Price Discrimination

Define, discuss, and account for the existence of price discrimination. Compare
and exemplify the first, second, and third degrees of such discrimination.


Overview Price discrimination is the practice of setting different pricing
formulas in different virtual markets, while still maintaining the same product
throughout. The prices are based upon the price elasticity of demand in each
given market. In more practical terms, that means that during “Ladies Night”
at M.P. OReillys, it costs more for me to have a beer than if I were a
female simply because this particular saloon sees fit to charge members of the
female species less as a means to draw more such females to the establishment on
such a night. Price discrimination is rampant in many areas of the commercial
and business world. Movie theatres, magazines, computer software companies, and
thousands of other entities have discounted prices for students, children, or
the elderly. One important note, though, is that price discrimination is only
present when the exact same product is sold to different people for different
prices. First class vs. coach in an airline (though sometimes just differing in
how many free drinks you can get) is not an example of price discrimination
because the two tickets, though comparable, are not identical. Price
discrimination is based upon the economic premise and practice of marginal
analysis. This conceptualization deals specifically with the differences in
revenue and costs as choices and/or decisions are made. A good example is
illustrated in the textbook by the Hartford Shoe Company model. The most
important portion of the model, however, is on page 201. Here, it is calculated
that if the company raises the prices of the shoes from $60 to $65, their
revenue and number of shoes sold will shrink…but their actual profit margin
will raise slightly due to that higher profit margin more than just offsetting
in the loss in sales. Profit maximization is achieved neither where the number
of products sold is the highest, nor where the price is the highest.

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Profitability Price discrimination is only profitable if and when the given
target groups price elasticity of demand differs to the point where the
separate prices yield to profit maximization for each given group in question
(where marginal revenue equals marginal cost). Groups that are more sensitive to
prices, students and senior citizens for example, have a lower price elasticity
of demand and are thus the ones that are often charges the lower prices for the
identical goods or services. The key to price discrimination and utilizing it to
fully compliment other economic practices, ultimately achieving the total profit
maximization, is the ability to effectively and efficiently collect, analyze,
and act upon data gathered about the different groups. First of all, the groups
must be accurately identified and the differences between groups must be
discerned ahead of time. Children, genders, and senior citizens are easily
singled-out by appearance, while military personnel, college students, and other
groups must carry some sort of identification. Firms typically will advertise
the highest prices in publications, and then offer discounts to qualified
groups. The three basic conditions for price discrimination to be effective are
as follows: 1) Consumers can be divided into and identified as groups with
different elasticities of demand. 2) The firm can easily and accurately identify
each customer. 3) There is not a significant resale market for the good in
question. First Degree Price Discrimination The premise behind the practice of
first degree price discrimination is that the firm has enough accurate
information about the end consumer that products can be sold each time for the
maximum amount that the consumer is willing to pay. The two most prevalent
examples of first-degree price discrimination are called “price skimming”
and “all-or-none offers”, both of which are described below. Skimming here
refers to the demand function, as firms take the top of the demand of a given
good to maximize profits on the per diem sale. This, of course, requires that
the firm know the actual demand for the good that it produces. Furthermore, the
firm must divide its customers into distinct, independent groups based upon
their respective demands for the good. The firm wants to first sell to the group
who will pay the highest price for the new product. It then reduces the cost
slightly and sells to another group with only slightly less demand for the good.


This process is replicated on numerous occasions until the marginal revenue dips
to equal marginal cost. While this example may seem similar to other examples of
price discrimination, it should be noted that the most significant difference
here is that there are a virtually limitless number of possible prices that,
charged sequentially, will yield profit maximization over the long haul. The
firm must, of course, be on the ball and must make constant reassessments of the
demand and thus, the price for the good at any given time after the initial
price is set and a number of units are sold. Firms practicing price skimming,
then, will generally start their pricing schedules where the demand schedule has
its vertical intercept. From there, as demand at any given price shrinks, the
firm readjusts the price of the good to spur more sales. As before, the firm
maximizes profits where the marginal revenue is equal to marginal cost. The firm
will not continue to sell the good below this threshold. The equality here is
unlike a scenario where a single profit-maximizing price scheme is practiced.


The trick to price skimming is that the consumers do not become accustomed to
the process and thus “wait” for the prices to drop, hence skewing the demand
uncharacteristically. Customers may be upset about paying a higher price
initially, and this may lead to the same customer not becoming a return customer
next time, or simply that the customer who bought at a high price this time will
hold off on a purchase next time, anticipating a price reduction. Price skimming
is no longer effective if the consumers have been conditioned to the process.


The other example of first-degree price discrimination is the “all-or-none”
model. This means that the firm will set a price for a given bundle of goods,
and no matter what portion of the goods you desire, you pay the same price as if
you were to purchase all of them. The diamond industry is a fine example of
this, often selling less-than-perfect supplemental gems along with perfect gems
in order to move the less-desirable merchandise. The other example, of leasing
motion picture reels, is perhaps more easily associated with the general public.


No one I knew would have ever wanted to see “Ernest Saves Christmas”, while
“The Hunt For Red October” was quite a good flick. By bundling goods
together in a veritable “grab bag”, firms can rid themselves of merchandise
that would in all likelihood not sell otherwise, or at least not for the same
price. Likewise, firms can sell larger-than-necessary volume sets of certain
items, even though no one in his or her right mind would willingly purchase such
large quantities of certain goods (e.g. 10-packs of household 3-in-1 oil). This
format of “moving” merchandise in a way where the amount or items purchased
arent necessarily discretionary is especially popular at auctions. Second
Degree Price Discrimination A tiered form of price discrimination, second degree
is the practice of selling incremental amounts of a good for incremental prices.


The first 12 pairs of shoes are $80, the next 12 pair are $72, and so on. The
customers, like in discrimination of the 3rd degree, are grouped together in the
corresponding tiers so to speak, and since the tiers all pay the same price, the
marginal revenue is constant within each tier and its purchases. Like 3rd degree
price discrimination, the 2nd degree often allows the firm to sell more quantity
that they would ordinarily. The catsup example is a fine one, making prices
variable due to the size of a given container of goods. This example also
illustrates how the consumers must be self-selective, based upon their lifestyle
and/or preferences. Customers with the higher demand prices will tend to buy
smaller quantities at higher average unit prices, while those with lower demand
prices will more often purchase the larger quantities at a lower unit cost.


Second degree price discrimination generally leads to a situation where more
quantity per unit is sold. Sams Club is the 2nd degree price discrimination
heaven. Mr. Waltons little warehouses across the land plainly aim for a
consumer that is willing to buy more at a lower price per unit. While the price
may, in fact, be a bit lower, it still troubles me to see people purchasing 256
ounces of Ivory dish washing detergent at a single time. Finally, 2nd degree
price discrimination yields itself well to a process called “product
bundling”. This should not be considered the same as the “Ernest Saves
Christmas” and “Hunt For Red October” scenario, but instead where tow
copies of the same film (to show it on two screens) is far less than just
leasing two copies of the same film reel. Product bundling is prevalent in the
personal computer industry. System packages are bundled together with the most
popular software and hardware alike, and this reduces possible haggling over
certain items. No one can argue about the value of not including a CD-ROM or
video card. Third Degree Price Discrimination Third degree price discrimination
deals with separating customers into distinct groups based upon their difference
in elasticity of demand. Based upon this elasticity, you then charge a higher
price to the group whose demand is less elastic. Marginal revenue is the change
in the total revenue that is the result of a small change in the sales of the
good in question. Therefore, price must, too, have changed slightly. The model
in the book (Hartford Shoe Company student discounts) illustrates this
phenomenon extremely well. When the non-student group of consumers experiences a
price increase of $5, this group purchases 625 fewer pairs of shoes.


Interpolation yields the concept that for every $1 that the price increases,
sales will fall by 125 units. Likewise, when the student price for the shoes in
question falls $5, 625 additional pairs of shoes will be sold. This again can be
interpolated to mean that every dollar less the shoes are priced, 125 more units
will be sold. Thus, a change of just $1 makes students and non-students alike
change their purchasing preferences by 125 pairs of shoes. We can use this
observation to generate the ideal price and sales figures necessary to achieve
the ideal situation of: Marginal Cost = Marginal Revenue We know that marginal
revenue is the change in the total revenue divided by the change in sales. When
the price of shoes is reduced by $1, total revenue will increase $2,625 as sales
again increase by 125. The marginal revenue associated with such a price
reduction is $21 (2625/125) and, since this marginal revenue is greater than the
marginal cost ($20), lowering the price from $66 to $65 actually does increase
profits for the Hartford Shoe Company. However, as illustrated in the text, if
the price is originally $65, and the price is lowered to $64, then the marginal
revenue from this move would only be $19. Due to the fact that this marginal
revenue is less than the marginal cost (still $20), profits would actually take
a small hit if this price reduction was carried out. Opportunity Cost Price
discrimination is based upon the most significant of all economic concepts:
opportunity cost. For example, American Airlines may offer college students a
fare from Saint Louis to Chicago for $149 round-trip, while “business class”
fares run significantly higher, say $279 for example. The business traveler, in
all likelihood, is more likely to be willing to pay the higher fare because he
or she is going to be working for a client in Chicago and will be paid $100 per
hour while there. The college student does not have the luxury of having any
extra money (he or she goes to Wash U.), and thus cannot justify paying the
higher rate to travel to Chicago for his or her fall break. Opportunity cost is
the most intrinsic measure of justification for reallocation of any of a
persons given resources…including (but not limited to) time, money, and
talent. People often say that they are “richer in time than in money”, but
in fact seldom consider the fact that by choosing not to work, they are actually”paying” for their recreation time. Such is the case with price
discrimination. If you are a Washington University student and you go to the
Esquire Theatre on a Friday night to see the latest big-budget, no-plot
Hollywood hit, you are inherently less likely to study your Organic Chemistry.


This could, in turn, lead to a lower grade in the class. The lower grade could
lead to acceptance to a less-respected graduate program, and such could lead to
a job with lower pay. I realize that most of this is highly hypothetical, but
the bottom line is always that, no matter what youre doing, you could be
doing something else. Opportunity cost should be a consideration every time
someone chooses to sleep in and miss class, or every time that someone takes off
of work for a day. Vacation, after all, is the most prevalent exercise and
exemplification of someone making a judgment regarding opportunity cost.


Conclusion Price discrimination is a significant and influential practice on the
market in the modern economic world. It aids in a firms profit maximization
scheme, it allows certain consumers with more-scarce resources the opportunity
purchase goods or services that would otherwise be attainable, and it aids firms
in balancing what is and is not sold. Devoid of an audience and consumer base
alert to it, price discrimination is an effective means by which a firm can sell
a higher quantity of goods, make a higher profit margin on the goods it does
sell, and build a broader consumer base due to differing price elasticity of
demand for given goods and services. Price discrimination ultimately equalizes
price and value for both the consumer and the firm, creating a more ideal
situation for both entities in terms of preference and opportunity cost.

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