What Is Price Discrimination, and How Does It Work?

Price Discrimination

Investopedia / Theresa Chiechi

What Is Price Discrimination?

Price discrimination is a selling strategy that charges customers different prices for the same product or service based on what the seller thinks they can get the customer to agree to. In pure price discrimination, the seller charges each customer the maximum price they 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.

Key Takeaways

  • With price discrimination, a seller charges customers a different fee for the same product or service.
  • With first-degree discrimination, the company charges the maximum possible price for each unit consumed.
  • Second-degree discrimination involves discounts for products or services bought in bulk, while third-degree discrimination reflects different prices for different consumer groups.

Price Discrimination

Understanding Price Discrimination

Price discrimination is practiced based on the seller's belief that customers in certain groups can be asked to pay more or less based on certain demographics or on how they value the product or service in question.

Price discrimination is most valuable when the profit that is earned as a result of separating the markets is greater than the profit that is earned as a result of keeping the markets combined. Whether price discrimination works and for how long the various groups are willing to pay different prices for the same product depends on the relative elasticities of demand in the sub-markets. Consumers in a relatively inelastic submarket pay a higher price, while those in a relatively elastic sub-market pay a lower price.

Price discrimination charges customers different prices for the same products based on a bias toward groups of people with certain characteristics.

With price discrimination, the company looking to make the sales identify 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, the 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

There are three types of price discrimination: first-degree or perfect price discrimination, second-degree, and third-degree. These degrees of price discrimination are also known as personalized pricing (1st-degree pricing), product versioning or menu pricing (2nd-degree pricing), and group pricing (3rd-degree pricing).

First-Degree Price Discrimination

First-degree discrimination, or perfect price discrimination, occurs when a business charges the maximum possible price for each unit consumed. Because prices vary among units, the firm captures all available consumer surplus for itself or the economic surplus. Many industries involving client services practice first-degree price discrimination, where a company charges a different price for every good or service sold.

Second-Degree Price 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

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.

Examples of Price Discrimination

Many industries, such as the airline industry, the arts/entertainment industry, and the pharmaceutical industry, use price discrimination strategies. Examples of price discrimination include issuing coupons, applying specific discounts (e.g., age discounts), and creating loyalty programs. One example of price discrimination can be seen in the airline industry. 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 response.

By contrast, when tickets for a flight are not selling well, the airline reduces the cost of available tickets to try to generate sales. 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.

Is Price Discrimination Illegal?

The word discrimination in price discrimination does not typically refer to something illegal or derogatory in most cases. Instead, it refers to firms being able to change the prices of their products or services dynamically as market conditions change, charging different users different prices for similar services, or charging the same price for services with different costs. Neither practice violates any U.S. laws—it would become unlawful only if it creates or leads to specific economic harm. 

Wouldn’t Consumers Be Better Off If Everybody Paid the Same Price?

In many cases, no. Different customer segments have different characteristics and different price points that they are willing to pay. If everything were priced at say the "average cost," people with lower price points could never afford it. Likewise, those with higher price points could hoard it. This is what is known as market segmentation. Economists have also identified market mechanisms whereby fixing static prices can lead to market inefficiencies from both the supply and demand sides.

When Can Companies Successfully Apply Price Discrimination?

Economists have identified three conditions that must be met for price discrimination to occur. First, the company needs to have sufficient market power. Second, it has to identify differences in demand based on different conditions or customer segments. Third, the firm must have the ability to protect its product from being resold by one consumer group to another.

Article Sources
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  1. Microsoft. "Compare Office 365 Education Plans." Accessed Feb. 7, 2022.