The first part of a two part series that looks at price discrimination. In this part: what is price discrimination, and what makes it possible?
What is price discrimination?
Price discrimination – the name can be misleading. ‘Discrimination’ has come to be associated with the abuse of others for predominantly racial reasons, as well as for those of gender and sexuality. However, price discrimination as an economic term is simply the practice of selling the same good or service at a different price to different groups of people. The key word here is ’same’ – a common pitfall is to look at an airline charging a higher price for a first class seat and refer to it as price discrimination, against the rich who like to travel in first class. This is not true, because it is more expensive to provide the service of a first class seat – the price differences should not be associated with the costs of production.
Why does price discrimination exist? To answer this, one must look back at the nature of demand in economics, and introduce a concept called consumer surplus. (For an introduction to demand, see this article).
Consider the above demand curve. Q1 of goods are provided to consumers at the price P1. However, as reflected by the demand curve, different people put different values on the same good – at prices higher than P1, there would still be quantities of the good supplied.
This is known as consumer surplus: the difference in the price that consumers are willing to pay, and what they actually pay, for a good or service. Consumer surplus is extremely good for the consumers. Suppose that you are willing to pay €5 for a soda, but it is available for €2: this is consumer surplus in action. Graphically, consumer surplus is shown by the shaded area in the above graph.
However, firms are losing out here in the profit they could make – thus the practice of price discrimination comes into play. Firms can capture some of this consumer surplus and convert it into profit for them by selling the same good at different prices to different consumers, who are willing to purchase the good at higher prices.
Of-course, in reality, price discrimination is not always possible. Certain conditions must be present in the market if price discrimination is to be implemented. Firstly, the firms in question must have a degree of power to set their own prices. Consider the situation of a market with many many small firms that all sell identical goods – this situation is purely theoretical, and is a benchmark referred to as a market in ‘perfect competition’ in economic terms. A firm in such a market cannot set a higher price for certain consumers, as these consumers will only buy the good or service from another one of the many firms selling it.
Another basic condition is that different groups of consumers must be willing to pay different prices for the same goods. For example, perhaps business travelers will be willing to pay more to travel – maybe because the costs are covered by the company – whereas tourists will not pay as much. If the people willing to pay more can be separated into a clear group, then price discrimination is possible, as it is easier to identify this group.
Finally, the firm must be able to separate the market according to these different groups of consumers. The main challenge here is to prevent a consumer from reselling the good on to a different group: there is no point having price discrimination in such a situation, as a consumer from one group may simply ask a friend from another group to buy the good for them. For this reason, price discrimination is most prevalent when providing services – rather than goods – as it is often impossible to resell a service, for example, a plane flight that one has already had.
This part should have shown you what price discrimination involves, and what is required to make it possible. Now, continue on to Part Two, where you will learn about the different types of price discrimination, and the effect it has on different groups in society.