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price discrimination

Asked by takizo | Mar 17, 2007 | AS Level > Economics > Revision
takizo asks:

How does price discrimination operate and is it of benefit to consumers if so how?......

etutor answers:

Price discrimination relates to the ability of a monopolist, protected by barriers to entry, to increase supernormal profits. There are three types of price discrimination, which is defined as charging different consumers or groups of consumers in different markets different prices for the same good or service. The markets must thus be separated by a factor such as time, age or geography, and resale must be impossible; for PD to be profitable, consumers' price elasticity of demand must be different in each market. First degree PD - very rare in practice - involves charging each individual consumer the maximum he/she is willing to pay. In this case, all consumer surplus disappears, being transferred in its entirety to the producer - clearly a reduction in economic welfare. Second degree PD involves selling off surplus stock/excess capacity at a lower, discounted price - such as in the case of scheduled airlines selling bargain fares at the last minute. This clearly benefits the producer, since otherwise the excess would remain unsold and no revenue would be earned. The practice also benefits those consumers who pay only the discounted price. Third degree PD is the most common - where the market is divided into two or more sectors, each with differing PED. This is seen in practices such as BT charging business users more than domestic users, and in off-peak and weekend calls being cheaper than in the peak period; ditto reduced price travel on railways and buses for pensioners and children, etc. The general rule is that the higher price is charged in the market where demand is inelastic - for example, rush hour rail commuters have few, if any alternative modes of travel. The lower price is charged in the market where consumer demand is elastic - this acts as an incentive to them to use the service or buy the good. Assuming that the total costs for the monopolist remain the same, then the gain in overall revenue from the two (or more) separate markets (compared with a strategy of not dividing the market, and therefore charging the same price to everybody) translates into pure profit. The beneficiaries are of course those who are offered the good or service in the lower priced segment of the market, since in an undivided market they would have to pay more. The losers are those having to buy in the more expensive market, since their consumer surplus is reduced as a result.

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