Should Firms Price Discriminate - Essay Example

PRICE DISCRIMINATION Should firms price discriminate? (1500words Profit maximizationis our target-price discrimination is our tool.” By Unknown monopolist History of economic thought states that the main objective of the firm is to minimize its cost and to maximize its profit using any legal methods available. Therefore, we can conclude that it would be profitable for a firm to apply price discrimination (PD). However, we should not ignore cases and issues arising when applying discriminatory strategies as this can affect a firm’s choice whether to discriminate or not. The utility and consumer surplus theorems played a vital role in our understanding of PD and importantly how it might help in achieving a business goal. Therefore, PD can be defined as the situation in which price charged to a customer can be based partly on the value of the good to the customer, rather than just on the cost of producing the good itself (Paul, 1987). As a result, allowing a firm to capture all or most of the consumer surplus, increasing overall profit of the firm. Although this definition is different, it highlights an importance of utility and consumer surplus theorems allowing us to analyze how firms might use their monopoly power. In other words, how PD could be applied, so maximum profit can be gained in different monopoly markets. First of all in order to discuss the usefulness of PD as a profit maximizing tool, we should identify the conditions that firm must meet in order to price discriminate. According to Fritz Machlup, (Fritz, 1955)there are three main prerequisites, firstly, a firm has to have the monopoly power in order to set the price. For example, if a firm is a price taker and its operates in perfectly competitive market it cannot price discriminate as demand curve is perfectly elastic, therefore there is no consumer surplus to capture, whereas if a firm is a monopoly it has a downward sloping demand curve therefore, there are some consumers who are willing to pay more than the uniform price. Secondly, for different groups of consumers it is necessary to have different price elasticity. For example, assume that all consumer groups have the same price elasticity then ceteris paribus; monopoly firm does not have an incentive to apply PD as the profit will be the same as a firm would have applied single price strategy. The third criteria, is that a firm must be able to prevent an arbitrage, in other words preventing resale of its products. For instance, why do Apple restricts on the number of IPhones that can be purchased, it is not because Apple products are exclusive, the reason is to prevent an arbitrage. Some people might buy IPhones in the US and sell them in the UK for much cheaper price due to tax and currency exchange differences. As a result, Apple might not be able to make higher profits by selling its phone’s in the UK (considering worth scenario). Having discussed the necessary conditions, we can move to the classifications of the PD. Going back to Pigou, (Pigou, 1920),where he defines first degree PD as a situation where firm is able to identify and set specific prices for each customer, as a result extracting full consumer surplus. Every spiritual entrepreneur would have applied perfect PD in order to enjoy high profits. However, in order to adopt this strategy firm should have information about consumer’s tastes and the price each customer is willing to pay. Assuming that firm is able to do so, than it is count reasonable that firm will apply this strategy. According to Shiller, some Internet retailers like; Netflix, Amazon, Staples etc have been very successful in exercising this method. For example, Netflix using the web browsing data knows about consumer preferences and his willingness to pay. In other words Netflix might identify whether customer is affluent or budget conscious. This allows firm to use tailored pricing. As a result some consumers are paying more than the others do for the same commodity. We can conclude that Perfect PD is a very powerful business tool in making PD desirable to use. However, there are some disadvantages that a firm needs to consider before using the first degree PD. As by using perfect PD, it might generate supernormal profits, attracting other firms to enter the market, therefore creating competition. In addition, consumers might feel deceived due to unfair pricing. According to public survey conducted by Kahneman, (Kahneman, Jack, & Richard, 1986), 91 % of consumers think that it is unfair to charge different prices for identical products. Therefore, a firm might lose its consumers and this will consequently affect profits of the firm directly. Since using the first degree PD might cause entry of competitors and negative response from consumers, it would be better for a firm to change its pricing strategy. According to Daniel Marburger (Innovative Pricing Strategies, 2012) instead of charging different prices to different consumers, firms should create price scheme that will cause consumers to self select based on their willingness to pay. This is known as a second degree PD. Using this price strategy (referring back to 2nd degree PD) firms might generate higher profits, and this would depend on whether they would have followed single price strategy. For, example, assume that cellular company has different packages, which include mobile calls, internet access and texting. Assume that, there are also three different types of consumers as shown in the figure 1. The diagram also shows the willingness to pay for each service. Consumer A B C Mobile Service (M.S) $60 $50 $40 Internet (I) $55 $50 $30 Texting (T) $0 $25 $40 Figure 1 (Authors calculations) Now, let’s consider that firm is going to charge each consumer individually. According to the table, if a firm sets a price for M.S at $60 only consumer A will purchase the service, therefore the firm will generate a profit of $60. However, the firm will charge $50 for M.S than both A and B will buy the product. As a result the optimal price for M.S will be $40 because at this price, the firm captures the highest profit of $120. Similar logic can be applied for I and T. As a result, overall profit of the firm generated by a single price strategy is $260. However, the monopolist can do better by offering a package. As you can see on the figure 2, the total profit made by an offering a package is $330 which is more than profit made by the single price strategy. Consumers Price for a bundle Number of consumers Profit A $115 2 $ 230 B $125 1 $ 125 C $ 110 3 $ 330 Figure 2 (Authors calculations) Therefore, we can conclude that it would be reasonable for a firm to use PD. However, the firm should not ignore the fact that, firm cannot distinguish different customers, when charging them a price (when using 2nd degree PD). Let us go back to figure 1 and assume that, if the willingness to pay of each consumers changes. According to the figure 3, now it is profitable for a firm to apply a single strategy as it generates a profit of $ 290 whereas, if firm uses PD it only makes a profit of $ 285. Consumer A B C Mobile Service (M.S) $ 40 $50 $ 60 Internet (I) $ 55 $ 50 $ 30 Texting (T) $ 0 $ 25 $ 40 Figure 3 (Authors calculations) Third degree Discrimination of Price This occurs when a firm charges different prices to 2 or more buying groups whose demand elasticity are different. The different buying grops are therefore differentiated in terms of sex, location and age. Three conditions are required in order for a firm to successfully be a third degree price discriminator. These include; market control, different buyers and segmented buyers. In market control, a firm should be able to the prices in the market. Monopoly is normally in the forefront of price discrimination since it is a price maker. The second condition, a firm must be able to identify different buyer groups. These groups should have different demand elasticities. This will mean that the buyers will be willing and able to pay different prices for the same good. For the last condition, it requires each buyer group should be segmented into distinct markets. This implies that buyers in one market cannot resell goods in another market. In this case, those buyers who would be charged a higher price could buy the same goods from those who purchase them at a lower price. In conclusion, I have analyzed three types of PD and the necessary conditions to PD, I think that firms should price discriminate. Because I have outweighed the cost and benefits of PD, I personally think that PD leads not only to higher profits but also to an efficient use of resources. That is important because the main problem which economics is trying to solve is how to allocate scarce resources correctly, Therefore, I strongly recommend firms to price discriminate. BIBLIOGRAPHY Andrew, O. (2003). Privacy, Economics and Price Discrimination. Twin Cities: University of Minnesota. Benajamin, R. S. (2013). First Degree Price Discrimination Using Big Data. Usa: Brandeis University Press. Daniel, M. (2012). Innovative Pricing Strategies. New York: Business Expert Press. Fritz, M. (1955). Characteristics and Types of Price Discimination. Business Concentration and Price Policy . Kahneman, D., Jack, L. K., & Richard, H. T. (1986). Fairness and Assumptions of Economics. Journal of Business , 59 (4), 6-7. Louis, P. (1983). The Economics of Price Discrimination. USA: Oxford University Press. Mikians, J. (2012). Detecting Price and Search Discrimination on the Internet. Scientific Publications , 1-3. Nancy, L. S. (1979). Intertemporal Price Discrimination. Oxford Economics Journal , 1-4. Paul, R. M. (1987). An Essay on Price Discrimination . Economics Working Papers 8732 . Pigou, A. C. (1920). The Economics of Welfare. London: Macmillan & Co. Publishers. Read More