Concepts in Industrial Organization: Price Discrimination

Price discrimination occurs when a seller charges different consumers different prices for the same product supplied at the same cost or when consumers are charged the same price, although the costs of supplying the good are different for each consumer. Price discrimination exists when prices different consumers pay are not proportional to the costs the seller incurs in delivering a given product to the consumers.

Price discrimination is only possible to conduct for a firm that has some kind of market power. Market power exists if a firm can increase the price it charges without losing all of its sales. A perfectly competitive firm cannot engage in price discrimination.

Effective price discrimination requires the ability to separate consumers into different groups, each with a different price elasticity of demand. Price discrimination also requires the ability to prevent transfers of the good from one group to another - or else the group that is charged a lower price will engage in pure arbitrage and sell the product to the group that is charged a higher price.

Price discrimination can improve efficiency, but only compared to a monopoly or oligopoly situation; it cannot improve efficiency compared to a perfectly competitive situation.

There are 3 types of price discrimination: 1^st-degree, 2^nd-degree, and 3^rd-degree price discrimination.

1^st-degree price discrimination is the rarest and is virtually impossible to achieve in its entirety. It is also known as "perfect" discrimination. Under 1^st-degree price discrimination, sellers can charge each consumer his reservation price - the maximum price he is willing to pay for a unit of the good. There is no real-world situation that wholly fits this scenario, but haggling is an example of an attempt to get at first-degree price discrimination. Sellers will try to discover consumers' reservation prices, and consumers will attempt to hide their reservation prices from sellers and pretend that their reservation prices are lower than is in fact the case.