When the firm charges each customer the maximum price that the customer is willing to pay the firm?

Price discrimination is a competitive pricing strategy used by businesses and sellers. Price discrimination involves the use of different prices charged to various customers for the same product or service. It is commonly used by larger, established businesses to profit from differences in supply and demand from consumers.

A company can enhance its profits by charging each customer the maximum amount they are willing to pay, thereby eliminating consumer surplus. Yet it is often a challenge to determine what that exact price is for every buyer. For price discrimination to succeed, businesses must understand their customer base and its needs. And they must be familiar with the various types of price discrimination. We look at the three most common types of price discrimination in this article: first-, second-, and third-degree discrimination.

Key Takeaways

• Price discrimination is a sales strategy of selling the same product or service to different customers for different prices.
• First-degree price discrimination involves selling a product at the exact price that each customer is willing to pay.
• Second-degree price discrimination targets groups of consumers with lower prices made possible through bulk buying.
• Third-degree price discrimination sets different prices based on the demographics of subsets of a client base.
• In order for price discrimination to work, businesses must prevent resale, must be able to operate in an imperfect market, and must demonstrate elasticities of demand.

First-Degree Price Discrimination

In a perfect business world, companies would be able to eliminate all consumer surplus through first-degree price discrimination. Also called personalized pricing or perfect price discrimination, this strategy occurs when businesses can accurately determine what each customer will pay for a specific product or service and then sell it for that price.

An expectation to negotiate the final purchase price is part of the buying process in some industries, such as the used automobile industry. The company selling the used car can gather information through data mining relating to each buyer’s past purchase habits, income, budget, and maximum available output to determine what to charge for each car sold.

This pricing strategy is well-suited for businesses and industries with high fixed costs as it allows the seller to capture the highest amount of available profit for each sale. It can only work if a company is able to segment or separate the market. It must also be able to stop the customer from selling the product or service to someone else at a higher price.

One of the drawbacks to first-degree price discrimination is that it is time-consuming and difficult to perfect for most businesses. It's not a process that many businesses can execute—especially large companies that have many customers.

Product differentiation is another competitive practice that businesses use. In this case, a business seeks to distinguish its product from a competing product to make it more attractive to a specific target market.

Second-Degree Price Discrimination

In second-degree price discrimination, the ability to gather information on every potential buyer is not present. Instead, companies price products or services differently based on the preferences of various groups of consumers. Put simply, companies price based on how much they can sell.

Second-degree price discrimination, which is also called product versioning or menu pricing, is normally applied through:

• Quantity discounts, such as special offers to customers who buy in bulk over those who buy a single product
• Buy-two-get-one offers
• Coupons
• Loyalty and rewards cards for frequent customers

This strategy is used by warehouse retailers, such as Costco or Sam’s Club. It can also be seen in phone plans that charge more for additional minutes above a set limit.

Second-degree price discrimination does not eliminate consumer surplus altogether, but it does allow a company to increase its profit margin on a subset of its consumer base. It's also a very easy strategy to execute since it doesn't take a lot of effort to attract and segment the consumer base.

Third-Degree Price Discrimination

Third-degree price discrimination occurs when companies price products and services differently based on the unique demographics of subsets of their consumer base, such as students, military personnel, or older adults. As such, it's commonly called group pricing.

You'll commonly see this type of pricing strategy in movie theater ticket sales, admission prices to amusement parks, and restaurant offers. The travel and tourism industry also uses third-degree price discrimination for those who book on a last-minute basis. Consumer groups that may otherwise not be able or willing to purchase a product due to their lower-income can be captured by this pricing strategy, thus increasing company profits.

Companies can understand the broad characteristics of consumers more easily than the buying preferences of individual buyers. Third-degree price discrimination provides a way to reduce consumer surplus by catering to the price elasticity of demand of specific consumer subsets. In order to be effective, companies must be able to ensure that customers don't sell these cheaper products and services to others.

Third-degree price discrimination is a common pricing strategy in the entertainment industry.

Environment Needed for Price Discrimination

Price discrimination of any kind can be a successful and profitable strategy provided it is done properly. This means that the company using it must follow certain conditions.

The resounding theme that echoes through first-, second-, and third-degree price discrimination is that companies must ensure there is no possibility of resale of their products or services. Put simply, customers should not be able to sell lower-priced products or services at a higher price to someone else otherwise the potential for profits is eliminated.

The company offering the lower price should be able to operate in the market as a monopoly of sorts. This means there must be some degree of imperfect competition where it is allowed to set up its own pricing structure, is allowed to put up certain barriers to entry for its competition, and compete for market share. Price discrimination wouldn't be possible in environments of perfect competition because there wouldn't be too many

The final consideration is being able to adapt to consumer demand based on prices. This is known as the price elasticity of demand. Consumers tend to increase their consumption of products and services (thereby increasing demand) when prices are low. This strategy doesn't work when people respond the same way to prices.

What Are the Conditions Necessary for Price Discrimination?

Businesses must meet certain criteria for price discrimination to work. They must ensure that their lower-priced products and services can't be resold to other individuals at a higher price. Secondly, there must be imperfect competition where a company can set its own pricing structure and put up certain barriers to entry. Finally, businesses must be able to adapt their pricing strategies to consumer demand.

How Often Do Competitive Firms Engage in Price Discrimination?

Price discrimination is very common. You can see it being used in different types of business, such as warehouse clubs and cell phone companies that offer discounts on bulk purchases. Other types of price discrimination are evident in pricing at restaurants and movies, through discounts for certain individuals, such as active military personnel and veterans, as well as coupons and loyalty rewards for frequent shoppers.

Is Third-Degree Price Discrimination Legal?

Third-degree price discrimination is legal and one of the most common forms of this strategy. It involves pricing goods and services based on the subset of a company's consumer base. For instance, a movie theater may offer lower prices for students and older adults who are more sensitive to higher prices.

The Bottom Line

Price discrimination is a very common strategy. And although there may be a negative connotation to it, it's actually very legal. It involves pricing goods and services in such a way that it drums up demand and consumption. There are various degrees of this strategy, notably first-, second-, and third-degree price discrimination. As a business owner, you can certainly see your profits increase by executing these strategies but only if you meet certain conditions. Make sure you ensure your goods or services can't be resold at a higher price to someone else, that you operate in an imperfect market, and that you're able to respond and price according to demand.

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