Degrees and Effects of Price Discrimination


Date Posted: 8/31/2018 5:45:27 AM

Posted By: Faimus  Membership Level: Silver  Total Points: 892

Price discrimination refers to a situation whereby sellers sell different units of output at different prices. Price discrimination is a concept that is widely used especially in high tech industries. This is because this concept has proven to be very advantageous. In high tech industries, the importance of this concept is justified by two reasons. The high fixed cost, low marginal cost technology in this industry often leads to significant market power with the usual inefficiencies, in particular, price will often exceed marginal cost meaning that the price benefits to price discrimination will be significant to the participants. Secondly, Information Technology allows for close observation and the eventual analysis of consumer behaviour. This allows for market strategies which would have otherwise difficult to carry out at least on large scale. The sellers are therefore able to set different prices for different commodities based on individual characteristics and behaviour.

There are four different types of price discrimination. The first is referred to as the first degree price discrimination.
First degree price discrimination is the most extreme case of price discrimination. In this case, the use of information technology allows the creation of a 'market of one'. This basically refers to the creation of a market where highly personalized products can be sold at highly personalized prices. This concept is therefore also referred to as mass customization or personalization. In this case, consumers are also able to personalize products. Companies, on the other hand, find it more attractive to utilize fine tune pricing in internet based commerce eliminating 'menu costs' from the pricing decisions. Internet retailers are able to revise their prices more often that conventional retailers and hence their prices are adjusted in much finer adjustments. First degree price discrimination is advantageous in the sense that personalized pricing raises pricing issues. A

seller that understands the tastes and preferences of the customers better can sell them products that best fit their need but will also charge more for the superior service. The limitation of this type of price discrimination is that online sellers face stiff competition from their fellow online sellers as well as offline sellers. However, adding competition to this model is arguably important.

There are two effects that arise from first degree price discrimination. The first is the enhanced surplus extraction effect. This refers to the fact that personalized pricing allows firms to charge closer to the reservation price for each customer. Reservation price is the maximum price that a buyer is willing to pay for a service or a good. The other effect is the intensified competition effect. This refers to the fact that each consumer is a market to be contested. When consumer tastes are not different, the intensified competition effect dominates the surplus extraction effect. This makes firms worse off and consumers better off with competitive personalized pricing than non personalized pricing.

Second degree price discrimination refers to a situation where everyone faces the same menu of prices for a number of related products. This concept is also referred to as market segmentation, product line pricing or versioning. In this case, sellers use their knowledge on the distribution of consumer tastes and preferences as a basis for the designing of a product line that appeals and adequately satisfies the needs of their different consumer market segments. This type in the sense that through versioning, sellers are able to effectively identify all the segments of a given costumer market, understand it's needs, tastes and preferences and thus design a product line that best fits any given market segment. This this allows certain segments of the market to be served which would have otherwise not been served. This is basically the standard output effect of price discrimination. On the other hand, this form of price discrimination may provide disadvantageous. In this model, the basic problem in designing a product line is 'competing against yourself'. This is because more often than not customers with high willingness to pay will be attracted to lower priced products that are targeted towards consumers with lower willingness to pay. This creates a 'self selection problem'. This problem can be solved by lowering the price of the high end products, lowering the 'quality' of the low end products or by a combination of the two.

Third degree price discrimination refers to selling the same product at different prices to different groups of people. This is generally the classic form of price discrimination and the most utilized one. The conventional treatment examines monopoly price discrimination but through increased research, made possible by the use of technology, there have been recently attempts to extend this analysis to the competitive case. From this attempts, it has been observed that consumers have essentially the same tastes and there is a fixed cost of servicing each consumer. This therefore brings forth the conclusion that third degree price discrimination will generally make consumers better off. Competition forces firms to maximize utility. Utility refers to customers satisfaction brought about by consumption of the goods produced by the firms. Price discrimination therefore gives them additional flexibility in dealing with the fixed costs. In a case where there are no fixed costs, consumer utility thus falls with third degree price discrimination.

The other form of price discrimination that is of considerate interest in high tech markets is price discrimination based on purchase history. A monopolist may discriminate between old and new customers by offering updates and enhancements. In a duopoly model which adds an adds an additional phenomenon of 'poaching', one firm can offer low prices to steal another's customers.

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