Price Discrimination

Price discrimination occurs when a firm charges different prices to different consumers (or in different markets) for the same or similar product, where the price differences are not justified by cost differences. It is a strategy used by firms with market power to increase their revenue and profit by extracting more consumer surplus.

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Conditions for Price Discrimination

For price discrimination to be possible, three conditions must be met:

Condition	Explanation	Why It Matters
Market power	The firm must be a price maker — it must face a downward-sloping demand curve	A perfectly competitive firm cannot price-discriminate because it must accept the market price
Ability to separate markets	The firm must be able to identify and separate groups of consumers with different price elasticities of demand	If consumers can easily resell the product between themselves (arbitrage), price discrimination breaks down
Different price elasticities	Different consumer groups must have different willingness to pay (different PED)	If all consumers have the same elasticity, there is no benefit from charging different prices

Exam Tip: The ability to prevent resale (arbitrage) is critical. Price discrimination works well for services (haircuts, flights, cinema tickets) because they cannot be resold. It is harder for physical goods — if a student buys a discounted laptop, they could resell it to an adult at full price, undermining the price discrimination.

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Types of Price Discrimination

First-Degree (Perfect) Price Discrimination

The firm charges each individual consumer the maximum price they are willing to pay — their reservation price. This extracts all consumer surplus and converts it into producer surplus (profit).

Feature	Detail
Definition	Each unit is sold at the highest price the consumer will pay
Consumer surplus	Eliminated entirely — all transferred to the producer
Output	The same as under perfect competition (P = MC for the last unit) — because the firm does not need to lower the price on all units to sell more
Deadweight loss	None — allocatively efficient (P = MC for the marginal unit)
Practicality	Virtually impossible in practice — requires perfect knowledge of every consumer's willingness to pay
Approximate examples	Auction houses, estate agents negotiating individual sale prices, car dealerships haggling with each customer

Second-Degree Price Discrimination

The firm charges different prices for different quantities consumed — typically offering lower unit prices for larger purchases. Consumers self-select into price categories based on how much they buy.

Method	How It Works	Example
Bulk discounts	Lower price per unit for larger orders	"Buy 3 for £10" offers in supermarkets
Block tariffs	Different prices for different blocks of consumption	Electricity pricing — the first 100 kWh at one rate, subsequent consumption at a different rate
Bundling	Multiple products sold together at a lower combined price than buying separately	Sky TV packages, Microsoft Office suite
Two-part tariffs	A fixed access fee plus a per-unit charge	Gym membership (monthly fee + pay per class), Costco membership + discounted prices

Third-Degree Price Discrimination

The firm divides consumers into identifiable groups based on observable characteristics and charges each group a different price. This is the most common form of price discrimination in practice.

Consumer Group	Typically Charged	Reason (PED)
Students	Lower prices	More price-elastic demand — limited income, more price-sensitive
Senior citizens	Lower prices	Often on fixed incomes — price-elastic demand
Peak-time travellers	Higher prices	Commuters have inelastic demand — they must travel at specific times
Off-peak travellers	Lower prices	Leisure travellers have elastic demand — they can choose when to travel
Business class passengers	Much higher prices	Business travellers' flights are paid by their employers — very inelastic demand
Children	Lower prices	Families are more price-sensitive; attracting children brings adult customers

The Profit-Maximising Rule for Third-Degree Price Discrimination

The firm maximises profit by setting MR equal across all market segments, and equal to MC:

MR₁ = MR₂ = ... = MC

In the market with more inelastic demand, the firm charges a higher price. In the market with more elastic demand, the firm charges a lower price.

Exam Tip: Students often describe third-degree price discrimination but forget to explain the link to elasticity. The examiner wants you to explain that different prices reflect different price elasticities of demand. The group with more inelastic demand is charged more because they are less responsive to price changes and will continue to buy even at higher prices.

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Real-World Examples of Price Discrimination

Airlines

Airlines are masters of price discrimination, using multiple strategies simultaneously: