1) Meaning: what is price discrimination?
Price discrimination occurs when a seller charges different prices to different buyers for the same product (or for units of the same product), and these price differences are not justified by differences in cost of supply.
In essence, the firm tries to capture more of the consumer surplus by extracting different willingness-to-pay levels.
Important clarification:
- Charging different prices because of different costs (e.g., shipping, quality differences) is not price discrimination in the strict economic sense.
- Price discrimination is most commonly associated with monopoly or market power, but it can occur with some degree of imperfect competition.
2) Necessary conditions for price discrimination (very testable)
A firm can successfully price discriminate only if:
2.1 Market power
The firm must have some control over price (not a pure price taker).
2.2 Ability to segment the market
The firm must identify different groups/markets with different demand elasticities or willingness to pay:
- student discounts,
- peak/off-peak pricing,
- domestic vs foreign markets.
2.3 No (or limited) resale / arbitrage
If buyers can resell from low-price market to high-price market, discrimination breaks down. So the firm must prevent arbitrage through:
- legal restrictions,
- product differentiation (versions),
- geographic separation,
- time restrictions.
3) Types (degrees) of price discrimination
Traditional classification:
3.1 First-degree (Perfect price discrimination)
The firm charges each unit to each consumer at their maximum willingness to pay.
- The firm extracts all consumer surplus.
- Output tends to be at the efficient level (where P=MC), but distribution changes: consumers get zero CS; producer captures all surplus.
Reality: Rare in pure form; approximated by personalized pricing, negotiations, auctions.
3.2 Second-degree (Non-linear pricing / quantity-based)
Price varies by quantity purchased or product version, not by identifying the buyer:
- block pricing (e.g., electricity slabs),
- quantity discounts,
- two-part tariffs (membership fee + per-unit price),
- versioning (basic vs premium).
Consumers self-select.
3.3 Third-degree (Market segmentation)
The firm charges different prices to different identifiable groups/markets based on elasticity differences:
- student vs non-student,
- domestic vs international market,
- peak vs off-peak (time segmentation).
This is the most commonly tested “formal” model in exams.