Price discrimination is a widely used marketing tactic. It is present when two or more identical units of the same products or services are sold at different prices, either to the same buyer or to different buyers. It is more often observed in sales to end-use buyers (consumers) than in intermediate-goods markets (where the buyer is a manufacturer, wholesaler, or retailer); this is because in many countries price discrimination in intermediate-goods markets is considered to be an “unfair” practice by antitrust authorities. Price discrimination is also known as “flexible pricing” or “targeted pricing.” Since they sound neutral, these alternative names are often used by the business community. Whatever it is called, however, price discrimination is nothing but a marketing technique used by a seller to generate higher profits by taking advantage of differences in consumers’ “willingness to pay” (i.e., a maximum amount that each buyer is ready to pay).
Typical examples of price discrimination include student discounts for motion pictures and quantity discounts in shopping malls. Other than these obvious examples, however, judgment is often required in deciding whether or not a particular pricing practice should be classified as price discrimination. For instance, a difference in the total price of a delivery is usually not considered to be price discrimination if it simply reflects a difference in transportation costs. Goods sold at different places at different dates give different utility, and they are therefore considered to be, to some extent, different goods. A less trivial example is a pricing practice for tiered classes in airplanes. This may be seen as product differentiation if one emphasizes that passengers in different classes actually enjoy differentiated goods (e.g., spacing, meals). In this case, however, the main part of the good is the flight itself, and it may be that the carrier simply wants to engage in price discrimination. The apparent product differentiation might therefore be of secondary importance. A similar practice is found in the way publishers sell a book. Many books are initially sold in hardcover editions, with a less expensive paperback edition being published at a later time.
To discriminate in pricing, firms must obviously have some control over the price that buyers face. This situation occurs when market competition does not drive the price down to a level at which a firm (i.e., a seller) considers exiting from the market because buyers are somehow “stuck” with particular sellers, either because it is too costly to look into all of the other alternatives, or because the number of firms in the market is so small that competition is not fierce. In addition, the cost of immediate resale among consumers must be impossible; otherwise some consumers will be better off buying the good at a lower price from other consumers (this behavior is called arbitrage).
A common taxonomy of price discrimination, contrived by Arthur C. Pigou in 1920, is based on how a firm sorts buyers, each of whom potentially has a different value of willingness to pay (i.e., a different maximum amount that each buyer is ready to pay). In first-degree price discrimination (also known as perfect price discrimination), a firm captures the entire amount of each buyer’s willingness to pay. In reality, however, this type of price discrimination is rarely observed, because the firm needs to know exactly what each buyer’s willingness to pay is, and this requirement is difficult to meet. Yet sellers may still have some idea of how many buyers there are for each particular level of willingness to pay. In second-degree price discrimination, a firm, by utilizing information on buyer preference, offers various pricing options, letting each consumer self-select into a different pricing schedule (e.g., quantity discounts or the aforementioned bookselling options). In third-degree price discrimination, the seller uses observable signals (e.g., age, occupation, location, time of use) to categorize buyers into different segments, and each segment is given a constant price per unit.
However, the boundary between second- and third-degree price discrimination is not absolute. For example, with price skimming (or behavior-based price discrimination), in which a firm offers different prices depending on a buyer’s history of past purchases and other behaviors (e.g., how often he or she has visited the firm’s Web site), a buyer usually faces a constant price for each product, while a different buyer may pay a higher or lower price depending on his or her behavioral history. Thus, price skimming does not fall within the three main types of price discrimination. Advances in information processing technology, such as the widespread use of the Internet, have made this type of price discrimination possible.
Firms are usually happy with discriminatory pricing as long as it does not make price competition too fierce. Since firms extract more of a buyer’s willingness to pay by price discrimination, a question arises as to whether buyers are always worse off than they would be with uniform pricing (when a seller offers an identical price to every buyer). Economists do not have a definite answer to this question. One instance of third-degree price discrimination that could benefit buyers as a whole, or in which every buyer could be better off, is when firms sell a good to consumers who would not purchase it under uniform pricing. In addition, as Takanori Adachi (2005) points out, with goods such as information or communications, where “network effects” are prevalent (that is, as more people buy the good, their willingness-to-pay increases), price discrimination has greater potential to improve consumer welfare. This is because a firm utilizes price discrimination to create more gains from the network effects, which can also benefit the buyers more than the amount a firm extracts from consumers’ willingness to pay. In studies combining formal modeling and data analysis, Eugenio J. Miravete (2002), Phillip Leslie (2004), and others have scrutinized the welfare effects of price discrimination. Miravete studied optional calling plans (a variant of quantity discounts) in the telephone service industry, and he concluded that the experimental introduction of optional calling plans might have harmed not only consumers, but also the telephone service company. Leslie investigated the welfare effects of both second- and third-degree price discrimination in the world of musical theater. He found that price discrimination increased a producer’s profits by 5 percent, while the loss in consumer welfare was negligible. As these studies show, there seems to be no general answer as to whether discriminatory pricing per se harms the buyer, and the question must therefore be considered on a case-by-case basis.
SEE ALSO Competition, Imperfect; Discrimination; Discrimination, Wage; Monopoly; Price Setting and Price Taking
Adachi, Takanori. 2005. Third-Degree Price Discrimination, Consumption Externalities, and Social Welfare. Economica 72 (285): 171–178.
Leslie, Phillip. 2004. Price Discrimination in Broadway Theater. RAND Journal of Economics 35 (3): 520–541.
Miravete, Eugenio J. 2002. Estimating Demand for Local Telephone Service with Asymmetric Information and Optional Calling Plans. Review of Economic Studies 69 (4): 943–971.
Pigou, Arthur C. 1920. The Economics of Welfare. London: Macmillan.