PRICE DISCRIMINATION

Price discrimination exists when the same product is sold at different prices to different buyers. The cost of production is either the same or different but not so much as the difference prices charged. The product is basically the same, but it may have slight differences (for example, different binding of the same book; different location of seats in a theatre; different seats in an aircraft or a train). The identical product, produced at the same cost is sold at different prices, depending on the preference of the buyers, their income, their location and the ease of availability of substitutes.
These factors give rise to demand curves with different elasticity in the various sectors of the market of a firm. It is also common to charge different prices for the same product at different time periods. For example, a new product is often sold at a high price, accessible only to the rich, while subsequently it is sold at lower prices that can be afforded by lower- income consumers. The following are the necessary conditions that must be fulfilled for the implementation of price-discrimination

1. The market must be divided into sub-markets with different price elasticity. 
2. The markets must be so separated from each other that no reselling can occur from a low-price market to a high- price market. This condition shows why price discrimination is easier to apply with commodities like electricity or gas, and services like services of a doctor, transport, a show, which are ‘consumed’ by the buyer and cannot be resold.

The reason for a monopolist (or any other firm) to apply price discrimination is to obtain an increase in his total revenue and his profits. By selling the quantity defined by the equation of his MC and his MR at different prices the monopolist realizes higher total revenue and hence higher profits as compared with the revenues he would receive by charging a uniform price.

Price Discrimination by Degrees

1. First Degree Discrimination

The simplest kind of discrimination of the first degree is one where, for some reason, consumers buy only one unit each from the firm. Knowing exactly how willing they are, the firm charges each one a price so high that the consumers almost, but not quite, refuse to pay the prices. If all of the consumers have different tastes, the firm has a different price for each one. The lowest price is determined by costs.

When consumers buy more than one unit of the firm’s product, they are willing to buy more units at lower prices. The firm must then adjust the units of sale. With first -degree price discrimination, the firm extracts the consumer’s entire surplus. The firm succeeds in getting all the area under the demand curve as revenue. Each consumer pays a price equal to the marginal utility of that unit for each unit consumed.
Discrimination of the first degree is the limiting, or extreme case. Obviously, it could occur only rarely, where a firm has only a few buyers and is shrewd enough to know the maximum prices they will pay. Doctors sometimes charge different fees according to the incomes of their patients. Universities may approach first-degree price discrimination by charging a high tuition. 

Second Degree Discrimination

In discrimination of the second degree, the firm captures parts of buyer’s consumers’ surpluses, but not all of them. The schedules of rates typically charged by public utilities can be regarded as a form of second-degree discrimination. The price varies according to the number of units purchased by a consumer.

 Second- degree price discrimination is necessarily practiced in markets where there are many buyers, sometimes hundreds or thousands of them. The same rate or price schedule must be offered to all buyers. Because tastes and incomes differ, the firm can seize only a small part of the consumer’s surplus of those buyers whose desires for the service are stronger and whose incomes are higher. Second -degree discrimination, furthermore, is limited to services sold in blocks of small units- cubic feet of gas, kilowatt of electricity, minutes of telephoning- that can easily be metered, recorded, and billed.

Third Degree Discrimination

Third-degree price discrimination means that the firm divides customers into two or more classes or groups, charging a different price to each class of customers. Public utility companies practice price discrimination of the third degree by grouping their customers into separate markets, such as residential, commercial and industrial, Each market is further subdivided into sub-markets, such as different times of the day and different uses of the service. Prices differ from one sub-market to another and, besides, second-degree discrimination is practiced within each sub-market.

Segmenting the market is a logical extension of product differentiation. The objective of price discrimination is to secure maximum profits by adjusting the price and the output in each distinct sub-market according to the demand conditions. Assuming that there is no change in cost conditions, the monopolist has to decide how much total output is to be produced and its distribution in each market and also what prices should be charged in different markets.

For analytical simplicity let us assume that the monopolist is able to divide the market for his product into two sub-markets A, and B whose demand curves are AR1 and AR2 respectively with different price elasticity of demand. Figure 1 depicts the marginal revenue curves corresponding to average revenue curves are given by MR1 and MR2 respectively. AAR & AMR are the aggregate average revenue and marginal revenue curves. Given the marginal cost curve MC for the whole output, the monopolist attains equilibrium at point E where the MC cuts the AMR from below. At equilibrium, the monopolist produces and sells total output OQ that he allocated between two markets in such a way that the marginal revenue in each market is equal to the marginal cost of the entire output. In order to locate the equilibrium price and output levels in the two sub-markets A and B, a horizontal line is drawn from the equilibrium point ’E’ that intersects MR1 and MR2 at points ‘E1’ and ‘E2’. In market A the monopolist charges P1 price and sells OQ1, while in market B he charges P2 price and sells OQ2 output. If we carefully look at the figure we can infer that the monopolist charges a higher price and sells lower output in a market with relatively inelastic demand curve, while in a relatively elastic demand curve he charges a lower price and sells a large output.