on price. The firm must be able to separate the different customer markets and must also be able to prevent the product being resold. This is impossible when selling a consumer durable from a shop but much easier in the tourism industry where it is easier to separate the different customer markets.

Activity 3: Conditions of price discrimination

Watch the following video which explains how price discrimination is used within the tourism sector of Bulgaria. Which conditions allow the tourist site to actively use price discrimination?

The video mentions a number of key conditions required for a firm to successfully employ price discrimination. The first of these is that the producer must have the ability to set prices, which it can as the only supplier of tickets for the attraction. Secondly, it is able to separate its market by language - tourists cannot read Bulgarian and so are unaware that cheaper tickets are available. The language and physical appearance also exposes potential tourists who choose to purchase their tickets second hand from unofficial sources. Lastly, the demand curve for tourists is significantly less PED elastic than the demand curve for local residents.

Activity 4: A focus on first degree price discrimination

First degree price discrimination is best illustrated in a closed auction process and this is sometimes called perfect price discrimination.

(a) Why does a closed auction process reduce consumer surplus to 0, offering what some economists call perfect price discrimination?

In a closed auction process each bidder makes just one bid - for the maximum they are willing and able to pay. They cannot risk offering less than this amount for fear of losing the sale.

(b) Why is an open bidding process more advantageous for the consumer than a closed bidding process?

In an open bidding process the consumer pays the minimum required to secure the sale, not necessarily the maximum they would be willing and able to pay for the product.

(c) Illustrate the market for a product under first degree price discrimination and highlight the additional revenue created when the firm employs price discrimination.

Activity 5: A focus on second degree discrimination

A mobile telephone company offers a standard package of 50 SMS messages a month for $20. Customers wanting more than 50, up to 100 messages are offered a discount on the second packet of 50 - just $10 extra per month.

(a) Illustrate this on a diagram and explain why offering the discount to customers buying in bulk creates additional revenue for the business.

In this example the company reduces the price when the user sends more than 50 messages per month. Without offering this discount, to customers buying in bulk, the company would receive only the revenue represented by the pale blue rectangle. By offering the discount to customers willing and able to purchase 100 text messages each month the firm makes additional revenue, represented by the dark blue rectangle.

Activity 6: Drawing the diagrams

In the beautiful city of Bath local residents and tourists queue side by side to visit the famous attractions that the city has to offer. Many customers purchase a museum pass which provides free entrance to the attractions for a 3 month period. Tourists pay around £26 for the card while local residents pay just £5. Residents must provide proof of residency before purchasing their ticket for the lower price of £5.

Questions:

a. Draw the market for the museum pass for both tourists and local residents on the diagrams provided.

b. How has the practise of price discrimination increased the profits made to the Bath Tourist Board?

In common with many other tourist attractions around the world, the Bath tourist card has two distinct markets - tourists who are willing and able to pay a high price for the card and whose PED elasticity is low, as well as local residents with a much higher PED. Diagram 3 illustrates the market for the tourist cards in a situation where the tourist board charged the same price to both tourists and and local residents. Diagrams one and two illustrate the impact on the market when the consumer is divided into two distinct markets - higher profits and arguably greater access to local attractions for local residents. This is because without the more profitable tourist ticket the tourist board may not be able to offer so many attractions?

Activity 7: The impact of price discrimination on efficiency

The following video considers the impact of price discrimination on efficiency. Watch the video and then answer the questions on social welfare:

(a) Summarise the impact that price discrimination has on social welfare.

As a general rule if the result of price discrimination is to increase the total output level then it probably increases welfare in the economy. If the result is a reduction in output levels then the opposite is likely to be true. For example, in the example of the pharmaceutical industry price discrimination enables companies to offer tablets at very low prices.

(b) Why is selling drugs in Africa for well below AC (just 50c) still profitable because of price discrimination?

50c is below the AC, but above the MC of production.

By charging higher prices to business travellers they enjoy the additional flexibility and seat guarantee that comes with the additional price, while the profits generated are used to subsidise seats for casual traveller who pay a price closer to the MC.

(d) What is perfect price discrimination?

When there is no consumer surplus, with every consumer paying the maximum they are willing and able to pay e.g. a closed auction process. This is sometimes called first degree discrimination.

8. Final reflection: Does price discrimination ever benefit the consumer paying the higher price?

Can you think of any examples of where price discrimination actually benefits the consumer or does it always benefit the producer / seller?

In most circumstances the answer would be no as by definition price discrimination is a method that firms use of maximising sales revenue at the consumers expense, by reducing their surplus. Only in situations where by one group of customers pays a higher price for increased convenience or flexibility can it benefit all parties. An example of this can be seen at certain tourist attractions - an obvious one being the Taj Mahal in India. Tourists flock to the attraction and are willing and able to pay a far higher fee than local visitors, many of whom receive very low wages.

During popular parts of the day there are also significant waiting times to enter the Palace and local visitors, paying a very small fee will often wait for longer than one hour to enter. By contrast, tourists paying a much larger fee to enter, can avoid the queues and enter without delay. In this way all parties are happy. Tourists, for whom time is more important than money, can enter the building without having to wait long periods in the sun. Local residents, for whom the opposite is the case, can enter for a very low fee while the organisers of the Taj Mahal maximise their revenue. So everybody benefits.

The photo above shows the Taj Mahal, one of the most beautiful buildings in the world and a tourist attraction where price discrimination takes place.

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