Differences Between Degrees of Price Discrimination to Increase Profits - Research Paper Example

PRICE DISCRIMINATION Differences between the three degrees of price discrimination with business examples and appropriate diagrams ……………………………… College/ University …………………….. Date of Submission …………………….. Introduction Pricing has gained reasonable place in the top of executive agendas and business strategies. Pricing decision is highly significant in almost all managerial and business strategy formulation because it can decide whether the company can achieve success in the market or not. One of the very strong forces in the market is competition and it is always closely related with pricing policies. Among the pricing policies, price discrimination has been considered to be a strategic step forward and has not always been regarded to be unlawful (Nagle and Hogan, 2006, p. 331). This research paper is an attempt to analyze price discrimination and to distinguish its three degrees. This paper presents examples of businesses that have used price discrimination with different degrees and strategies and details how these three degrees can increase the profits of the business with helps of appropriate diagrams. Price Discrimination Generally in Economics, it is assumed that a firm will sell identical products at the same price in all markets. But, it is not the case always and firms may often sell identical products in two or more markets and it may charge different prices too. According to Stavins (1996), firms have no market power to discriminate price in a perfectly competitive market, but, a monopolist can discriminate provided that he has information about consumers’ taste differences and transaction costs (p 3). Price discrimination occurs when the same commodity is sold at different prices to different customers. It was a generally accepted definition of price Discrimination. Philips (1983) argued that there is no price discrimination if the same goods are sold in different places for different prices due to the differences in the cost of carrying goods and so on (p. 5). According to Armstrong and Porter (2007), price discrimination exists when prices vary across customer segments in manner that cannot entirely explained by variations in marginal costs (p. 2224). In broad term, price discrimination exists when two similar products which have same marginal cost to produce are sold by a firm at different prices (Armstrong, 2006, p. 1). In short, price discrimination means: 1) Products with identical costs are sold in different markets for different prices, or 2) The ratio of price to marginal cost is different for identical products (Keat and Young, 2009, p. 393). Differences between three degrees of Price Discrimination Geetika, Ghosh and Choudhury (2008) quoted Pigou (1920), an early economist, as he has identified the major three degrees of price discrimination in his work of ‘The Economics of Welfare’, based on seller’s estimation of consumer’s paying capacity and their willingness to pay for goods or services (p. 291). The three degrees of price discrimination are generally termed as first degree, second degree and third degree price discrimination. First Degree Price Discrimination Sloman (2006) stated that first degree of price discrimination occurs when the firm charges each consumer the maximum price he or she is ready and prepared to pay for each unit (p. 361). In the first degree of price discrimination, the seller would be able to charge different prices for different units of the same commodity from the same customer. This condition is described as perfect discrimination by Joan Robinson (Geetika, Ghosh and Choudhury , 2008, p. 291). According to Dwivedi, the discriminatory pricing that attempts to take away the entire consumer surplus is called first degree price discrimination (p. 327). A firm can discriminate price in the ground of first degree only when he knows the exact price each buyer is willing to pay. The monopolists would be able to know the buyer’s demand curve for the product. Dwivedi described that it is clear when a seller first sets the highest possible price at which all those who are willing to buy will buy at least one unit for that price and when the consumer surplus of that price level is exhausted he gradually lowers the price for his goods (p. 327). The diagram below (Fig-1) shows that the individual would be able to pay 0P1 for the one unit of goods rather than he would pay 0P2 for a second unit, 0P3 for a third unit and so on. The monopolist who made differentiated pricing in this way of unit by unit can be said to have implemented first degree of price discrimination. Business example: Townsend (1995) identified IBM, in its early post war years, as an example of first degree of price discrimination. IBM has then required their customers to pay for computer services in two parts; a computer rent plus a punched card which was used to feed in input (p. 90). Barrows and Smithin (2008) found that first degree price discrimination has been normally practiced by service related businesses like car dealers, mechanics and lawyers etc (p. 103). Impact on profit: When a firm sells it commodities for an auction or based on bidding, it is an attempt to encourage customers to bid for the prices so that customers with high preservation prices purchase the goods. If the business gets more high reservation purchasers, it gets increased profits (Barrows and Smithin, 2008, p. 103). In first degree of price discrimination, sellers are able to charge different prices to different customers depending on their abilities and thus they can sell more goods and earn high profits than they would earn if they charged the same price to all consumers (Barrows and Smithin, 2008, p. 104). Second Degree Price Discrimination Second degree of price discrimination occurs when a firm charges customers different prices according to how much they purchase. The firm may charge a high price for the first certain number of units, a lower price for the next few units and again lower for the next few units (Sloman, 2006, p. 361). Fig- 2 diagram shows the second degree price discrimination in which a firm sets the price of $24 for the first six units and price 418 for the next 6 more units. The total revenue earned by the firm will be $252 (114= 24 *6 from the first batch units and 108= 18*6 from second batch). Business Example The second degree price discrimination is quite common in the case of electricity companies in most countries as it charges higher prices for the first block of units lower for the next block of units and again lower prices for the next block and so on. A consumer with lower paying capacity will consume less units of electricity and will be charge less where as a person with high paying capacity will consume more units of electricity and will be charge higher pay for the extra units or block of units he has consumed. Impact on profit Barrows and Smithin (2008) emphasized that consumers end up with some consumer surplus that in turn means that second degree price discrimination yields lower profits for the firm than that of first degree of price discrimination. But still, the second degree profits are also higher than they would have been if the firm has used a simple strategy to change price for all units being sold (p. 105). Third Degree Price Discrimination In third degree of price discrimination, the seller takes a very small portion of consumer surplus. It is also a very common type of price discrimination in which the market is segmented and different groups of consumers are offered different prices. Economically, consumers with inelastic demand are obliged to pay a higher price than those with elastic demand (Townsend, 1995, p. 91). According to Dastidar (2006), the third degree price discrimination occurs when consumers are charged different prices, but each consumer faces a constant price for all units of outputs purchased by consumers (p. 1). The fig- 3 (Third Degree Price Discrimination Diagram) shows that customers are willing to pay higher prices than those in market B, may be because of that there is less competition in market A. The third degree price discrimination occurs only when the seller is able to segment market in to submarkets as shown market A and market B in the diagram. Moreover, the seller must be able to avoid any significant resale of goods from lower priced market to a higher priced market (Barrows and Smithin, 2008, p. 107) Business Examples Dastidar (2006) outlined the most common examples of third degree price discrimination. Students’ discounts, airline discrimination between business and tourist traffic, prices charged differently on different week are good examples of this type of price discrimination (p. 1). Professional baseball teams earn revenues through ticket sales and in order to maximize the profits, they offer lower ticket prices for children (whose demand is elastic) than adults as they are charged high and their demand is inelastic (McConnel and Brue, 2004, p. 452) Impacts on Profits Barrows and Smithin (2008) argued that third degree price discrimination also yields increased profits. The profit maximizing rule is to produce output in a level where marginal revenue is equal to marginal cost (p. 107). The additional revenue gained from selling an additional unit in market A will be equal to the additional revenue obtained from selling an additional unit in market B. Conclusion Even though the three degrees of price discrimination are different in the way the prices are charged, it is no doubt that all the three degrees can help a firm maximize the profit. First degree is when the seller charges different prices for different units from the same customer, the second degree is when the prices vary with successive blocks of units and third degree is when market is segmented and different prices are charged for different consumers. This piece of research paper has outlined the major differences between the three degrees of price discrimination and has detailed the impacts on increasing the profit of the firm. References Armstrong M and Porter R (2007), Handbook of industrial organization, Volume 3, Illustrated Edition, Elsevier Armstrong M (2006), Price Discrimination, University College London Barrows D and Smithin J (2008), Fundamentals of Economics for Business, Illustrated Second Edition, World Scientific Dastidar KG (2006), On third degree price discrimination in Oligopoly, The Manchester School, Dwivedi (nd), Microeconomics: Theory and Applications, Pearson Education India Geetika, Ghosh P and Choudhury P.R (2008), Managerial economics, Tata McGraw Hill Keat P.G and Young P.K.Y (2009), Managerial Economics: Economic Tools for Todays Decision Makers, Sixth Edition, Prentice Hall, Pearson Education, Inc. McConnel C.R and Brue S.L (2004), Economics: Principles, Problems and Policies, Sixteenth Edition, McGraw Hill Nagle T.T and Hogan J.E (2006), The strategy and tactics of pricing: a guide to growing more profitably, Prentice Hall, Pearson Education Inc Philips (1983), The economics of price discrimination, Illustrated and Reprint edition, Cambridge University Press Sloman (2006) Economics for Business, Pearson Education India Stavins J (1996), Price Discrimination in the Airline Market: The effect of market concentration, Federal Reserve Bank of Boston Townsend H (1995), Foundations of business economics: markets and prices, Illustrated Edition, Routledge Read More