Price discrimination
Price discrimination or price differentiation is a pricing strategy where identical or largely similar goods or services are transacted at different prices by the same provider in different markets or territories.[1][2][3] Price differentiation is distinguished from product differentiation by the more substantial difference in production cost for the differently priced products involved in the latter strategy.[3] Price differentiation essentially relies on the variation in the customers' willingness to pay.[2][3]
The term differential pricing is also used to describe the practice of charging different prices to different buyers for the same quality and quantity of a product,[4] but it can also refer to a combination of price differentiation and product differentiation.[3] Other terms used to refer to price discrimination include equity pricing, preferential pricing,[5] and tiered pricing.[6] Within the broader domain of price differentiation, a commonly accepted classification dating to the 1920s is:[7][8]
- Personalized pricing (or first-degree price differentiation) — selling to each customer at a different price; this is also called one-to-one marketing.[7] The optimal incarnation of this is called perfect price discrimination and maximizes the price that each customer is willing to pay,[7] although it is extremely difficult to achieve in practice[7] because a means of determining the precise willingness to pay of each customer has not yet been developed.
- Group pricing (or third-degree price differentiation) — dividing the market in segments and charging the same price for everyone in each segment[7][9] This is essentially a heuristic approximation that simplifies the problem in face of the difficulties with personalized pricing.[8][10] A typical example is student discounts.[9]
- Product versioning[2][11] or simply versioning (or second-degree price differentiation) — offering a product line[7] by creating slightly different products for the purpose of price differentiation,[2][11] i.e. a vertical product line.[12] Another name given to versioning is menu pricing.[8][13]
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Types of price discrimination
First degree price discrimination
This type of price discrimination requires the monopoly seller of a good or service to know the absolute maximum price (or reservation price) that every consumer is willing to pay. By knowing the reservation price, the seller is able to sell the good or service to each consumer at the maximum price he is willing to pay, and thus transform the consumer surplus into revenues. So the profit is equal to the sum of consumer surplus and producer surplus. The marginal consumer is the one whose reservation price equals to the marginal cost of the product. The seller produces more of his product than he would to achieve monopoly profits with no price discrimination, which means that there is no deadweight loss. Examples of where this might be observed are in markets where consumers bid for tenders, though, in this case, the practice of collusive tendering could reduce the market efficiency.[15]
Second degree price discrimination
In second degree price discrimination, price varies according to quantity demanded. Larger quantities are available at a lower unit price. This is particularly widespread in sales to industrial customers, where bulk buyers enjoy higher discounts.[16]
Additionally to second degree price discrimination, sellers are not able to differentiate between different types of consumers. Thus, the suppliers will provide incentives for the consumers to differentiate themselves according to preference. As above, quantity "discounts", or non-linear pricing, is a means by which suppliers use consumer preference to distinguish classes of consumers. This allows the supplier to set different prices to the different groups and capture a larger portion of the total market surplus.
In reality, different pricing may apply to differences in product quality as well as quantity. For example, airlines often offer multiple classes of seats on flights, such as first class and economy class. This is a way to differentiate consumers based on preference, and therefore allows the airline to capture more consumer's surplus.
Third degree price discrimination
In third degree price discrimination, price varies by attributes such as location[17] or by customer segment, or in the most extreme case, by the individual customer's identity; where the attribute in question is used as a proxy for ability/willingness to pay.
Combination
These types are not mutually exclusive. Thus a company may vary pricing by location, but then offer bulk discounts as well. Airlines use several different types of price discrimination, including:
- Bulk discounts to wholesalers, consolidators, and tour operators
- Incentive discounts for higher sales volumes to travel agents and corporate buyers
- Seasonal discounts, incentive discounts, and even general prices that vary by location. The price of a flight from say, Singapore to Beijing can vary widely if one buys the ticket in Singapore compared to Beijing (or New York or Tokyo or elsewhere).
- Discounted tickets requiring advance purchase and/or Saturday stays. Both restrictions have the effect of excluding business travelers, who typically travel during the workweek and arrange trips on shorter notice.
- First degree price discrimination based on customer. It is not accidental that hotel or car rental firms may quote higher prices to their loyalty program's top tier members than to the general public.[citation needed]
Modern taxonomy
The first/second/third degree taxonomy of price discrimination is due to Pigou (Economics of Welfare, 4th edition, 1932). See, e.g., modern taxonomy of price discrimination. However, these categories are not mutually exclusive or exhaustive. Ivan Png (Managerial Economics, 2nd edition, 2002) suggests an alternative taxonomy:- Complete discrimination -- where each user purchases up to the point where the user's marginal benefit equals the marginal cost of the item;
- Direct segmentation -- where the seller can condition price on some attribute (like age or gender) that directly segments the buyers;
- Indirect segmentation -- where the seller relies on some proxy (e.g., package size, usage quantity, coupon) to structure a choice that indirectly segments the buyers.
- profitability and
- information requirement.
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