“Explain the necessary conditions for price discrimination to take place. “Discuss the advantages and disadvantages of price discrimination for consumers and producers.”

25 Jan

Tuesday 7 November 2006 Paper 1

1. “Explain the necessary conditions for price discrimination to take place.
“Discuss the advantages and disadvantages of price discrimination for consumers and producers.”

2. Price Discrimination: Price discrimination is the practice of charging different prices for the same or similar product/service to different consumers where the price differences do not reflect the differences in cost of supply.

Types of Price Discrimination:

First Degree: charge whatever the market will bear e.g. auction.

Second Degree: discount for quantity purchases

Third Degree: market separated into distinct groups

3. Copy paste from triple A

Reasons for price discrimination

Price discrimination is carried out primarily to increase the profits of the discriminating firms. It occurs where different consumers are charged different prices in different markets for the same product or service, or where the same consumer is charged different prices for the same product, where the different prices are not due to differences in supply costs.

Necessary conditions for price discrimination

Condition 1

There must be some imperfection of the market. If there were perfect competition, price discrimination would be impossible since the individual producer could have no influence on price. At least some degree of monopoly power is therefore necessary so that producers have some ability to make rather than take the market price.

Condition 2

The discriminating supplier must be able to split the market into separate sections and keep them separate, such that it is difficult to transfer the seller’s product from one sector to another i.e. there must be no ‘seepage’ between markets in the sense that goods can be bought in the cheaper market and re-sold in the dearer.

Barriers between markets may be:

  • Geographical in that customers are separated by distance e.g. the international dumping of cheap goods, where goods are sold overseas at prices below those in the home market, and often below the cost of production e.g. the East European Communist block countries used to sell their exports to the West at lower prices than those prevailing in domestic markets to earn hard foreign currency.
  • Temporal in that customers are separated by time e.g. it may be cheaper to travel by train after 9.30am than before 9.30 am, and the two markets can be kept separate as ticket office staff will not sell the cheaper tickets until after this time
  • According to customer type so that customers are separated according to some easily identified feature of the customers themselves e.g. age, sex, income or occupation; examples of this would include cheaper theatre tickets for children, old age pensioners and the unemployed, reduced price rail travel for students and higher private physician consultation fees for those who are perceived as being able to pay more.

The two conditions discussed so far would make price discrimination possible, but for it to also be profitable a third condition must also be satisfied:

Condition 3

Price elasticity of demand in each market must be different; if this were the case , the discriminating supplier would increase price in the market with an inelastic demand curve, and reduce price where demand is elastic in order to increase total revenue and profits. If the elasticity of demand in each market was the same at each and every price, a common price would be charged in both markets as this price would represent the profit maximising price in each market where MC = MR. You might wish to refer back at this stage to where we discussed the relationship between price elasticity of demand and total revenue.

Advantages and disadvantages of price discrimination

Disadvantages

The main disadvantage will be experienced by consumers, particularly those having to pay the higher prices who may object to the discrimination against them e.g. users of peak time public transport. It could be argued that price discrimination represents a transfer of welfare from consumers to producers and is a way in which producers gain at the expense of consumers through the extraction of consumer surplus. In the extreme case of perfect or first degree price discrimination, no consumer receives any consumer surplus at all.

In more general terms, the higher profits earned through price discrimination could be viewed as an unjustifiable redistribution of income in favour of profit takers with higher prices reducing consumers’ real incomes.

Advantages

  • Producers of course benefit from the higher profits as previously shown. It could also be argued that if such profits are re-invested, consumers might derive long run benefits in terms of increased efficiency and lower costs and prices.
  • Those consumers paying the lower price may be able to obtain a good or service that they might not otherwise have been able to afford e.g. half price tickets for children at football matches.
  • Consumer and producer alike may gain if a loss making firm is turned into a profitable one.

4. Sum-up main ideas

  • Three types of price discrimination: first degree, second degree, third degree
  • Three types of conditions: imperfection of the market, supplier must be able to split the market into separate sections and keep them separate, Price elasticity of demand in each market must be different

5. Include pp Slides

Example of third degree discrimination

6. Include Diagrams

Equilibrium of the discriminating monopolist

The profit gain from price discrimination is (x + y) – z

Consumer and producer alike may gain if a loss making firm is turned into a profitable one.

In figure 2, the producer’s best output, where MC = MR is at OQe, but the price of OPe does not cover the average cost of OC, and a loss, equivalent to the rectangular area x, is made. However, a loss can be transformed into a profit by charging those consumers who are prepared to pay, a higher price of OPe1. The shaded area y shows the additional revenue that accrues to the firm from charging a two-part tariff. As area y exceeds that of x, the loss making firm is now able to make a profit at the current output level.

In the absence of price discrimination, this good would probably not be supplied in the long run, which would particularly represent a loss to society if it were one which generated positive externalities e.g. a doctor in a remote area charging wealthier patients more than the less affluent ones.

7. Evaluation if necessary

Disadvantages

The main disadvantage will be experienced by consumers, particularly those having to pay the higher prices who may object to the discrimination against them e.g. users of peak time public transport. It could be argued that price discrimination represents a transfer of welfare from consumers to producers and is a way in which producers gain at the expense of consumers through the extraction of consumer surplus. In the extreme case of perfect or first degree price discrimination, no consumer receives any consumer surplus at all.

In more general terms, the higher profits earned through price discrimination could be viewed as an unjustifiable redistribution of income in favour of profit takers with higher prices reducing consumers’ real incomes.

Advantages

  • Producers of course benefit from the higher profits as previously shown. It could also be argued that if such profits are re-invested, consumers might derive long run benefits in terms of increased efficiency and lower costs and prices.
  • Those consumers paying the lower price may be able to obtain a good or service that they might not otherwise have been able to afford e.g. half price tickets for children at football matches.
  • Consumer and producer alike may gain if a loss making firm is turned into a profitable one.

As you can see by the information provided above, the disadvantages for price discrimination are greater than the advantages in most cases.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Follow

Get every new post delivered to your Inbox.

%d bloggers like this: