Features of Price Discrimination - Essay Example

Introduction The fundamental theory of economics is based on the principle of demand and supply. From the very first lecture till the time one becomes a champion of economics, this assumption, law, rule of thumb, commandment or sacred Gospel of economics holds valid and does not waver even though other assumptions and models begin to evolve as more and more theories begin to surface (Samuelson, 2004). However, economics is a very cunning area of study in terms of the number of shortcuts and twists it offers to the people who are well aware of the complete picture of theories and practices of economics. Economists are often referred to as "legal crooks" owing to the fact that their knowledge of economics and the underlying principles along with the "valid" practices within the framework of law (Brue, 2004). The works of economics in various fields have been criticized for not being implementable in the real world and this has been one of the most serious failures of economists. However, there are still a number of theories which can be implemented in the real markets as they are in the books and work well in the human environment due to the fact that they have been developed over years after observing human nature and business functioning methods. This paper will be discussing the concept of price discrimination and how it can be used to benefit firms instead of the general notion that discounts and special fares for different target groups will lead to lower profit margins and losses. The paper is outlined in a continuous flow that will explain the basic three degrees of price discrimination with illustrations. After the theories have been discussed in detail, the practical examples will give the reader an idea of how the theory works in the actual environment which will be followed by a prompt conclusion. Price Discrimination Though the term says it all, it is necessary to consider the mechanisms of demand and supply and the rubrics of price determination in a market where buyers and sellers have the natural tendency to bargain and ask for discounts if their purchases are above a standard quantity while sellers would love to settle for a lower price if buyers are willing to purchase more just because of the selling price being reduced. The definition of price discrimination is to "charge different buyers different prices for the same good, even though there is no difference in costs between customers" (Price Discrimination Notes, 2009). There are three degrees of price discrimination which form the complete function of this theory and while all can be practiced at the same time, it all is a matter of information flow in the system as to how long the practice can be sustained without forces acting towards price restoration (Case & Fair, 2004). This section will identify the three forms of price discrimination in theory clearly understating how it can still be profitable for firms to operate even though may be discriminating against prices. The above graph shows a typical demand-supply curve for a real market. With no price discrimination, the consumer surplus is the value the consumers received extra i.e. they did not pay for this value. However, the producer surplus represents the value of goods which the producer pocketed money for but actually never produced. The above demand and supply schedules are only possible because of the different willing-to-pay prices of different customers (Mankiw, 2002). This leads to some customers having to buy a product at a price which above which they valued the product while others have to pay an amount greater than the value they perceived for that product. Perfect Price Discrimination - First Degree of Price Discrimination The normal case of demand and supply match is twisted slightly by sellers in the first degree of price discrimination. Here the sellers discriminate "perfectly" amongst their consumers. This means that a consumer willing to pay $10 instead of the $5 market price will have no clue as to the fair market value of the product and will end up paying $10 - which is what they "value" the product to be. Sellers are able to discriminate by concealing the actual value of the product and expecting the buyers to make the first offer based on their "perception". In this way, sellers are able to pocket the consumer suurplus section as well ending up with higher profits than earlier. Perhaps there arevery few examples of such a perfectly discriminated system; however, auction houses are ideal exmaples of such a scenario where the customer gets the first say and the customer bids for a value which they perceive to be the fair value of the product (which is generally higher than the real market value) resulting in sellers making greater profits than if they did not discriminate (Price Discrimination Notes, 2009). Quantity Discounts - Second Degree of Price Discrimination By far one of the most widely practised forms of price discrimination, sellers discrimnate between buyers on the basis of the quanityt they purchase (Samuelson, 2002). For exmaple, if Jack purchases a single T-shirt from a bargain shop, it might cost him $1.50. However, if Jack buys eleven T-shirts instead of one, he can surely expect that the unit price of the T-shirt will be lesser than $1.50. Although the seller would have loved eleven different "Jack's" to have purchased a single T-shirt resulting in him selling at the same profit margin for each T-shirt, he nonetheless will be happy to offer Jack a discount on the original price of the T-shirt since Jack would be buying in bulk (Price Discrimination Notes, 2009). In the business world, there are countless examples of this form of price discriination. The underlying economic theory is of economies of scale - which allows the seller to produce larger quanitities resulting in lower costs per unit in turn allowing the seller to offer discounts on bulk buying. Discounted reailers like WalMart and K-mart buy in bulk so that they receive generous discounts from suppliers which is in turn passed to the consumers to maintain competitive advantage. This form of price discrimination is by far the most "fair" form of practice in the market (Mankiw, 2002). Different prices in different markets - Third Degree of Price Discrimination Probably one of the most cynical practices to be held in real markets, this form of discrimination works best, but not necessarily always requires isolation of markets (as described later) i.e. when two markets are not close to each other. Sellers generally incur different costs in selling the same product in different markets. However, the principle of price discriination states that discrimination is selling at different prices assuming that the "costs remain the same" (Brue, 2006). Thus, the assumption cannot be nullified and we have to assume two markets where the seller finds it equi-costly to sell the product. However, on reaching the market, the seller finds out that there is a shortage of the produc tin one of the markets. This results in a demand without an equally matching supply resulting in increasing the equilibrium price of the product in the market (Mankiw, 2002). In this way, a seller may be able to charge one customer a higher price while another customer a lower price pocketing the margins and ultimately making a better profit. However, the practice is possible within the same market as well even though there may be information about the practice dissipated within thr market. Examples of such a practice include frequent flyer programs (which probably would fall under the second degree) but however the practise of discounts for seniors citizens, students and other smaller sections of a larger target market is considered to be the true third degree of price discrimination. The main question that arises at this point is the feasibility of such a practise, because clearly speaking the discount is given (dsicrimination is carried out) regardless of the demands of the beneficary in question. Features of Price Discrimination Since there are three degrees of price discrimination, there are three features of such a system, without which the discrimination process would not hold for long enough: 1. The seller must be able to idenfity and judge the maximum "willing-to-pay" cost of the buyer. Without this, the seller not having an estimate of the buyer's perception cannot make an offer. 2. Once identified, the seller must be able to sell the product at that price. If the seller has identified the price then there would be suitable methods and coaxing techniques through which the seller can ensure that the buyer purchases it at the price theya re willing to pay (not knowing that it may higher than market value) (Price Discrimination Notes, 2009). 3. The products should not be resellable easily. This means that if the products could be re-sold around easily then the buyers buying it at lower prices would begin practising what is called as "re-seller retailer strategy" (Case & Fair, 2004). This would mean that normal customers would stop coming to a buyer and senior citizens would continuously buy in large quanitites and re-sell it to their acquaintances, etc for a little margin which would still keep the price lower than the seller's normal price without discrimination. It may seem that price discrimination is only useful from the seller's point-of-view because it helps them to increase their profits and production. Surprisingly, price discrimination benefits consumers as well. A targeted segment of the market reaps the benefits of reduced prices, while the assurance that seller's with increased profits will have higher production levels is the best prixe for the customer - this ensures that the product is never out of stock even though normal pricing may have resulted in losses leading to sellers having to close down their production units (Samuelson, 2002). Demonstration of the Advantage of Price Discrimination Product: Return ticket flight from Sydney to Los Angeles Assumption: Target market is bi-modal i.e. it has two different sets of travelers: Businessmen Students 100 willing to pay $1000 50 willing to pay $400 Fixed Costs for the Flight $ 100,000 Marginal Cost of a customer (held constant) $ 80 Scenarios 1. Fixed Price: $1000 (Only businessmen will fly) Total Revenues = Psqs = $1000 * 100 = $ 100,000 Total Variable Costs = MC * qs = $80 * 100 8,000 Total Costs = Total Fixed Costs + Total Variable Costs = 108,000 Profit = Total Revenues - Total Costs = $ (8,000) 2. Fixed Price: $400 (Businessmen travel overjoyed; all students travel) Total Revenues = Psqs = $400 * 150 = $ 60,000 Total Variable Costs = MC * qs = $80 * 150 12,000 Total Costs = Total Fixed Costs + Total Variable Costs = 100,000 Profit = Total Revenues - Total Costs = $ (40,000) 2. Charging Businessmen $1000 and Students $400 (everyone travels) Total Revenues = Psqs + Pbqb =($1000 * 100) + ($400 * 50) = $ 120,000 Total Variable Costs = MC * qs = $80 * 150 12,000 Total Costs = Total Fixed Costs + Total Variable Costs = 112,000 Profit = Total Revenues - Total Costs = $ 8,000 Profit at last! The above illustration displays why price discrimination is after all a technique which allows seller's to maintain their profits in spite of offering a smaller target market a lower cost. The idea is that if that portion was not targeted, it would have resulted in lost profits of not targeting that segment. Conclusion Price discrimination may not be one of the top most options for firms trying hard to increase their profit margins, but is surely are not a bad idea at all. Considering the examples and illustrations of the previous sections, it is clearly visible that the three degrees of price discrimination work well in the real markets even though most economic theories are only applicable in ideal markets. Price discrimination is one of those practices which often leads to considerable hue and cry amongst buyers when they find out that they have been "cheated and robbed" however, it is the discretion of the seller which has led to their consumer surplus being zero (Samuelson, 2002). In conclusion, I would like to mention the fact that there are hardly any markets in the world where the three degrees of price discrimination are not applicable. Ranging from multinationals to domestic manufacturers, from airlines to cement manufacturers, the concept of price discrimination is highly profitable for businesses wishing to bend the curves of supply and demand in order to benefit in a higher production volume simultaneously sustaining a profitable sale (Samuelson, 2002). Thus, ideal or non-ideal, US or British, every market in the world, however much developed, will have the elements of the three degrees of price discrimination embedded in it - because consumers and suppliers have human tendencies of bargaining which cannot be eliminated form the nature of mankind. Works Cited Brue, S. L. (2006). Macroeconomics, 17th edition. New York: McGraw-Hill/Irwin. Case, K. E., & Fair, R. C. (2004). Principles of Economics. NJ: Prentice Hall. Mankiw, N. G. (2002). Macroeconomics, 5th edition. Washington D.C.: Worth Publishers. Price Discrimination Notes. (2009). Retrieved April 2, 2009, from CalHoun: http://webnt.calhoun.edu/distance/internet/business/eco231/downloads/lncm7.pdf Samuelson, P. (2004). Principles of Economics. Montana: Montana Publishers Inc. Read More