Price discrimination is a strategy that consists of a business or seller charging a different price to various customers for the same product or service. It is one of the competitive practices used by larger, established businesses in an attempt to profit from differences in supply and demand from consumers.

A company can enhance its profits by charging each customer the maximum amount he is willing to pay, eliminating consumer surplus, but it is often a challenge to determine what that exact price is for every buyer. For price discrimination to succeed, businesses must understand their customer base and its needs, and there must be familiarity with the various types of price discrimination used in economics. The most common types of price discrimination are first, second, and third-degree discrimination.

First-Degree Price Discrimination

In an ideal business world, companies would be able to eliminate all consumer surplus through first-degree price discrimination. This type of pricing strategy takes place when businesses can accurately determine what each customer is willing to pay for a specific product or service and selling that good or service for that exact price.

In some industries, such as used car or truck sales, an expectation to negotiate final purchase price is part of the buying process. The company selling the used car can gather information through data mining relating to each buyer's past purchase habits, income, budget, and maximum available output to determine what to charge for each car sold. This pricing strategy is time-consuming and difficult to perfect for most businesses, but it allows the seller to capture the highest amount of available profit for each sale.

Second-Degree Price Discrimination

In second-degree price discrimination, the ability to gather information on every potential buyer is not present. Instead, companies price products or services differently based on the preferences of various groups of consumers.

Most often, businesses apply second-degree price discrimination through quantity discounts; customers who buy in bulk receive special offers not granted to those who buy a single product. This type of pricing strategy is used most often in warehouse retailers, such as Sam's Club or Costco (COST), but it can also be seen in companies that offer loyalty or rewards cards to frequent customers.

Second-degree price discrimination does not altogether eliminate consumer surplus, but it does allow a company to increase its profit margin on a subset of its consumer base.

Third-Degree Price Discrimination

Third-degree price discrimination occurs when companies price products and services differently based on the unique demographics of subsets of its consumer base, such as students, military personnel, or seniors.

Companies can understand the broad characteristics of consumers more easily than the buying preferences of individual buyers. Third-degree price discrimination provides a way to reduce consumer surplus by catering to the price elasticity of demand of specific consumer subsets.

This type of pricing strategy is often seen in movie theater ticket sales, admission prices to amusement parks, or restaurant offers. Consumer groups that may otherwise not be able or willing to purchase a product due to their lower income are captured by this pricing strategy, increasing company profits.