Price discrimination is a price strategy used by monopolists (see Market Structures) to profit maximise. There are three types of price discrimination:
- First degree
- Second degree
- Third degree
First degree price discrimination is a practise in which monopolists charge the consumer the maximum price they are willing to pay. The highest price a consumer is willing to pay is also referred to as the ‘reservation price’. As stated above, since firms charge the maximum price they can to a consumer, it means that they have perfect knowledge of the market and consumer habits. However, in reality this is far from true and everyone in the market; firms and consumers alike suffer from asymmetry of information (see Key Words). Because monopolists charge the highest price that consumers are willing to pay, they convert all the surplus available to producer surplus.
In this theoretical example we will assume a firm has a marginal cost of 10p for selling an apple. There are ten consumers, five of them willing to pay 50p per apple, three willing to pay 30p per apple and two consumers willing to pay 5p an apple. Because firms do not have perfect knowledge of how much customers are willing to pay, they just charge a single price of 25p to the consumers. Consumers one to eight are willing to pay the 25p, and so they buy the apple, and consumers nine and ten don’t because they were only willing to pay 5p. Thus the firm makes revenue of £2 (price x quantity) and a profit of £1.20 (revenue – cost).
However, if the firm had perfect knowledge of how much customers were willing to pay. They’d charge the first five consumers 50p each, the next three consumers 30p each, and they wouldn’t sell to consumers nine and ten because they aren’t willing to pay the minimum of 10p, which covers their marginal cost. By using first degree price discrimination, the firm would make revenue of £3.40 (5 x 50p + 3 x 30p) and profit of £2.60 (£3.40 – (8 x 10p)).
The closest real life example we can get to demonstrate first degree price discrimination is websites such as eBay or auctions, as buyers bid accordingly to how much they are willing to pay. However, like the theory firms do not have the knowledge of how much the consumer is willing to spend on eBay or the auction.
Second degree price discrimination is a practise in which monopolists charge different prices depending on the quantity bought by consumers. ‘Second degree price discrimination is also known as non-linear pricing’.
Third degree price discrimination is a practise in which monopolists charge different prices to different consumer markets and their elasticities.