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What is 'Price Discrimination'

Price discrimination is a pricing strategy that charges customers different prices for the same product or service. In pure price discrimination, the seller charges each customer the maximum price he or she will pay. In more common forms of price discrimination, the seller places customers in groups based on certain attributes and charges each group a different price.

BREAKING DOWN 'Price Discrimination'

Price discrimination is most valuable when the profit from separating the markets is greater than profit from keeping the markets combined. This depends on the relative elasticities of demand in the sub-markets. Consumers in the relatively inelastic sub-market pay a higher price, while those in the relatively elastic sub-market pay a lower price.

Conditions for Price Discrimination

The company identifies different market segments, such as domestic and industrial users, with different price elasticities. Markets must be kept separate by time, physical distance and nature of use. For example, Microsoft Office Schools edition is available for a lower price to educational institutions than to other users. The markets cannot overlap so that consumers who purchase at a lower price in the elastic sub-market could resell at a higher price in the inelastic sub-market. The company must also have monopoly power to make price discrimination more effective.

Types of Price Discrimination

First-degree discrimination, or perfect price discrimination, occurs when a company charges the maximum possible price for each unit consumed. Because prices vary among units, the firm captures all available consumer surplus for itself.  Companies rarely practice this type of discrimination.

Second-degree price discrimination occurs when a company charges a different price for different quantities consumed, such as quantity discounts on bulk purchases.

Third-degree price discrimination occurs when a company charges a different price to different consumer groups. For example, a theater may divide moviegoers into seniors, adults and children, each paying a different price when seeing the same movie. This discrimination is the most common.

An Example of Price Discrimination in Airlines

Consumers buying airline tickets several months in advance typically pay less than consumers purchasing at the last minute. When demand for a particular flight is high, airlines raise ticket prices. In contrast, when tickets for a flight are not selling well, the airline reduces the cost of available tickets. Because many passengers prefer flying home late on Sunday, those flights tend to be more expensive than flights leaving early Sunday morning. Airline passengers typically pay more for additional legroom too.

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