Price discrimination is defined, discussed, and justified while comparing and providing examples of the three degrees of such discrimination.
Price discrimination refers to the strategy of setting different pricing structures in various online markets, while keeping the product consistent. The pricing is determined based on the price elasticity of demand in each specific market. In simpler words, this means that during Ladies Night at M.P. OReillys, the cost of a beer is higher for me compared to a woman, solely because this establishment believes in charging females less to attract more of them on such an occasion. Price discrimination is widespread across various sectors in the business and commercial realms.
Discounted prices are often given to students, children, or the elderly in industries like movie theatres, magazines, and computer software companies. It is important to understand that price discrimination only happens when identical products are sold at different prices to different people. The difference between first class and coach tickets on an airline, which may include different complimentary beverages, does not count as price discrimination because the tickets are not identical but rather comparable.
Price discrimination is rooted in the economic principle of marginal analysis and involves evaluating the variations in revenue and costs that occur when choices or decisions are made. The Hartford Shoe Company model serves as a concrete illustration in the textbook.
The main focus of the model is on page 201. The research shows that increasing the price of shoes from $60 to $65 results in a decrease in revenue and number of shoe sales. However, there is a slight rise in profit margin as the higher profit made compensates for the decline in sales. It’s important to note that maximizing profit does not occur when either the number of products sold or the price is at its highest point.
Profit optimization is accomplished by utilizing price discrimination, which capitalizes on the diverse price elasticity of demand within different target groups. This approach enables the maximization of profits by offering lower prices to specific groups with a lower price elasticity of demand, like students and senior citizens, while charging higher prices to other individuals for identical goods or services.
In order to fully optimize profit by implementing price discrimination and integrating it with other economic strategies, it is crucial to proficiently and systematically gather, evaluate, and respond to gathered data concerning various cohorts. The initial step entails accurately identifying the groups and distinguishing their disparities in advance. Certain groups like children, genders, and senior citizens can be distinguished based on their physical attributes, whereas military personnel, college students, and other cohorts may require some form of identification.
Firms often advertise their highest prices in publications but then provide discounts to qualified groups. Effective price discrimination requires three basic conditions:
- Consumers can be divided into and identified as groups with different elasticities of demand.
- The firm can easily and accurately identify each customer.
- There is not a significant resale market for the good in question.
First degree price discrimination is based on the idea that a company has sufficient knowledge about its customers to sell products at the highest possible price that the customer is willing to pay. There are two main types of first degree price discrimination, namely price skimming and all-or-none offers, which will now be explained.
Skimming in this context refers to a strategy used by firms to maximize profits by focusing on the highest demand for a specific product. To achieve this, firms need accurate information regarding the actual demand for their product. Additionally, these firms must segment their customers into different groups according to their individual demands for the product.
The firm’s strategy is to initially sell the new product to the highest paying group. Then, it slightly decreases the price and sells to another group with slightly less demand. This process is repeated multiple times until the marginal revenue equals the marginal cost. What sets this example apart from other instances of price discrimination is that there are countless possible prices that, when charged sequentially, will result in long-term profit maximization.
The firm must consistently assess the demand and price for the product after setting the initial price and selling a certain number of units. For firms using price skimming, they typically start their pricing at the point where demand is highest. As demand decreases at a certain price, the firm adjusts the price to stimulate more sales. Like before, the firm maximizes profits when marginal revenue equals marginal cost. The firm will not sell the product below this threshold, as it differs from a scenario where a single profit-maximizing price is used.
The key to price skimming is to prevent consumers from getting used to the process and waiting for prices to drop, which distorts demand. Customers may be unhappy about paying a higher price at first, which could result in them not being repeat customers in the future or delaying future purchases in anticipation of a price decrease. Price skimming loses its effectiveness when consumers become accustomed to the strategy.
The all-or-none model exemplifies first-degree price discrimination, whereby a firm establishes a price for a bundle of goods. Irrespective of the desired quantity of goods, customers pay the same price as if they were to purchase the entire bundle. The diamond industry utilizes this model by offering less-than-perfect supplemental gems alongside flawless ones to sell their less-desirable merchandise. Leasing motion picture reels is another example that resonates more with the general public. Although The Hunt For Red October was a popular film, only a few individuals I knew showed interest in watching Ernest Saves Christmas.
By bundling goods together in a veritable grab bag, firms can eliminate merchandise that would likely not sell otherwise, or at least not for the same price. Similarly, firms can sell excessive volume sets of certain items, even though no rational person would willingly purchase such large quantities of certain goods (e.g. 10-packs of household 3-in-1 oil). This method of moving merchandise, where the quantity or items purchased is not necessarily optional, is particularly favored at auctions.
Second degree price discrimination involves selling goods in tiers, with increasing prices for incremental amounts. For instance, the initial 12 pairs of shoes are priced at $80, the subsequent 12 pairs at $72, and so forth. Comparable to third degree price discrimination, customers are organized into tiers where each tier pays a consistent price. This guarantees constant marginal revenue for both the tier and their purchases. Similar to third degree price discrimination, second degree pricing enables firms to sell a greater quantity than usual.
The illustration involving catsup showcases how the size of the container can impact prices, highlighting the importance for consumers to choose products that align with their lifestyle and preferences. Individuals seeking a greater quantity of catsup generally opt to purchase smaller amounts at a higher price per unit, whereas those with lesser demand prefer larger quantities at a lower cost per unit.
Second degree price discrimination usually results in higher quantities sold per unit. Sams Club serves as a paradise for this type of price discrimination. The small warehouses owned by Mr. Walton target consumers who are willing to purchase more at a lower price per unit. Although the price may indeed be slightly lower, it still concerns me to witness individuals buying 256 ounces of Ivory dishwashing detergent at once.
In terms of pricing, 2nd degree price discrimination is effectively utilized through product bundling. It is important to note that this is distinct from the scenario depicted in the movies “Ernest Saves Christmas” and “Hunt For Red October,” but rather refers to the situation where two copies of a film are provided (to be shown on two screens) at a significantly lower cost than leasing two separate film reels. The concept of product bundling is commonly seen in the personal computer industry, where system packages are offered together with popular software and hardware. This practice helps to minimize negotiations over specific items, as there is no dispute regarding the value of including a CD-ROM or video card.
Third degree price discrimination involves categorizing customers into different groups based on their elasticity of demand. Accordingly, the group with less elastic demand is charged a higher price. Marginal revenue refers to the change in total revenue caused by a slight alteration in the sales of the specific product.
Hence, it can be inferred that the price has also experienced a slight change. The example given in the book (Hartford Shoe Company student discounts) effectively demonstrates this phenomenon. In the case where the non-student consumers face a $5 price rise, they buy 625 fewer pairs of shoes. By extrapolation, it can be concluded that for every $1 increase in price, sales will decrease by 125 units.
The student price of the shoes decreases by $5, causing an additional 625 pairs to be sold. This indicates that for every dollar reduction in price, 125 more units will be sold, regardless of whether the buyer is a student or not. So, a $1 decrease prompts both students and non-students to change their purchasing preferences by 125 pairs. By using this observation, we can determine the ideal price and sales figures needed to achieve the desired outcome: Marginal revenue is calculated by dividing the change in total revenue by the change in sales. When the shoe price decreases by $1, total revenue increases by $2,625, as sales go up by 125 units.
By reducing the price from $66 to $65, the Hartford Shoe Company can increase profits as the marginal revenue associated with this price reduction is $21, which is higher than the marginal cost of $20. However, if the price is initially $65 and lowered to $64, the marginal revenue would only be $19. In this case, since the marginal revenue is lower than the marginal cost, implementing this price reduction would slightly decrease profits.
Price discrimination is founded on the principle of opportunity cost, which is a fundamental economic concept. To illustrate, American Airlines might provide a round-trip fare of $149 for college students traveling from Saint Louis to Chicago, while business class fares are notably higher at $279. The business traveler is likely to be more inclined to pay the higher fare since they will be working for a client in Chicago and earning $100 per hour during their stay.
The college student attending Wash U lacks the funds to justify spending more on travel for their fall break to Chicago. The assessment of reallocating resources, including time, money, and talent, is determined by opportunity cost. Many individuals assert having more time than money but fail to acknowledge that opting not to work means essentially paying for leisure time. This notion also pertains to price discrimination. For instance, if a Washington University student opts to visit the Esquire Theatre on a Friday evening to watch a plotless Hollywood blockbuster film, they are less inclined to dedicate time studying Organic Chemistry which could potentially lead to a lower grade.
The possibility of receiving a lower grade could result in admission to a graduate program of lesser renown, and consequently lead to employment with a lower salary. I understand that this scenario is largely hypothetical, but the core principle remains that, irrespective of one’s current activity, there is always an alternative course of action. Every instance where an individual decides to prioritize sleeping in and skipping class or takes a day off from work should involve considering opportunity cost. Ultimately, vacations epitomize and serve as the most widespread demonstration of individuals making decisions based on opportunity cost.
Price discrimination is advantageous for firms as it helps them maximize profits and efficiently manage sales in the current market. Moreover, it allows consumers with limited resources to access goods or services that would otherwise be out of their reach.
Price discrimination is a strategic method that companies can employ to boost sales, enhance profits, and attract a wider range of customers. By taking advantage of the varying price sensitivity for different products and services, firms can optimize pricing and value. This approach benefits both consumers and companies by satisfying preferences and maximizing opportunities.