A Simplified Understanding of Price Discrimination

by: Ejiro U. Osiobe

Introduction:

To understand the different types of price discrimination, the foundation of these strategies is the consumer and producers supplies theory. Understanding those terms will help you through the five types of price discrimination. From the supply-side economics pricing discrimination was introduced in the market to reduce the deadweight loss. This academic letter aims to explain [theoretically and graphically] the five types of price discrimination graphically and illustratively.

First Degree Price Discrimination:
Also known as the “Perfect Price or Price is Right discrimination” this is a situation where the customers within the same market economy are charged the maximum possible price the customer is willing and able to pay for each unit of demand.

Example:
The airline industry is a good example of a market that practices a perfect price discrimination strategy. They divide their customers into the following groups [first-class, business-class, prime-economy, and economy] when it comes to booking a travel ticket. Another industry that is involved with perfect price discrimination is the telecommunication sector. In this market, customers are allowed to select the plan they which to use from their phone carriers depending on their budget and willingness to pay. For example, having a phone plan with [1 GB, free calls, & text; 50 GB, free calls, & text; and unlimited data, free calls, & text]. An industry that uses first-degree price discrimination divides its customers into groups of prime, standard, and economy to reduce the deadweight loss.

Second Degree Price Discrimination:
Also known as “Bulk Pricing Discrimination”, it involves giving discounts for each additional good or service added into the demand. Second-degree price discrimination charges customers differently for the same product based on the total amount or quantity of goods and services bought or demanded by the customer. The bulk-pricing discrimination capitalizes on the consuming nature of human-unlimited wants and this is an indirect form of regressive tax.

Example:
The Costco store and Sam’s Clube are good examples of stores that participate in second-degree price discrimination. Because consumers are buying in bulk, they get the store's discount. Also, the stated two examples illustrate the “Two-Part Pricing system,” where you have to pay (membership due) to partake in the discount.

Third-Degree Price Discrimination:
Also known as “Price-Elasticity Discrimination” unlike the first-&-second-degree price discrimination, This type of price discrimination occurs when different prices are set for different demographics/groups of consumers. The discrimination is usually based on [age, income, time, occupation, and geography]. Third-degree price discrimination aims to divide the population by demographic [elderly, students, military, and location].

Example:
A good example will be, stores charging students lesser [student-discounts] because they are students or giving military personnel discounts for their service to the nation, the elderly discounts for living-long, and paying more for living in a BIG city, for example, the price of a BIG MAC in Irvine CA is different from that in Iraan, TX although the products are identical and taste the same.

Fourth Degree Price Discrimination:
Also known as “Reverse Price Discrimination” because it is faced by the producers’, based on their average cost of production. In this case, the firm is faced with unplanned diseconomies of scale & scope as a result of unanticipated additional services or products added to the order/demand.

Example:
Say, Jackie placed a catering order for her son’s 10-year-old birthday party, and a week to the party the catering service finds out that the birthday boy is a vegetarian, now the catering service will have an additional cost of production to add vegetarian cuisine to the party’s menu, while the cost of the order remains the same. This example can also be seen in the airline industry after a person buys a plane ticket and informs the airline that they’re vegan; the flight will have to accommodate that person even if they are the only vegan on that particular flight.

Fifth-Degree/Premium-Price Discrimination:
Also known as the “Premium-Price Discrimination” based on increasing the producers’ total marginal revenue, as a result of an additional unit or scope of production. In this case, the firm is faced with planned economies of scale & scope; as a result, the firm’s marginal revenue will increase. In any market, both the consumer and producers aim to increase their utils or revenue.

Example:
The petroleum industry is a good example of a sector that practices fourth-degree price discrimination. For example, it may cost ExxonMobil a based $## to produce “Regular-gasoline”; an extra $0.05 to produce “MidGrade-gasoline”; an extra $0.05 to produce “SuperPremium-gasoline”, but ExxonMobil will sell the MidGrade-&-Superpremium-gasoline way above the cost of production.

Comparison:
The main difference between all five types of price discrimination is, first-degree price discrimination sets different prices for the product to different consumers based on their willingness; second-degree price discrimination targets groups that can buy in bulk for a discount; third-degree price discrimination sets different prices based on their demographics (age, location, military status, etc.); fourth-degree price discrimination is based on the producer’s incurring unplanned diseconomies of scale & scope; increasing their average cost of production; while the fifth-degree price discrimination, the producers enjoy economies of scales & scope.