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1st, 2nd and 3rd Price discrimination

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Definition

Price Discrimination according to Barron's Educational Series is, "Charging a different

price for a different product or to a different buyer without any true cost differential to justify the
different price" (2000).

1st Degree Price Discrimination follows the definition above but is charging a different
price based on the customer.

2nd Degree Price Discrimination is charging a different price based on quantity sold.
3rd Degree Price Discrimination is charging a different price based on location of
customer segment.
1st Degree Price Discrimination

This type of discrimination, also known as perfect price discrimination, essentially states the
company charges the consumer the maximum price that individual is willing to pay for that
product. This extracts all the consumer surplus and earns the firms the highest possible profits.
This method of discrimintation is also one of the most difficult to adopt because it requires the
company knows each of its customers perfectly at each level of consumption (Baye, 2006). This
can best be seen in car dealers, where the price on the car is negotiable, and the dealers job is
to get the most out of the consumer as possible, the consumer surplus will be 0. In some
cultures, bargaining for goods and services, i.e., first degree price discrimination is the norm. In
others, first degree discrimination is much less prevalent and consumers are more used to
prices which are not negotiable. The aim of first degree price discrimination is for the firm to
appropriate the entire consumer surplus (see fig. 1,2, and 3).
Figure 1

Figure 2

Figure 3

Examples of 1st degree price discriminators:

Car dealerships mechanics, doctors, and lawyers (service related business).
2nd Degree Price Discrimination
In this type of discrimination the companies are actually not able to differentiate between the
different types of consumers. This practice creates a schedule of declining prices for different
quantities. Using this strategy the company can extract some of the consumer surplus without
knowing much about the individual consumer. The consumer chooses the amount of product
they wish to consume with the posted prices, and this allows consumers to differentiate
themselves according to preference. This type of discrimination can easily be seen in the bulk
purchases of large consumers like Walmart, who in turn pass the savings onto the eventual
consumer. This can also be seen in quantity discounts, the more you purchase the more you
save. A family pack of soap powder or biscuits tends to cost less per kg than smaller packs. This
of course discriminates against people living alone, often pensioners and students. In some
supermarkets the price per kg of product is listed, which helps the customer by providing
information on which to base decisions on.
Figure 4

Examples of 2nd degree price discriminators:

Electric utilities, cable companies, water & sewage companies, trash collection.

3rd Degree Price Discrimination

This type of price discimination, is based around the idea that the firm sets prices that will
accomodate the consumer. The firms know broad demographics about the particular types of
consumers they will supply, and charge prices such that everyone will be able to consume the
product. In order for this form of discrimination to work the firm must be able to predict the
elasticity of demand in various consumers. This type of discrimination can be seen in the movie
theater business. Student and senior discounts are given because these groups of consumers
have more elastic price elasticity of demand. It is because of this discrimination that the firm is
able to extract the consumer surplus of those who might not otherwise pay the standard rate.
Third degree price discrimination relies on the firm being able to separate the segments. If
separation of segments is not possible then the product can be transferred.
The example below shows the total market for public transport journeys before 9.00am. The
total market demand (Dm) is the sum of the demand of two segments, adults (Da) and students
(Ds). For adults the price of a bus ticket is only a small part of their income and this means that
their demand (Da) is more inelastic than that of students for whom a bus ticket is a larger part of
their income, (see the determinants of elasticity).
In fig. 3 the firm we once again decides on their output by equating MC with MR. However there
is not just one price. By drawing a horizontal line through the MC=MR point until it intersects
with the MR curves for adults and students and then reading the price off the respective
demand curves Da and Dr the price in each segment is determined, Pa and Pr. Not surprisingly
the price in the adult market is higher.
Figure 5

This discrimination allows the firm to appropriate more, but not all, of the consumer surplus, fig.
6.
Figure 6

Firms can often segment the market by charging different amounts for providing the product or
service at different times, e.g. Weekend rail fares. The firm can also change the basic product in
some way, for example offering faster check-in for flights, slightly more legroom and
complimentary drinks. These firms can also segment markets by location, selling in different
places at different prices, car sales are an example of this. Car prices tend to be different in
different countries and these differences in prices cannot always be explained away.
Examples of 3rd degree price discriminators:
Wall street journal (student pricing), movie theaters (student & senior discounts), hotels (senior
discounts).
Benefits and costs of price discrimination
These of course depend on whether you are the firm or the consumer. Price discrimination
means that consumer surplus can be appropriated, and as long as the cost of the marketing
scheme (adverts, identity cards, ticket inspectors etc.) is less than the extra revenue the
scheme brings in then it is advantageous to the firm. At first sight it would seem the loser is the
consumer. But a second examination reveals that students are gaining, they pay less than if
there was a single market price. But an even deeper examination shows how adults might gain.
If by price discriminating the firm can increase output substantially, the average costs may fall
because of economies of scale. These economies may even outweigh the price difference
between adults and students. In conclusion, it is necessary to look at price discrimination on a
case-by-case basis.