PRICE DISCRIMINATION

Price discrimination is the practice of setting different prices for similar goods and services, where the price difference is not related to costs. The term “discrimination” comes from the Latin word “discriminatio”, which means “to distinguish” or “to differentiate”.

Pricing in a monopoly market interests many marketers and business owners because the state no longer controls prices, and regular monitoring of competitors’ prices is an important part of developing a marketing strategy.

What is being discussed?

• The essence of price discrimination
• Degrees of price discrimination
  • First-degree (perfect) price discrimination
  • Second-degree price discrimination
  • Third-degree price discrimination
• Types of price discrimination
  • Individual discrimination
  • Group discrimination
  • Product discrimination
• When is price discrimination possible?
• Examples of price discrimination
• How does marketing affect pricing?
• Conclusions

The Essence of Price Discrimination

There are always buyers willing to pay more for the same quantity of goods. Even if the price were to increase, consumers would not stop purchasing altogether but would buy a smaller quantity. Much depends on the uniqueness of the product, meaning the absence of direct competitors. Budget substitutes for popular products do not attract all consumers. Certain categories of buyers are willing to pay for the brand, consciously choosing a more expensive option in the hope of higher quality or simply expressing their loyalty to the brand, emphasizing their social status.

This leads to strong companies capturing the market and increasing their profits through price discrimination.

“Price discrimination is the practice of a manufacturer setting different prices for products given the same production costs and product quality.” “Price Discrimination”, Wikipedia

Pricing depends on the age, location, income of potential clients, and their willingness to buy goods or order certain services. A company can segment its target audience and increase its profit while offering discounts. Different conditions are offered to various categories of consumers based on their purchasing power. Prices are differentiated based on demand.

“Price differentiation is a way of determining variable prices that consumers are willing to pay. Their willingness to pay depends on the structure of their respective needs and the demand generated by them.” “Price Discrimination”, Wikipedia

Price discrimination is most typical in the service industry. The reason is that a service can realistically be used only once, and it cannot be resold at a higher price. You can buy a dozen sports suits and sell each at 10% more, with some advertising effort. But if a car service customer orders a car diagnostic, only they will use this service, and only once.

While many newcomers in a particular field try to gain clients by offering low prices, this doesn’t always work. Price can be seen as an indicator of product quality. For many consumers, a high price indicates the brand’s prestige and serves as a guarantee that it is not a counterfeit. In the service industry, a very low price is associated with the inexperience of the specialist. The opportunity to save a lot in such cases is off-putting. For example, hardly anyone would trust the photography of their wedding or another important event to a photographer who works for peanuts.

The essence of discriminatory pricing is to use all opportunities to set the maximum price for each unit of product. Price discrimination can apply to an individual client, such as in legal services, or to various customers, such as when choosing groceries in a supermarket.

However, in some cases, prices for similar goods or services differ due to different production conditions, logistics, etc. If the buyer pays extra for the features of an individual deal that require corresponding expenses, the price differences are not considered discriminatory.

Price discrimination usually involves offering the same product to different buyers at different prices. But there are situations where product prices remain the same while the costs for some of these goods or services are different. Consumers might not even realize this. For example, a programmer or designer might do template work for a new client at their usual price, while for a regular client, they spend more time and create a unique project for the same money.

Under price discrimination, each individual producer can influence the price of their product. This is feasible if competing firms sell non-standardized goods. They can change the quality, appearance, packaging, and add new characteristics. Industries such as household chemicals, confectionery, coffee, and cigarettes can be considered monopolistic.

Price discrimination is characteristic of monopolists who capture a certain market. Monopolies most often appear in large businesses—gas extraction, metallurgy, engineering. However, the dominance of a few producers can also occur in other sectors, such as food production.

For example, in supermarkets and small grocery stores, most chocolate products are represented by the Nestle brand. There is nothing particularly special about their products, but their correct positioning and large-scale marketing campaigns allow them to mark up their sweets.

This type of market is characterized by the dominance of a single economic entity, which sets the prices for goods or services. A monopoly is a single producer, seller. In this case, the price is considered a monopoly price, and the additional income is monopoly profit.

Degrees of Price Discrimination

The English economist Arthur Pigou distinguished three degrees of price discrimination.

First-Degree (Perfect) Discrimination

This occurs when each unit of a good or service is sold at a price equal to its demand price. Thus, the cost for different buyers will vary. This phenomenon is quite rare and almost never occurs in its pure form because it is difficult to obtain reliable and complete information about the demand functions of all potential buyers of the product. 

The closest to pure price discrimination are business owners where each product or service is produced or provided to individual orders of specific consumers. The number of orders in this case is small, although each buyer can bring significant profit over a long period.

For example, a monopolist can sell 4 units of a product at 30 USD each. The revenue in this case is: 4*30 = 120 USD. If price discrimination is applied, the first unit can be sold for 50 USD, the second for 45 USD, the third for 35 USD, and the fourth for 30 USD. The total revenue would be: 50 + 45 + 35 + 30 = 160 USD, which is 40 USD more than selling the goods at the same price.

Let’s consider the algorithm of price discrimination on a graph. The optimum of a regular monopoly is determined by the intersection of the MC and MR curves (point K). The output volume will be QM, the price will be RM, consumer rent will be LPMA, and producer rent will be РМАКМ. If the monopolist can practice perfect price discrimination, they will sell each unit of the product at a price equal to the corresponding demand price: the first unit at P1, the second at P2, and so on. 

The output volume can be increased until the intersection of the MC and D curves, i.e., up to level QK, which leads to perfect competition. However, instead of a single price PK, a monopolist practicing perfect price discrimination will sell the products at different prices.

In practice, perfect price discrimination is only possible when the monopolist has perfect information about the demand function of all possible consumers of their product. This situation is only possible when each unit of the product is produced to individual order.

Second-Degree Price Discrimination

In this situation, the prices of goods or services are the same for all buyers but differ depending on the volume of sales. The product is divided into certain groups, each with a different price.

A vivid and common example is discount pricing. This can also include discounts on seasonal train tickets. Time discrimination may appear in the form of different prices for morning, afternoon, and evening cinema sessions.

An example of how second-degree price discrimination works is shown on a graph. The monopolist divides the entire volume of produced goods into a certain number of groups. Without price discrimination, the combination of RM and QM ensures maximum profit, equal to the area of the lower shaded rectangle. If the monopolist can sell Q1 units of the product at price R1 and the remaining group QM-Q1 at price RM, their profit increases by the area of the upper shaded rectangle.

When dividing the entire output into two groups to be sold at different prices, profit will be maximized if the following relationships are maintained:

MR1(q1) = P2(q1,q2);

MR2(q2)=MC(q1,q2). 

Regardless of the business sector and the number of product or service groups, the general rule for setting prices for second-degree price discrimination always applies: the marginal revenue from selling the first group of products must equal the price of the first batch, and the marginal revenue from selling the last group must equal the marginal costs.

In the graph, the product is divided into three groups, each with its own price.

Given the industry demand, the choice of q1 determines the price P1. The intersection point of MR1 with the perpendicular from q1 determines P2. At this price, the batch q2-q1 can be sold. The intersection of MR2 with MC reveals the price at which the last group q3-q2 should be sold.

Implementing price discrimination allows the monopoly to, on one hand, obtain more profit and, on the other hand, retain consumers with low purchasing power in the market.

Third-Degree Price Discrimination

Third-degree price discrimination is characterized by offering goods or services to consumers at different prices, but each unit of the product purchased by a specific buyer is paid for at the same price.

In the first two degrees of price discrimination, the division of goods or services into groups was assumed. Instead, third-degree price discrimination is based on segmenting the buyers themselves according to income, age, place of residence, type of work, and other criteria. 

The cost of the product depends on the profile of the target audience representative of a particular group. For example, there are different prices for individual and team online training, and different ticket prices in museums for students, retirees, and other categories of the population.

The increase in the company’s total profit under third-degree price discrimination can be represented by the equation:

MR1 = MR2 =… = MRΣ= MC.

The marginal revenue in each market is the same and equals the total marginal revenue of the monopolist and the marginal costs for the entire output volume.

The graph shows the position of a monopoly conducting third-degree price discrimination based on dividing buyers into two markets—A and B—characterized by the demand lines DA and DB, respectively. Market A is smaller in volume but more elastic than market B. MRA and MRB are the marginal revenue lines. The dashed line MRΣ is the total marginal revenue line of the monopolist, representing the horizontal sum of MRA and MRB.

Types of Price Discrimination

Fritz Machlup proposed a classification of price discrimination, dividing it into three groups:

• personal discrimination
• group discrimination
• product discrimination

Each group has its subtypes, which differ in the characteristics of discriminatory behavior.

Personal Discrimination

Based on differences identified among individual buyers.

• Haggle-every-time: Involves individual negotiation and bargaining with each contract. Example: the sale of used cars or new cars made to individual order.
• Give-up-if-you-must: The seller promises a discount to the buyer for switching from a competitor. This can occur within the framework of choosing a permanent supplier of a particular resource.
• Size-up-their-income: Wealthy consumers are covertly charged higher prices than those with lower incomes. Example: discounts and special prices for legal and medical services.

Group Discrimination

Uses differences between groups of buyers.

• Absorb-the-freight: Delivery costs are included in the price of the product or inflated for buyers who live at varying distances from the production or warehousing location. This method can be used by any online store.
• Kill-the-rival: Prices are systematically lowered, even below cost levels, but only in regions where strong competitors operate. For example, in the 1900s, the American Tobacco Company sold certain brands of chewing and smoking tobacco at prices lower than their production costs. This deprived competitors of profit and pushed them out of their territory.
• Dump-the-surplus: Products produced in quantities exceeding demand are sold at reduced prices abroad, while monopoly domestic prices remain unchanged.
• Get-the-most-from-each-region: Prices in regions with weak competition are consistently maintained at a higher level compared to prices in regions with stronger competition. Very often, in stores in small settlements, prices for essential goods are inflated, whereas in large cities, the same item or product can be purchased more cheaply. A similar situation exists with notary, lawyer, and private medical services, etc.

Product Discrimination

Involves price differences for different goods or services. 

• Appeal-to-the-classes: Some more expensive goods are indeed of higher quality than budget counterparts, but the markup is not entirely justified. For example, the cost of publishing illustrated books is higher than similar resources spent on books with fewer or no illustrations. However, the price difference can significantly exceed the manufacturer’s cost difference. A similar situation exists with certain car brands, where functionality and design may not differ significantly, but the prices vary greatly.
• Make-them-pay-for-the-label: Manufacturers sell physically homogeneous products under different brands, setting higher prices for more popular brands. This applies to almost all sectors—from chocolates to clothing and cosmetics.
• Clear-the-stock: To sell off stock or increase sales volume and attract buyers with low purchasing power, retail stores offer seasonal discounts. This is how most clothing and electronics stores operate.
• Switch-them-to-off-peak-times: To ensure stable utilization of company capacities, some reduce prices for the same products during periods of low demand. For example, free coffee with breakfast at a café or pre-Christmas discounts on website development services.
• Bundle-the-outputs: Mobile service providers and internet providers often include services that users do not need much in their plans. They may choose expensive service packages for unlimited calls, but these people might never use roaming minutes or free SMS.

Price discrimination by monopolists varies depending on the criterion by which the business changes prices. According to this classification, there are five types of price discrimination:

1. Spatial: Sales in the city and countryside, seating in a circus or concert.
2. Temporal: Prices for daytime and evening cinema sessions, tariffs for electric heating.
3. Based on consumer income: Premium services and budget options.
4. Based on consumption volume: Minimum necessary quantity and surplus.
5. Based on consumer social status: Travel tickets for students, hotel rates for foreigners.

When is Price Discrimination Possible?

Price discrimination should be profitable for the business owner. For this, three conditions must be met:

1. The company must have some monopoly power, controlling prices.
2. There must be a way to identify customers on the market who are willing to pay the maximum price or those with different demand elasticities.
3. Reselling the product sold at a low price must be impossible or have minimal likelihood.

Considering the last point, the service industry is optimal for price discrimination. Manicures, dental treatments, massages, event organization, and cleaning services can all be offered to different clients at different prices, with the business owner controlling costs and quality of service.

It is crucial that competitors cannot sell the product cheaper where the company intends to sell it at a higher price. Much depends on the size of the customer base: if there are few buyers, the departure of each one is noticeable to the seller, and the ability to control prices is limited.

Buyers should not have the opportunity to purchase where it is sold cheaper. On a large scale, this is manifested as customs control. A more everyday example is the placement of cafés away from kiosks selling cheap coffee. Expensive boutiques are often located close to each other, while budget clothing is sold separately.

Of course, e-commerce blurs these boundaries. It’s quite common to see clothing advertised at above-average prices, followed by another targeted ad showing an identical dress at half the price. Which of these sellers is the manufacturer, what is the difference, is the fabric really the same, or is it about the brand’s popularity? It is entirely possible that some sellers use price discrimination and offer goods from their assortment to specific segments of the target audience from different profiles under different brand names.

It’s important to consider that the costs of implementing a discriminatory policy should not exceed the benefits of such activity; otherwise, it is impractical. If you want to increase profits through price discrimination, test your hypothesis on one project or a specific group of goods. Prolonged negotiations with each client, studying the purchasing power of different target audience categories, and controlling staff who must know how to correctly set prices and be honest with management—all these can exhaust the entrepreneur and top managers and, conversely, hinder business development.

Examples of Price Discrimination

One of the most notable examples of spatial price discrimination is the pharmaceutical industry. The same medications are sold at different prices in European countries and the USA. A similar but more familiar situation is the price difference for products in different districts of the same city.

Research results from the “Center for Strategic Marketing” show that the price difference for the same product in similar retail locations can exceed 20%.

Price discrimination is an integral part of airline marketing. Experienced travelers compare prices not only between different airlines but also within the same airline, as the ticket price depends on the seat location, date, and time of the flight.

The price difference for the same products in different supermarkets can be up to 100% in some cases. This is related to attracting customers with cheap products while simultaneously selling other goods at inflated prices. Much also depends on the status of the supermarket and its geographical location.

A buyer can save money by shopping for groceries in another district of their city. However, it is unlikely that anyone will spend their time monitoring every item in all the supermarkets in the city—unless they are a marketer with a specific task. Generally, food products, small items, and dining establishments are more expensive in high-traffic areas such as the city center or near train stations. However, if prices are related to the cost of renting the premises or utility services, this is not considered price discrimination.

Coupons, familiar to everyone, are one method of applying price discrimination. They are used in retail to differentiate buyers by their level of purchasing power. Consumers who collect coupons are more sensitive to higher prices than those who do not pay attention to promotions and discounts. By offering coupons on a website, the seller can set a higher price for price-insensitive customers and offer a discount to those who are more price-sensitive. Thus, customers with higher purchasing power compensate the company for the costs of providing coupons to less affluent buyers.

Group price discrimination with the inclusion of delivery costs (absorb-the-freight) is common in takeaway food establishments, particularly sushi. Often, “bonuses” such as sauces, attractive packaging, juice, or soda are added to the main order. The price of the product is higher than that of competitors, and consumers get the impression that this is justified by a high level of service or the special quality of the ingredients. Meanwhile, the rolls may have less weight, and the rice might be purchased at a more favorable price for the producer.

Lastly, let’s consider an example of perfect price discrimination, which is extremely rare in the modern market. Rolls-Royce cars are sold at the maximum demand price since each car is made to individual order. The manufacturer can anticipate the capabilities of its customers, who are few but bring significant income.

How Does Marketing Affect Pricing?

A well-implemented marketing strategy and advertising across various channels can build brand loyalty among the target audience, allowing the company to raise prices without any improvements to products, services, or support.

Promotion through social media, contextual advertising, SEO, content marketing, and other marketing tools increases brand recognition and attracts new customers. For a company in perfect competition, advertising is not crucial, but for a company in monopolistic competition, it is the most important factor in development. Through marketing and price discrimination, a business can convince consumers of the uniqueness of its products and outcompete rivals.

Advertising often yields desired results for product groups such as computers, household appliances, office equipment, audio and video equipment, cars, furniture, building materials, and communication devices.

Advertising explains to the consumer the advantages and differences of a product compared to others, helps create new needs through emotional appeal, logical explanations, case studies, and storytelling. It can create product differentiation where it does not actually exist.

The graph shows how, through advertising costs, a monopolistic competitor can increase its market share. Advertising expenses increased the cost per unit of output (AC1, AC2), but at the same time, the demand for the company’s products increased (D1, D2), ultimately increasing its revenue.

TR2=P2Q2>TR1=P1Q1

Of course, the impact of advertising on the company’s profits depends on whether its competitors are also advertising their products. Under monopolistic competition, advertising may only lead to a temporary increase in profit.

Conclusions

The term “price discrimination” was introduced into economic theory by the English economist Arthur Pigou, although the phenomenon itself was known earlier. There are three levels of price discrimination:

• First-Degree (Perfect): This is only possible if one has information about the demand function of all potential consumers of their product.
• Second-Degree: This occurs when the product is divided into certain groups, each with a different price.
• Third-Degree: This is the most common in the modern market. It is based on market segmentation, with each target audience group having a set sale price.

There is a common belief that price discrimination is purely negative for consumers. However, if all goods and services were priced at a single “average price”, people with lower purchasing power would have to forgo many things, while the most affluent buyers would accumulate money. Price rigidity and the lack of market segmentation can lead to inefficiencies for both businesses and clients.

However, when it comes to abusing the possibility of applying price discrimination, excessive price discrimination can lead to the loss of trust from the target audience. It is important to choose a pricing method that is convenient for both the business and the consumers.

Examples of price discrimination can be seen not only in the analysis of large businesses and well-known corporations. An ordinary grape seller at a market can determine the social status and other characteristics of buyers and set a different price for their product each time. This way, they can increase their profit and outperform competitors.