Degrees of Price Discrimination - Literature review Example

Introduction

Price discrimination is one of the pricing strategies in economics. It is a situation where different prices are charged on the same product or service. Discrimination in its absolute sense involves charging each customer the maximum price that they are ready and willing to pay for the product or service that they are looking to buy (Esteves, 2014). The most commonly practiced form of price discrimination involves putting customers in different groups or categories on the basis of specific attributes, and charge different prices for different groups. For instance, the customers could be grouped according to income levels such that high income earners are made to pay a higher price for a commodity or service for which less income earners will pay much less (Lambrecht et al., 2012). Another example is the pricing strategy in the movie/theatre industry where the distinct customer categories include seniors, adults and youths, with the assumption being that adults are the highest incomes earners, while the seniors are probably retirees whose finances have gone down. The adults will pay a slightly higher price for a movie session than seniors, while the youths will pay the lowest fees (Cowan, 2012). There are three types of price discrimination, namely, first degree price discrimination, second degree price discrimination, and third degree price discrimination.

• First Degree Price Discrimination

1st degree price discrimination, sometimes referred to as perfect price discrimination, is where a firm charges customers the maximum price that they are willing and ready to pay for a product or service (Lambrecht et al., 2012). It involves extracting the consumer surplus with a view to maximizing profits for the firm. It is regarded as one impracticable forms of price discrimination since it requires the firm to know all every single customer perfectly at all levels of consumption. The customers have to be profiled to enable a firm to offer personalized prices which could be based on past performances. It is never possible to know all customers perfectly because apart from being too many, most of the information that the firm requires to build profiles for each of them is always difficult to extract (Esteves, 2014). In this case, a customer knows only the price that they are paying for the product or service, but will never have clue about what a previous customer paid, or what a customer that comes next will pay for the same (Esteves, 2014). This creates harmony between the different consumer categories and profiles since one would most likely feel offended if they were to realize that they actually paid more for a product or service than another customer.

A car dealer will always look to get as much out of the customer as possible, to a point where the consumer surplus hits 0. It can be easily practiced in businesses that involve bargaining or negotiating the price of products or services, such as car dealership (Cowan, 2012). There are cultures where first degree price discrimination is considered normal, but may not be prevalent in cultures or backgrounds where customers are not to negotiating the prices of products and services. Appropriation of the entire consumer surplus is the major aim of first degree price discrimination.

• Second Degree Price Discrimination

Second degree price discrimination is practiced where customers are unable to differentiate consumers, and thus cannot cluster them in different categories on the basis of any attributes. Price differentiation in this case is therefore based on the quantities of products and services purchased by consumers (Cowan, 2012). A firm thus tries to extract consumer surplus without really having to know much about the individual customers. It is the consumer who chooses the amount of product or service that they wish to purchase based on the unit prices posted. The customers differentiate themselves according to their preference. This type of price discrimination is often seen in bulk purchasing (Esteves, 2014). Large-scale retailers like Walmart are bulk purchasers that get large trade discounts, and that results in savings which can then be transferred to the eventual consumers. In quantity discount arrangements, the amount of discount given increases with the amount of products of services purchased. The bigger the purchase, the higher the amount a consumer saves through quantity discounts (Esteves, 2014). A section of customer will always prefer to buy more for much less whenever offers are on.

In retail stores, one would always meet offers like “buy three, get one free”, implying that one gets four pieces of the commodity for the price of three. In other cases, products are packed in different amounts, from one kilogram, 2 kilograms, five kilograms and so on (Chevalier & Kashyap, 2014). The price of a one kilogram pack will always tend to be slightly higher than one kilogram in the or five kilogram pack, for instance, if the listed price for the latter were to be divided by five. This type of price discrimination does not favor consumers who do not have big families since they will not always have a reason to make big purchases that would attract reasonable discounts (Chevalier & Kashyap, 2014). Such people end up paying the full price of a product or service, while they may not be earning as much income as those purchasing in bulk. One feature of this type of price discrimination is that one chooses to pay more or less, depending on the amount of purchases that they wish to make, and where they have to pay more, they will always know the reason.

• Third Degree Price Discrimination

Third degree price discrimination is where firms set commodity or product prices that they believe will accommodate the consumer. Here, the firms have broad knowledge of the demographics of the customers they will encounter, and will always want to levy prices that allow as many people as possible to consume the product (Courty & Pagliero, 2012). The intention is to be as inclusive as possible by charging prices that are not prohibitive. For this type of price discrimination to work successfully, firms must at any given time be able to predict demand elasticity for all consumers (Courty & Pagliero, 2012). In the movie theatre business, for instance, students and seniors will in many cases be given discounts since they tend to have more price elasticity of demand than adults. Courtesy of this kind of discrimination, firms are always able to extract consumer surplus for the consumer categories that are believed to be unable to pay the standard prices for the products or services ordered (Courty & Pagliero, 2012). A firm must therefore be able to separate the segments, and where it is not possible to separate segments, the product can be transferred.

One advantage of third degree price discrimination is that it gives a firm an opportunity to expand the market for its products or services by selling to a group of consumers who would otherwise not make any purchases (Lambrecht et al., 2012). The firms will in most cases not engender any bad feelings among customers that do not fall into the discounted group so long as the general prices have not been raised as a way of making up for the discounts offered (Lambrecht et al., 2012). No customers are made to pay over the odds for any product or service that they purchase, and this is mainly because firms would, at the maximum, tend not to charge anything above the standard prices. Knowing the customer demographics can be difficult at first, but the once a firm can have in-depth knowledge about its customers in terms of their abilities, it can always charge prices that a customer can afford (Lambrecht et al., 2012). The product or service prices will always lie between the standard price and a price that is slightly lower than the standard one. Depending on the segments in which a customer belongs they will pay either the standard price or a lower one.

How Price Discrimination Influences the Market

Competition in different markets increasingly takes place along the price discrimination concept. Firms try to outdo each other in the market by constantly trying to curve niches, and that is mainly achieved through understanding who a firm’s customers are, and creating a profile for as many customers as possible (Cowan, 2012). A firm owns the discretion to determine the amount of discount to offer, or the lowest amount they can accept from a customer after haggling. Customers have the power to assess the market and settle for the best deals. A firm will therefore try to keep its traditional customer base by offering commodities at the best price that they can find around (Courty & Pagliero, 2012). Since prices are negotiable, or are made to change under different circumstances, mostly depending on the firm’s price-setting philosophy, a firm would be ready to accept a reduced profit margin on a product or service, and not look to make up for it elsewhere since that would be exploitative to a group of customers at the expense of another (Courty & Pagliero, 2012). Any form of exploitation through pricing is risky because it would prompt a customer to go for competitors in their subsequent shopping.

Price Discrimination Benefits and Costs

Benefit or cost of price discrimination depends on whether one is the firm or the consumer (Cowan, 2012). Price discrimination involves appropriation of the consumer surplus, and so long as the marketing scheme costs do not exceed the extra costs brought about by the schemes, it would be an advantage to the firm, but definitely not a loss to the consumer. A keener examination of the costs would reveal that the customers end up paying less than they would if there was one standard price for products or services (Chevalier & Kashyap, 2014). Where discrimination causes a substantial increase in a firm’s output, the average product or service price may go even lower as a result of the economies of scale. Economies of scale can sometimes outweigh the price differences between different consumer segments. Firms always need to look at issues related price discrimination issues on a case by case basis.

Conclusion

Price discrimination is the one pricing strategy that has led to the most intense competition at both industry and market levels. Bigger firms will always have the necessary economies of scale to offer some of the attractive discounts on bulk purchases than small firms. They can also offer lower prices to a segment of its customers and still not suffer any losses because of the wide customer base. A hyperactive market and industry as a result of price discrimination ensures that firms do everything to keep hold of its traditional customer base which it would otherwise lose to rival firms that offer reduced prices. Most firms would prefer quantity discount as a price discrimination strategy since it allows the customers to go for the quantity of goods that they wish to purchase, and get the discount that the quantity of goods or services purchased attracts.