Price Discrimination Prices are based upon the price elasticity of demand in each given market. In other terms, this means that during ladies night at the local bar, it costs more for men to have a beer than women simply because these bars find it o.k. to charge females less, as a way to draw more females to the business on a specific night. Price discrimination is part of the commercial and business world. Movie theaters, magazines, computer software companies, and thousands of other businesses have discounted prices for students, children, or the elderly. One important note though, is that price discrimination is only present when the exact same product is sold to different people for different prices.
First class vs. coach in an airline (though sometimes just differing in how many free drinks you can get) is not an example of price discrimination because the two tickets, though comparable, are not identical. Price discrimination is based upon the economic thoughts and practice of marginal analysis. This process deals specifically with the differences in revenue and costs as choices and/or decisions are made. Profit maximization is achieved not when the number of products sold is the highest, nor when the price is the highest. Profitability price discrimination is only profitable if and when the given target groups price elasticity of demand differs to the point where the separate prices yield to profit maximization for each given group in question (where marginal revenue equals marginal cost).
Groups that are more sensitive to prices, (students and senior citizens for example), have a lower price elasticity of demand and are the ones that are often charged the lower prices for the identical goods or services. The key to price discrimination and using it to fully compliment other economic practices, ultimately achieving the total profit maximization, is the ability to effectively and efficiently collect, analyze, and act upon data gathered about the different groups. First of all, the groups must be accurately identified and the differences between groups must be thought of ahead of time. Children, genders, and senior citizens are easily singled-out by appearance, while military personnel, college students, and other groups must carry some sort of identification. Firms typically will quote the highest prices in advertisements, and then offer discounts to qualified groups.
The three basic conditions for price discrimination to be effective are: 1) Consumers can be divided into and identified as groups with different elasticities of demand. 2) The firm can easily and accurately identify each customer. 3) There is not a significant resale market for the good in question. The thought process behind the practice of first degree price discrimination is that the firm has enough accurate information about the consumer, and that products can be sold each time for the maximum amount that the consumer is willing to pay. The two more common examples of first-degree price discrimination is called price skimming and all-or-none offers.
Skimming refers to the demand function, as firms take the top of the demand of a given good to maximize profits on the sale. This, of course, requires that the firm know the actual demand for the good that it produces. The firm must divide its customers into distinct, independent groups based upon their respective demands for the good. The firm wants to first sell to the group who will pay the highest price for the new product. It then reduces the cost slightly and sells to another group with only a slightly less demand for the good.
This process is copied on numerous occasions until the marginal revenue drops to equal marginal cost. While this example may seem similar to other examples of price discrimination, you should remember that the most significant difference here is that there are a virtually limitless number of possible prices that, if charges correctly, will lead to profit maximization in the end. The firm must, of course, be on the ball and must make constant changes of the demand, and the price for the good, at any given time, after the initial price is set, and a number of units are sold. Firms practicing price skimming will generally start their pricing schedules where the demand schedule has its vertical interception. From there, as the demand at any given price shrinks, the firm readjusts the price of the good to get more sales.
As before, the firm maximizes profits where the marginal revenue is equal to marginal cost. The firm will not continue to sell the good below this point. The trick to price skimming is that the consumers do not become accustomed to the process and therefore wait for the prices to drop. Customers may be upset about paying a higher price initially, and this may lead to the customer not becoming a return customer next time, or simply that the customer who bought at a high price this time will hold off on a purchase next time, waiting for a price reduction. Price skimming is 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 good, and no matter what portion of the good you desire, you pay the same price as if you were to purchase all of them. The diamond industry is an example of this, often selling less-than-perfect gems along with the perfect gems in order to get rid of the less-desirable merchandise. By putting goods together in a grab bag, firms can rid themselves of merchandise that would normally not sell otherwise, or at least not for the same price. Likewise, firms can sell larger than necessary volumes of certain items, even though no one in his or her right mind would willingly purchase such large quantities of certain goods. This format of moving merchandise is especially popular at auctions. A branch of price discrimination, second degree is the practice of selling incremental amounts of a good for incremental prices.
For example, the first 12 pairs of shoes are $80, the next 12 pair are $72, and so on. The 2nd degree often allows the firm to sell more quantity than they would ordinarily. Customers with higher demand prices will tend to buy smaller quantities at higher average unit prices, while those with lower demand prices will more often purchase the larger quantities at a lower unit cost. Second degree price discrimination generally leads to a situation where more quantity per unit is sold. Sam’s Club is the 2nd degree price discrimination heaven.
Mr. Walton’s little warehouses across the land clearly aim for a consumer that is willing to buy more at a lower price per unit. Finally, 2nd degree price discrimination yields itself well to a process called product bundling. Product bundling is more common in the personal computer industry. System packages are bundled together with the most popular software and hardware, and this reduces possible arguing over certain items.
No one can argue about the value of not including a CD-ROM or video card. Third degree price discrimination deals with separating customers into distinct groups based upon their difference in elasticity of demand. Based upon this elasticity, you then charge a higher price to the group whose demand is less elastic. Marginal revenue is the change in the total revenue that is the result of a small change in the sales of the good in question. Therefore, price must also have to change slightly. Opportunity Cost Price discrimination is based upon the most significant of all economic concepts: opportunity cost.
For example, American Airlines may offer college students a fare from Saint Louis to Chicago for $149 round-trip, while business class fares run significantly higher, say $279 for example. The business traveler, is more willing to pay the higher fare because he or she is going to be working for a client in Chicago and will be paid $100 per hour while there. The college student does not have the luxury of having any extra money, and therefore cannot see paying the higher rate to travel to Chicago for his or her break. Opportunity cost is the most essential measure of justification for reallocation of any person’s given resources, including (but not limited to) time, money, and talent. People often say that they are richer in time than in money. The bottom line is always that, no matter what you’re doing, you could be doing something else. Opportunity cost should be a consideration every time someone chooses to sleep in and miss class, or every time that someone takes off work for a day.
Vacation, after all, is the most common exercise of someone making a judgment regarding opportunity cost. Price discrimination is a significant and influential practice on the market in the modern economic world. It aids in a firm’s profit maximization scheme, it allows certain consumers with more scarce resources the opportunity to purchase goods or services that would otherwise be usable, and it aids firms in balancing what is and what is not sold. Price discrimination is an effective means by which a firm can sell a higher quantity of goods, make a higher profit margin on the goods it sells, and builds a broader consumer base due to differing price elasticity of demand for given goods and services. Price discrimination ultimately equalizes price and value for both the consumer and the firm, creating a more ideal situation for both entities in terms of preference and opportunity cost.
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