In this video we’ll explore first, second and third degree price discrimination.
First I’ll explain what it means, then we’ll look at why firms do it and then analyze three
separate diagrams of the differing degrees.
Finally, we’ll look at the economic impact on the consumer.
Let’s begin with the definition.
Price discrimination occurs when a firm charges consumers different prices for an identical
good or service.
You’ve probably experienced this at the cinema as a student.
In many places, students are charged less for tickets than adults.
Now let’s try and get a better understand as to why firms price discriminate.
There are several potential benefits to firms of price discrimination.
First, it allows firms to sell more of their products and increase their revenue.
This can lead to higher profits.
If an airline has empty seats on a flight in the next few days, it would benefit them
to sell the tickets at a lower price just to fill them as opposed to continuing the
flight with some seats empty.
This also allows them to make better use of spare capacity.
Finally, as they increase output firms are also possibly able to benefit from economies
of scale.
This can be the case for a firm producing medicines and selling them domestically and
globally.
Being able to charge higher prices in richer countries and lower prices in others, allows
them to increase output and lower average costs.
Now let’s take a look at the diagrams of each of the three.
First degree price discrimination is when a seller charges each consumer the maximum
price they are willing to pay.
Every consumer pays the maximum they are willing to pay.
This would essentially transfer all consumer surplus to the producer.
While this diagram is how a competitive market would typically look in equilibrium, we have
to change it for first degree price discrimination.
This is how producer surplus looks like after first degree price discrimination after the
consumer surplus has been transferred due to price discrimination.
Now let’s move on to second degree price discrimination.
For second degree price discrimination, the producer offers different prices to different
groups of consumers.
Unlike first degree price discrimination, consumers are broken into groups that receive
different prices based on the quantity they purchase.
If they purchase more, or bulk buy, they will pay P4.
If they purchase less, say Q1, they will pay a price of P1.
Next up is third degree price discrimination.
For third degree price discrimination to take place, these conditions must hold true.
We’ll consider each condition in turn.
First, the firm must be able to segment their markets by elasticity at minimal cost.
In the UK, you can purchase train tickets for off-peak and peak travel.
The cost to separate the markets is minimal.
I’ve experienced this first hand when I travelled in the UK during peak hours with
a non peak ticket.
A ticket officer walked up and down the aisles checking tickets and I was asked to pay the
full fare.
I mistakenly thought I was traveling during off peak hours.
Peak travelers are likely to have inelastic demand whereas off-peak travelers who have
more flexibility are more sensitive to price changes.
Second, the firm has to have a high degree of market power.
If they don’t, charging higher prices will just turn consumers away to their competition.
Third, they need to be able to prevent arbitrage.
This means that a buyer cannot buy in one market and resell to the other.
In the case of pharmaceutical drugs, they are sometimes sold at lower prices overseas
than domestically to provide affordable access to consumers in less economically developed
countries.
However, it has happened in the past that these same drugs purchased overseas are resold
into domestic markets.
The producer must be able to prevent such a thing from happening.
Now let’s see how the diagram looks.
If these conditions are met, a firm can move away from the pricing model we’ve seen above
of the profit maximiser, towards something quite different.
We’ll take this market of Q* and break it into two segments.
One segment with inelastic demand and another with elastic demand.
Assume the previous market output is being produced of Q*.
We’ll use the corresponding marginal and average costs from before.
If you’re curious as to why, what we’ve done is split the Q* quantity into separate
markets, one with inelastic demand and the other with elastic demand.
The sum of the total quantities in the two markets will equal Q*, thus we apply marginal
and average cost across from our previous diagram.
Firstly, we have the inelastic market.
We look for the intersection of MC and MR and follow up to our demand curve to establish
price.
The price here is higher than the price charged by the firm with the markets combined.
Here the area labeled SNPi is the supernormal profit from this specific market.
Now we do the same in the elastic market and get our supernormal profits there, SNPe.
This price is lower than the previous price charged by the firm.
These two areas combined should be greater than our initial supernormal profits if this
firm has discriminated successfully.
We can check that on the next slide.
To help visualize this further, I’ve cut and pasted each of the areas of supernormal
profits from the previous three diagrams.
The supernormal profits generated from the inelastic market plus the supernormal profits
generated from the elastic market are greater than the supernormal profits in the unsegmented
market.
Let’s make it even clearer.
I’ll place the original supernormal profits at the bottom and place the others on top.
You can see that the supernormal profits from the segmented markets are greater than the
original one.
It may seem like the benefits mostly fall to the producers of price discrimination.
However, some consumers will benefit.
Those who are charged lower prices obviously benefit.
This allows for greater choice for some consumers.
Since those with inelastic demand are faced with higher prices, firms can charge lower
prices and thus offer their product to a market that may not have been able to afford the
product under the profit maximizing condition.
That completes this extensive examination of price discrimination.
If you have any questions or comments, please leave them below or email me at enhancetuition@gmail.com.