Price discrimination

Overview

Price discrimination, firm prevent resale if it is to price discriminate successfully and difference between first-degree.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is price discrimination, and how does it differ from simply charging different prices for different products?

   Model answer

   Price discrimination is charging different prices to different buyers for the same good where the price difference does not reflect a difference in the cost of supplying them. Charging more for a first-class rail seat than a standard one is not discrimination, because the two services genuinely cost different amounts to provide. Charging two passengers different fares for the identical seat because one booked earlier is discrimination. The test is always whether the price gap is bigger than any cost gap.

2. 2

   State the three conditions a firm must satisfy before it can price discriminate.

   Model answer

   First, it must have some price-setting power, so its demand curve slopes downwards; a price taker cannot charge more than the market price. Second, it must be able to separate buyers into groups with different price elasticities of demand and identify which group a buyer belongs to, using age, time of purchase, location or willingness to book ahead. Third, it must be able to prevent resale between the groups, so that those charged the low price cannot sell on to those charged the high price, which is why discrimination is common in services and rare in easily transported goods.

3. 3

   Why must a firm prevent resale if it is to price discriminate successfully?

   Model answer

   If resale is possible, the buyers charged the low price have an incentive to purchase extra units and sell them to the high-price group at a price between the two. That arbitrage undercuts the firm's own high-price sales and, if it continues, drags both prices towards a single market price, destroying the discrimination. Services are easier to protect because they are consumed at the point of sale and can be tied to an identity, such as a named ticket or a student card. Physical goods that are easy to store and transport are far harder to keep separated.

4. 4

   Explain the difference between first-degree, second-degree and third-degree price discrimination.

   Model answer

   First-degree, or perfect, discrimination charges every buyer the maximum they are individually willing to pay, so no consumer surplus survives. Second-degree discrimination charges different prices according to the quantity or version purchased, such as bulk discounts or off-peak tariffs, and buyers sort themselves by choosing between the options. Third-degree discrimination divides buyers into identifiable groups, such as adults and children or peak and off-peak travellers, and charges each group a different price according to its elasticity of demand. Third-degree is by far the most common because it needs only an observable characteristic rather than knowledge of each individual.

5. 5

   State and explain the rule that determines the prices a third-degree price discriminator sets in two separated markets.

   Model answer

   The firm allocates output so that marginal revenue is equal in both markets and equal to the marginal cost of total output. If marginal revenue were higher in one market, shifting a unit into it would raise revenue at no extra cost, so equality is required for a maximum. Because a given marginal revenue corresponds to a higher price where demand is less elastic, the rule produces a higher price in the market with the more inelastic demand and a lower price where demand is more elastic. The mark-up over marginal cost is therefore larger in the inelastic market.

6. 6

   A firm with costs TC = 30 + 10Q + Q² sells in two separable markets, where PA = 110 − 4QA and PB = 90 − 4QB. Find the discriminating prices and outputs.

   Model answer

   Marginal revenue is 110 − 8QA in market A and 90 − 8QB in market B, and marginal cost is 10 + 2Q where Q = QA + QB. Setting each marginal revenue equal to marginal cost gives 110 − 8QA = 10 + 2QA + 2QB, so 5QA + QB = 50, and 90 − 8QB = 10 + 2QA + 2QB, so QA + 5QB = 40. Solving, QA = 8.75 and QB = 6.25, a total of 15 units. Marginal cost is 10 + 30 = £40 and both marginal revenues equal £40, as required. The prices are PA = 110 − 35 = £75 and PB = 90 − 25 = £65.

Other ways to work this

The same content, four other ways.

What is inside Levo

Six ways to work the same material.