Price Discrimination (Cambridge (CIE) A Level Economics): Revision Note

Conditions for effective price discrimination

• Price discrimination occurs when a firm charges a different price for the same good or service in order to maximise its revenue

  • There are different types (degrees) of price discrimination

1. First-degree price discrimination

• Occurs when a firm separates consumers based on their ability to pay

  • E.g market traders can often easily identify high-worth customer and double the price of the product offered – especially in situations where the product prices are not displayed

2. Second-degree price discrimination

• Occurs when a firm gives discounts for bulk buying, e.g., 3 for 2 offers 

3. Third-degree price discrimination

• Occurs when a firm charges different prices to different consumers for the same good or service, e.g., rail fares are priced differently depending on the time of travel

• Third-degree markets are often sub-divided based on time, age, income and geographic location

  • Some airline ticket portals charge higher prices to customers using an Apple computer, as they are likely to have higher income

Conditions required for price discrimination to occur

Illustrating third-degree price discrimination

• In order to illustrate third-degree price discrimination diagrammatically, the different sub-market diagrams are placed side by side

• The total market diagram is a combination of the sub-market diagrams

  • The total profit is a combination of profits from the sub-markets

• The diagram below illustrates the market for rail travel in the UK, where inelastic demand is 'peak' hour demand and elastic demand is any other time of the day, i.e., 'off-peak'.

Third-degree price discrimination

Diagram analysis

• Each train route has an effective monopoly provider

• The overall firm is producing at the profit-maximising level of output, where MC=MR

  • This point is extrapolated to both sub-markets on the left by using the lower dotted line

  • The average cost is extrapolated across both sub-markets using the upper dotted line (C₁)

• A higher price for peak travel has been set at P_a & a lower price for off-peak travel has been set at P_b

• Following the revenue rule, total revenue increased in both markets

• The profit for sub-market A = (P_a-C₁) * Q₁

• The profit for sub-market B = (P_b-C₁) * Q₂

• The firm's total profit is the average selling price minus the average costs

  • Total profit = (P_t-C₁) * Q₃

• The firms' total profits are higher than if they had charged a single price to all customers

Consequences of price discrimination

• Price discrimination redistributes consumer surplus and profit between consumers and firms