Thus far we have examined firms that set just one price for their product. Some- times firms charge more than one price for the very same product. For example, pharmacies may charge senior citizens lower drug prices than “regular” citizens, airlines frequently charge business travelers higher airfares than leisure travel- ers, and Walmart gives lower prices to buyers who choose to purchase large quantities. In other words, we have focused only on uniform pricing, which is the simplest form of pricing. Uniform pricing occurs when businesses charge the same price for every unit of the product they sell, no matter who the buyers happen to be or how much they choose to buy. In this section, we explain why firms wish to avoid uniform pricing whenever possible, and then we introduce price discrimination as a more profitable alternative to uniform pricing. As we will explain shortly, price discrimination is not always possible, and firms may be forced to charge the same price for all units they sell.
The Trouble with Uniform Pricing
The problem with uniform pricing concerns the consumer surplus generated when a firm charges the same price for all units it sells. Recall from Chapter 2 that consumer surplus is the area under demand and above market price over the range of output sold in the market. Charging the same price for every unit creates consumer surplus for every unit sold (except for the very last unit sold). Savvy
uniform pricing Charging the same price for every unit of the product.
marketing managers view the existence of any amount of consumer surplus as evidence of underpricing. They will then try to devise pricing schemes to take consumer surplus away from buyers, effectively transforming consumer surplus into profit for the firm. This process is called capturing consumer surplus.
Figure 14.1 illustrates the opportunity for price-setting firms to capture the con- sumer surplus generated by uniform pricing. Suppose a firm possessing market power faces the demand curve D and production costs are constant, so that marginal and average costs are both equal to $4 per unit for all output levels. If the firm prac- tices uniform pricing, the manager maximizes profit by applying the MR = MC rule, and charges $7 for each of the 3,000 units sold (point U). For the 3,000th unit sold, the uniform price of $7 is the maximum price a buyer will pay for this particular unit.
However, for each of the other 2,999 units, consumers are willing to pay more than
$7. As you learned in Chapter 2, buyers gain consumer surplus when they pay less for a product than the maximum amount they are willing to pay. The total consumer surplus generated by the uniform price of $7 is $4,500 (= 0.5 × 3,000 × $3), which is the area of the triangle abU. If the firm could find a way to charge the demand price for every one of the 3,000 units sold, it could increase total revenue by $4,500 by taking all of the consumer surplus from buyers. As long as the process of capturing consumer surplus is costless, capturing consumer surplus adds $4,500 to the profit earned by producing and selling 3,000 units. The area abU is only part of the lost revenue and profit caused by uniform pricing.
capturing consumer surplus
Devising pricing schemes to transform consumer surplus into economic profit.
0 1,000 2,000
Quantity
3,000 4,000 5,000 6,000 7,000 8,000 9,000 10,000 1
2 3 4 5 6 7 8 9 10
Price and cost (dollars)
D g
MR e
c d
a
b U
F MC = AC
F I G U R E 14.1
The Trouble with Uniform Pricing
The loss of revenue and profit caused by uniform pricing extends beyond the 3,000 units sold at point U on demand. Over the segment of demand from point U down to point F (3,001 to 5,999 units), the demand prices for these units exceed the marginal cost, $4, of producing these units. Since buyers are willing to pay more than the marginal cost of producing these units, the firm can earn additional profit equal to the area of shaded triangle UdF—but, as before, only if the firm can find a way to charge the demand price for each of the units between U and F on demand. The lost profits in the two shaded triangles in Figure 14.1 are sometimes referred to by marketers as the “curse” of uniform pricing. As we will show you in Section 14.2, capturing every bit of the consumer surplus in these two triangles, a practice called first-degree or perfect price discrimination, is practically impos- sible. Other forms of price discrimination, however, are widely used to capture some of the consumer surplus created by uniform pricing. We should mention here that, although the “curse” of uniform pricing generally applies in most cases, there are circumstances under which discriminatory pricing techniques may in fact increase total consumer surplus relative to the amount of surplus created un- der uniform pricing. You can learn about these special circumstances in advanced courses in microeconomics or industrial organization. We are now ready to discuss various types of price discrimination that can be used to capture the surplus cre- ated by uniform pricing.
Types of Price Discrimination
Economists and business firms have long recognized that when buyers can be sepa- rated into groups with different elasticities of demand, a firm can charge different prices for the same product and increase its profits above what could be earned if it charged a uniform price. In 1920, economist A. C. Pigou named this pricing practice price discrimination, decades before the word “discrimination” carried disparag- ing connotations. Most marketing managers and consultants avoid using the term
“discrimination,” instead calling this practice various other names, such as revenue management, yield management, or market segmentation. No matter what you call it, the objective of charging different prices for the same good or service is to cap- ture consumer surplus, transforming it into profit for the firm.
When a firm charges different prices across different units or different mar- kets for the same product, the seller is price discriminating. There are two crucial points that must be carefully examined in the definition of price discrim- ination. First, exactly the same product must have different prices. If consum- ers perceive that goods are not identical, they will value the goods differently, creating separate demand curves and separate markets for the different goods.
Obviously, a situation of “different prices for different goods” does not indicate the presence of price discrimination. Frequently, differences in timing or quality subtly create different products. For example, a lunchtime meal at Bern’s Steak- house is not the same product as a dinnertime meal at Bern’s. Even if the lunch and dinner menus are identical, the dining experience differs. The purpose of a lunchtime meal may be to talk about business or take a quick nutritional break
price discrimination Charging different prices for the same product for the purpose of capturing consumer surplus.
from work (with no wine service), while the purpose of an evening dinner may be to engage in relaxing social conversation with friends or family (with wine service). And, in many instances, quality differs between lunch and dinner din- ing experiences. Meal portions may be larger at dinner, and waiters may be more attentive during longer evening meals—tips are larger for evening meals!
Obviously, lunch and dinner meals are different dining experiences, and thus different products. Second, for price discrimination to exist, costs must be the same for each market. If costs vary across markets, a profit-maximizing man- ager who follows the MR = MC rule will, of course, charge different prices.
This is not a case of price discrimination. Cost differences are frequently sub- tle and difficult to detect. A motel located near Busch Gardens offers 10 per- cent discounts for military families. According to the motel’s owner/manager, military families are more reliable about checking in and out on time, and their children cause less trouble than children from nonmilitary families. Since costs differ between military and civilian families, the price difference is not a case of price discrimination.1
Sometimes the price differential between two separate markets is propor- tionately larger than the cost differential between the higher- and lower-priced markets. This situation is also a case of price discrimination, because the difference in prices cannot be fully explained by the difference in costs. To generalize the definition of price discrimination to cover this kind of price discrimination, econo- mists say that price discrimination between two markets A and B exists when the price to marginal cost ratio (P/MC) differs between the two markets or buyers:
PA/MCA ị PB/MCB. In our motel pricing example, there is no price discrimination if the marginal cost of supplying motel rooms to military families is exactly 10 percent lower than the marginal cost of supplying civilian families. If provid- ing rooms for military families is only 5 percent less costly, then the 10 percent price discount cannot be fully explained by cost differences, and thus the motel is practicing price discrimination.
Conditions for Profitable Price Discrimination
As you might expect, certain conditions are necessary for the firm to be able to price-discriminate profitably, otherwise price-setting firms would never engage in uniform pricing. First, a firm obviously must possess some market power. Since monopolists, monopolistic competitors, and oligopolists possess market power, they may be able to profitably price-discriminate, if they can meet the rest of the necessary conditions. Second, the firm must be able, in a cost-effective manner, to
1To be technically complete, we should mention that price discrimination also occurs if firms charge a uniform price when costs differ across buyers or across units sold. Profit-maximizing firms do not generally practice this type of price discrimination; it is usually undertaken by government agen- cies or government-regulated firms. For example, the U.S. Postal Service (USPS) charges all customers the same price to deliver a first-class letter, regardless of differences in the cost of supplying the service to different kinds of customers. Rural postal patrons, for example, are more costly to service than urban patrons, but all patrons pay the same price.
identify and separate submarkets. Submarkets must be separated to prevent resale of the product. If purchasers in the lower-price submarket are able to resell the prod- uct to buyers in the higher-price submarket, price discrimination will not exist for long. Consumer arbitrage—low-price buyers reselling goods in the high-price mar- ket—will soon restore a single, uniform price in the market. Goods and services that cannot be easily traded are more likely to experience discriminatory prices than those that can be easily transferred. For example, doctors, dentists, accountants, and lawyers are known to use “sliding scales” to charge higher prices to higher- income clients and lower prices to lower-income clients. Clearly, a patient paying a lower price for an appendectomy, a root canal, or a divorce settlement cannot resell these kinds of professional services to higher-price buyers. Finally, demand func- tions for the individual consumers or groups of consumers must differ. As we will demonstrate later, this statement can be made more specific to require that the price elasticities must be different. We have now established the following principle.
Principle Price discrimination exists when the price to marginal cost ratio (P/MC) differs between markets: PA / MCAị PB /MCB. To practice price discrimination profitably, three conditions are necessary:
(1) the firm must possess some degree of market power, (2) a cost-effective means of preventing resale between lower-price and higher-price buyers must be implemented, and (3) price elasticities must differ between individual buyers or groups of buyers.
The following sections describe the various types of price discrimination that can exist and set forth the theory explaining each type. We begin with an analysis of first-degree or perfect price discrimination, which allows the price- discriminating firm to capture all of the consumer surplus that is lost in uniform pricing. As mentioned previously, first-degree price discrimination is the most dif- ficult type of price discrimination to practice. Second-degree price discrimination, which is something of an approximation to perfect price discrimination, can be implemented much more easily. We will discuss two particularly common forms of second-degree price discrimination: block pricing and two-part pricing. Third- degree price discrimination is the last type we will discuss. While generally less common than second-degree price discrimination, real-world examples of third- degree pricing are nonetheless easy to find and interesting to analyze.