Price discrimination and elasticity are fundamental economic concepts describing how businesses strategically price their products and how consumers respond to those prices. Simply put, price discrimination is selling the same product at different prices to different customers, while elasticity measures how much demand or supply changes in response to price or income shifts.
Understanding Price Discrimination
Price discrimination occurs when a seller charges varying prices for the same good or service based on differences in customer willingness to pay or market segment. The goal is to capture more consumer surplus and maximize profits.
Types of Price Discrimination
Economists categorize price discrimination into three main types:
- First-Degree Price Discrimination (Perfect Price Discrimination): This involves charging each customer the maximum price they are willing to pay for each unit. It's rare in practice due to the difficulty of knowing each individual's precise willingness to pay, but it's the most profitable for the seller.
- Example: A car salesperson negotiating a unique price with each buyer.
- Second-Degree Price Discrimination: This involves charging different prices based on the quantity consumed. Prices decrease as the quantity purchased increases.
- Example: Bulk discounts, tiered pricing for utilities (e.g., electricity bills where the price per kWh decreases after a certain usage threshold).
- Third-Degree Price Discrimination: This is the most common type, where sellers divide consumers into different groups (segments) based on characteristics like age, income, location, or time of purchase, and then charge each group a different price.
- Example: Student discounts, senior citizen rates, airline tickets priced differently for business travelers vs. leisure travelers, or matinee movie tickets being cheaper than evening shows.
Conditions for Successful Price Discrimination
For price discrimination to be effective, several conditions must be met:
- Market Power: The seller must have some degree of market power, meaning they are not a "price taker" in a perfectly competitive market.
- Market Segmentation: The seller must be able to segment the market into groups with different price elasticities of demand.
- Prevention of Resale (Arbitrage): Consumers who purchase the product at a lower price must not be able to easily resell it to consumers who would have paid a higher price.
Understanding Elasticity
In economics, elasticity is a measure of the responsiveness of one economic variable to a change in another. When discussing price discrimination, the most relevant form is price elasticity of demand.
Price Elasticity of Demand (PED)
Price elasticity of demand measures how much the quantity demanded of a good responds to a change in its price.
- Elastic Demand: Occurs when the quantity demanded changes significantly in response to a small change in price (PED > 1). Consumers are highly sensitive to price changes.
- Example: Luxury goods, products with many substitutes.
- Inelastic Demand: Occurs when the quantity demanded changes very little, if at all, in response to a change in price (PED < 1). Consumers are less sensitive to price changes.
- Example: Essential goods like medication, gasoline (in the short term), products with few substitutes.
- Unit Elastic Demand: Occurs when the the quantity demanded changes by the same percentage as the price (PED = 1).
Factors Affecting Price Elasticity of Demand
Several factors influence how elastic or inelastic the demand for a product is:
- Availability of Substitutes: The more substitutes available, the more elastic the demand.
- Necessity vs. Luxury: Necessities tend to have inelastic demand, while luxuries have elastic demand.
- Proportion of Income Spent: Products that represent a large portion of a consumer's budget tend to have more elastic demand.
- Time Horizon: Demand tends to be more elastic in the long run as consumers have more time to find substitutes or adjust their behavior.
- Definition of the Market: A narrowly defined market (e.g., "blueberries") usually has more elastic demand than a broadly defined market (e.g., "fruit").
The Relationship Between Price Discrimination and Elasticity
The concept of elasticity is central to successful price discrimination. Businesses use price elasticity of demand to identify and segment customer groups. The core strategy is to charge higher prices to customer segments with inelastic demand (who are less sensitive to price changes and will buy even if the price increases) and lower prices to customer segments with elastic demand (who are very sensitive to price changes and will only buy at a lower price).
For instance, consider the example of movie theatre tickets. Different prices are offered for seniors and children compared to adults. Consumers who are highly elastic, such as seniors or children, may gain consumer surplus from these lower prices. This is because their demand is more sensitive to price, meaning a lower price makes it much more likely they will purchase a ticket. By offering discounts, the movie theatre attracts a segment of the market that might otherwise not attend, thereby increasing overall revenue.
| Market Segment | Price Elasticity of Demand | Pricing Strategy in Price Discrimination | Outcome |
|---|---|---|---|
| Elastic Demand | High (PED > 1) | Charge Lower Prices | Attracts price-sensitive customers, increases volume, may increase consumer surplus for these groups. |
| Inelastic Demand | Low (PED < 1) | Charge Higher Prices | Maximizes revenue from customers less sensitive to price changes. |
In essence, price discrimination is an application of understanding varying consumer sensitivities to price, as measured by elasticity, to optimize pricing strategies and profitability.
