What is Price Discrimination? 

Price discrimination or differential pricing is based on the principle that the seller will charge the buyer a price based on the buyer’s ability and willingness to pay for the product rather than applying uniform pricing for all. 

Ever wondered why tickets for flights are cheaper when one books in advance and become costly as the travel date is nearing? Why an unbranded t-shirt is sold for a lesser price, and the same t-shirt gets priced almost three times higher once a brand logo is added to it? Why does one get a discount when one buys something in large quantity? In all the above instances, it is the same product, and yet the buyer pays different prices depending on when or how much they are buying. These are instances of Price Discrimination as applied in the real world.   

Types of Price Discrimination 

Price Discrimination can be achieved through various pricing strategies like versioning of products, discount coupons, personalized pricing, group pricing, dynamic pricing, and so on. There are three degrees of price discrimination: 

1. First Degree Price Discrimination – Here each buyer is charged the maximum price he can pay. For this to work, the seller needs to know how much a buyer is willing to pay. It is essentially a monopoly. There is no consumer surplus. Since each buyer would have a different ability and willingness to pay, this is perfect price discrimination or personalized pricing.   

2. Second Degree Price Discrimination – Here the seller lets the buyers choose from among the versions of products available with the seller and charges differently for each version. This would make the buyers reveal their preferences, ability to pay, and reservation prices. It is like going to the pizza restaurant and ordering different variants of the pizza. This is also called product versioning. 

3. Third Degree Price Discrimination – Here, the seller separates the market into segments or sub-markets and has different prices for each sub-market, but the members within the sub-market are offered the same price. This is also referred to as Group Pricing. For this to be successful, there must be no possibility of arbitrage profits wherein buyers can buy from the low-priced sub-market and re-sell in the high-priced sub-market. Consider an example of how a buyer can buy the same shoes for a 50% discount to the Retail Price offered in a brick-and-mortar store. One cannot buy the goods online and sell them to the store owner or to the potential customers walking in to purchase from in-store stocks. Another way to segment the market is to offer discounts to women customers or student customers, or corporate employees.   

The role of Market Power in Price Discrimination 

Consider Perfect Competition with unlimited buyers and unlimited sellers, uniformity in the availability of information, and no barriers to entry or exit. Such a market will have equilibrium prices and no scope for price discrimination, especially because there are too many sellers. Buyers can always buy from someone else if a particular seller is trying to charge a higher price. There is high elasticity of demand, and consumers are price sensitive. 

Consider a monopoly or an oligopoly with one or very few sellers. Because it is a seller’s market, they will be able to control supplies of the product, control availability of information, determine the price they want to charge, and will do so blatantly. Since there are high entry barriers for other sellers in a monopoly/oligopoly, the consumers will be price takers. A monopolist will be able to practice perfect price discrimination because the consumer would have nowhere else to go. If monopolies sustain, then the consumers get exploited. To avoid such a situation, the governments enact Anti-Trust laws like Robinson-Patman Act to prevent unfair trade practices among the businesses.   

For, e.g., at the start of the Covid-19 pandemic, some companies manufacturing treatment drugs, ventilators, testing kits, and masks were able to charge a very high price for their products in certain markets. However, since the governments intervened in various ways, the price of these essentials was controlled in some forms until other players entered the market and started supplying the same products. In this case, the demand was highly inelastic because the products were essential supplies with no substitutes available for some time.       

Now consider Monopolistic Competition where there is a relatively large number of sellers with sizable market share, the entry barriers are relatively low, but the sellers need to keep on creating moats around themselves through information asymmetry or perception of higher value among different consumers and adjust the prices on a real-time basis to achieve the maximization of profits and retain price-sensitive as well as price-insensitive customers. 

Common Mistakes 

People make in applying this concept is assuming that they know about consumers’ ability and willingness to pay for a product. When that information is not available, the sellers should adopt versioning or proper grouping of sub-markets and leave room for arbitrage profits. 

Context and Applications 

All MBA Marketing Courses and all economics majors require a strong understanding of this concept. Price Discrimination is applied in real-life e-commerce, retail, consumer goods, industrial goods, and all major businesses. It is widely practiced by business managers, marketing managers, branding managers, and product managers in determining the correct pricing strategy for profit maximization. 

Related Concepts 

Marginal Costs, Marginal revenues, consumer surplus, anti-trust regulations, revealed preferences, two-tiered pricing, Freemium models in product launches, etc.