Price Discrimination

Definition

Price discrimination is the practice of selling the same product or service at different prices to different customers, based on their willingness or ability to pay. It allows sellers to capture more consumer surplus by charging each customer the maximum price they are willing to pay.

5 Must Know Facts For Your Next Test

1. Firms can only successfully practice price discrimination if they can segment the market and prevent arbitrage (resale) between customers.
2. The more price elastic a customer segment is, the lower the price the firm will charge that segment to maximize revenue.
3. Perfect price discrimination, where each customer pays their maximum willingness to pay, results in the firm capturing all consumer surplus.
4. Price discrimination is commonly observed in industries with high fixed costs and low marginal costs, such as airlines, software, and entertainment.
5. Governments may restrict price discrimination if it is deemed anti-competitive or unfairly exploitative of certain customer groups.

Review Questions

• Explain how price elasticity of demand enables firms to engage in price discrimination.
  • Price elasticity of demand measures the responsiveness of quantity demanded to changes in price. Firms can practice price discrimination when different customer segments have varying price elasticities of demand. By charging higher prices to customers with more inelastic demand, and lower prices to those with more elastic demand, the firm can capture a greater portion of the total consumer surplus and maximize its revenue.
• Describe how price discrimination relates to the concepts of marginal revenue and consumer surplus.
  • Marginal revenue is the additional revenue a firm earns by selling one more unit. Firms engage in price discrimination to maximize marginal revenue from each customer segment, charging the highest possible price that each segment is willing to pay. This allows the firm to capture a greater share of the consumer surplus that would otherwise be enjoyed by the customers. The more the firm can segment the market and price discriminate, the closer it can get to perfect price discrimination, where it extracts the full consumer surplus.
• Discuss the arguments in support of and against restricting imports through the lens of price discrimination.
  • Governments may choose to restrict imports as a way to enable domestic firms to engage in more effective price discrimination. By limiting foreign competition, domestic firms can segment the market and charge higher prices to domestic consumers with inelastic demand, while offering lower prices to more price-sensitive export markets. However, this practice can also be viewed as anti-competitive and unfairly exploitative of certain customer groups. Policymakers must weigh the potential benefits of enabling price discrimination against the potential costs to consumer welfare and overall economic efficiency.

Related terms

Elasticity of Demand: The responsiveness of quantity demanded to changes in price. Firms can engage in price discrimination when customers have different price elasticities of demand.

Marginal Revenue: The additional revenue a firm earns by selling one more unit of a product. Firms practice price discrimination to maximize marginal revenue from each customer segment.

Consumer Surplus: The difference between the maximum price a consumer is willing to pay and the actual price they pay. Price discrimination allows firms to capture more of this surplus.