Define, discuss, and account for the existence of price discrimination. Compareand exemplify the first, second, and third degrees of such discrimination. Overview Price discrimination is the practice of setting different pricingformulas in different virtual markets, while still maintaining the same productthroughout. The prices are based upon the price elasticity of demand in eachgiven market. In more practical terms, that means that during “Ladies Night”at M.
P. OReillys, it costs more for me to have a beer than if I were afemale simply because this particular saloon sees fit to charge members of thefemale species less as a means to draw more such females to the establishment onsuch a night. Price discrimination is rampant in many areas of the commercialand business world. Movie theatres, magazines, computer software companies, andthousands of other entities have discounted prices for students, children, orthe elderly. One important note, though, is that price discrimination is onlypresent when the exact same product is sold to different people for differentprices.
First class vs. coach in an airline (though sometimes just differing inhow many free drinks you can get) is not an example of price discriminationbecause the two tickets, though comparable, are not identical. Pricediscrimination is based upon the economic premise and practice of marginalanalysis. This conceptualization deals specifically with the differences inrevenue and costs as choices and/or decisions are made. A good example isillustrated in the textbook by the Hartford Shoe Company model. The mostimportant portion of the model, however, is on page 201.
Here, it is calculatedthat if the company raises the prices of the shoes from $60 to $65, theirrevenue and number of shoes sold will shrink. . . but their actual profit marginwill raise slightly due to that higher profit margin more than just offsettingin the loss in sales. Profit maximization is achieved neither where the numberof products sold is the highest, nor where the price is the highest.
Profitability Price discrimination is only profitable if and when the giventarget groups price elasticity of demand differs to the point where theseparate prices yield to profit maximization for each given group in question(where marginal revenue equals marginal cost). Groups that are more sensitive toprices, students and senior citizens for example, have a lower price elasticityof demand and are thus the ones that are often charges the lower prices for theidentical goods or services. The key to price discrimination and utilizing it tofully compliment other economic practices, ultimately achieving the total profitmaximization, is the ability to effectively and efficiently collect, analyze,and act upon data gathered about the different groups. First of all, the groupsmust be accurately identified and the differences between groups must bediscerned ahead of time. Children, genders, and senior citizens are easilysingled-out by appearance, while military personnel, college students, and othergroups must carry some sort of identification. Firms typically will advertisethe highest prices in publications, and then offer discounts to qualifiedgroups.
The three basic conditions for price discrimination to be effective areas follows: 1) Consumers can be divided into and identified as groups withdifferent elasticities of demand. 2) The firm can easily and accurately identifyeach customer. 3) There is not a significant resale market for the good inquestion. First Degree Price Discrimination The premise behind the practice offirst degree price discrimination is that the firm has enough accurateinformation about the end consumer that products can be sold each time for themaximum amount that the consumer is willing to pay. The two most prevalentexamples of first-degree price discrimination are called “price skimming”and “all-or-none offers”, both of which are described below. Skimming hererefers to the demand function, as firms take the top of the demand of a givengood to maximize profits on the per diem sale.
This, of course, requires thatthe firm know the actual demand for the good that it produces. Furthermore, thefirm must divide its customers into distinct, independent groups based upontheir respective demands for the good. The firm wants to first sell to the groupwho will pay the highest price for the new product. It then reduces the costslightly and sells to another group with only slightly less demand for the good.
This process is replicated on numerous occasions until the marginal revenue dipsto equal marginal cost. While this example may seem similar to other examples ofprice discrimination, it should be noted that the most significant differencehere is that there are a virtually limitless number of possible prices that,charged sequentially, will yield profit maximization over the long haul. Thefirm must, of course, be on the ball and must make constant reassessments of thedemand and thus, the price for the good at any given time after the initialprice is set and a number of units are sold. Firms practicing price skimming,then, will generally start their pricing schedules where the demand schedule hasits vertical intercept. From there, as demand at any given price shrinks, thefirm readjusts the price of the good to spur more sales.
As before, the firmmaximizes profits where the marginal revenue is equal to marginal cost. The firmwill not continue to sell the good below this threshold. The equality here isunlike a scenario where a single profit-maximizing price scheme is practiced. The trick to price skimming is that the consumers do not become accustomed tothe process and thus “wait” for the prices to drop, hence skewing the demanduncharacteristically. Customers may be upset about paying a higher priceinitially, and this may lead to the same customer not becoming a return customernext time, or simply that the customer who bought at a high price this time willhold off on a purchase next time, anticipating a price reduction. Price skimmingis no longer effective if the consumers have been conditioned to the process.
The other example of first-degree price discrimination is the “all-or-none”model. This means that the firm will set a price for a given bundle of goods,and no matter what portion of the goods you desire, you pay the same price as ifyou were to purchase all of them. The diamond industry is a fine example ofthis, often selling less-than-perfect supplemental gems along with perfect gemsin order to move the less-desirable merchandise. The other example, of leasingmotion picture reels, is perhaps more easily associated with the general public. No one I knew would have ever wanted to see “Ernest Saves Christmas”, while”The Hunt For Red October” was quite a good flick.
By bundling goodstogether in a veritable “grab bag”, firms can rid themselves of merchandisethat would in all likelihood not sell otherwise, or at least not for the sameprice. Likewise, firms can sell larger-than-necessary volume sets of certainitems, even though no one in his or her right mind would willingly purchase suchlarge quantities of certain goods (e. g. 10-packs of household 3-in-1 oil). Thisformat of “moving” merchandise in a way where the amount or items purchasedarent necessarily discretionary is especially popular at auctions. SecondDegree Price Discrimination A tiered form of price discrimination, second degreeis the practice of selling incremental amounts of a good for incremental prices.
The first 12 pairs of shoes are $80, the next 12 pair are $72, and so on. Thecustomers, like in discrimination of the 3rd degree, are grouped together in thecorresponding tiers so to speak, and since the tiers all pay the same price, themarginal revenue is constant within each tier and its purchases. Like 3rd degreeprice discrimination, the 2nd degree often allows the firm to sell more quantitythat they would ordinarily. The catsup example is a fine one, making pricesvariable due to the size of a given container of goods. This example alsoillustrates how the consumers must be self-selective, based upon their lifestyleand/or preferences.
Customers with the higher demand prices will tend to buysmaller quantities at higher average unit prices, while those with lower demandprices will more often purchase the larger quantities at a lower unit cost. Second degree price discrimination generally leads to a situation where morequantity per unit is sold. Sams Club is the 2nd degree price discriminationheaven. Mr. Waltons little warehouses across the land plainly aim for aconsumer that is willing to buy more at a lower price per unit. While the pricemay, in fact, be a bit lower, it still troubles me to see people purchasing 256ounces of Ivory dish washing detergent at a single time.
Finally, 2nd degreeprice discrimination yields itself well to a process called “productbundling”. This should not be considered the same as the “Ernest SavesChristmas” and “Hunt For Red October” scenario, but instead where towcopies of the same film (to show it on two screens) is far less than justleasing two copies of the same film reel. Product bundling is prevalent in thepersonal computer industry. System packages are bundled together with the mostpopular software and hardware alike, and this reduces possible haggling overcertain items. No one can argue about the value of not including a CD-ROM orvideo card.
Third Degree Price Discrimination Third degree price discriminationdeals with separating customers into distinct groups based upon their differencein elasticity of demand. Based upon this elasticity, you then charge a higherprice to the group whose demand is less elastic. Marginal revenue is the changein the total revenue that is the result of a small change in the sales of thegood in question. Therefore, price must, too, have changed slightly.
The modelin the book (Hartford Shoe Company student discounts) illustrates thisphenomenon extremely well. When the non-student group of consumers experiences aprice increase of $5, this group purchases 625 fewer pairs of shoes. Interpolation yields the concept that for every $1 that the price increases,sales will fall by 125 units. Likewise, when the student price for the shoes inquestion falls $5, 625 additional pairs of shoes will be sold.
This again can beinterpolated to mean that every dollar less the shoes are priced, 125 more unitswill be sold. Thus, a change of just $1 makes students and non-students alikechange their purchasing preferences by 125 pairs of shoes. We can use thisobservation to generate the ideal price and sales figures necessary to achievethe ideal situation of: Marginal Cost = Marginal Revenue We know that marginalrevenue is the change in the total revenue divided by the change in sales. Whenthe price of shoes is reduced by $1, total revenue will increase $2,625 as salesagain increase by 125. The marginal revenue associated with such a pricereduction is $21 (2625/125) and, since this marginal revenue is greater than themarginal cost ($20), lowering the price from $66 to $65 actually does increaseprofits for the Hartford Shoe Company. However, as illustrated in the text, ifthe price is originally $65, and the price is lowered to $64, then the marginalrevenue from this move would only be $19.
Due to the fact that this marginalrevenue is less than the marginal cost (still $20), profits would actually takea small hit if this price reduction was carried out. Opportunity Cost Pricediscrimination is based upon the most significant of all economic concepts:opportunity cost. For example, American Airlines may offer college students afare from Saint Louis to Chicago for $149 round-trip, while “business class”fares run significantly higher, say $279 for example. The business traveler, inall likelihood, is more likely to be willing to pay the higher fare because heor she is going to be working for a client in Chicago and will be paid $100 perhour while there.
The college student does not have the luxury of having anyextra money (he or she goes to Wash U. ), and thus cannot justify paying thehigher rate to travel to Chicago for his or her fall break. Opportunity cost isthe most intrinsic measure of justification for reallocation of any of apersons given resources. . .
including (but not limited to) time, money, andtalent. People often say that they are “richer in time than in money”, butin fact seldom consider the fact that by choosing not to work, they are actually”paying” for their recreation time. Such is the case with pricediscrimination. If you are a Washington University student and you go to theEsquire Theatre on a Friday night to see the latest big-budget, no-plotHollywood hit, you are inherently less likely to study your Organic Chemistry.
This could, in turn, lead to a lower grade in the class. The lower grade couldlead to acceptance to a less-respected graduate program, and such could lead toa job with lower pay. I realize that most of this is highly hypothetical, butthe bottom line is always that, no matter what youre doing, you could bedoing something else. Opportunity cost should be a consideration every timesomeone chooses to sleep in and miss class, or every time that someone takes offof work for a day.
Vacation, after all, is the most prevalent exercise andexemplification of someone making a judgment regarding opportunity cost. Conclusion Price discrimination is a significant and influential practice on themarket in the modern economic world. It aids in a firms profit maximizationscheme, it allows certain consumers with more-scarce resources the opportunitypurchase goods or services that would otherwise be attainable, and it aids firmsin balancing what is and is not sold. Devoid of an audience and consumer basealert to it, price discrimination is an effective means by which a firm can sella higher quantity of goods, make a higher profit margin on the goods it doessell, and build a broader consumer base due to differing price elasticity ofdemand for given goods and services. Price discrimination ultimately equalizesprice and value for both the consumer and the firm, creating a more idealsituation for both entities in terms of preference and opportunity cost.
