8.1: Overview and Objectives
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Price discrimination is a way for firms to turn consumer surplus into profits by charging different consumers different prices based on their willingness to pay. A number of pricing schemes are encountered in everyday commerce, which are discriminatory in one way or another. Such schemes are common in food and agricultural markets as well. The goal of this chapter is to explain the economic logic of these pricing schemes.
Price discrimination occurs when consumers or groups of consumers are charged different prices even though the cost of providing the product or service to each consumer or each group of consumers is the same. For example, it would be price discrimination if a cafe offers a senior-citizen discount for its coffee. The cost of providing the cup of coffee is the same regardless of whether the customer is 25-years old or 75-years old. Nevertheless, the 25-year-old customer is being charged more. As you will learn below, the cafe owner probably has evidence that senior citizens have more elastic demands than young or middle-aged customers. Because of these differences in elasticity, the cafe can make more money by charging a different price to seniors than it charges to everyone else. It is important to reiterate that price discrimination occurs when different prices are charged even though the cost of providing the good or service is the same. There are non-discriminatory situations where some customers are charged more than others. For example, parents of teenage drivers pay more for automobile insurance. This, however, is not price discrimination because teenage drivers are more likely to be in accidents and are more costly to insure.
Some forms of price discrimination are illegal under anti-trust laws. Specifically, price discrimination that reduces competition is illegal under the Robinson-Patman Act (Lieberman and Siedel 1989). Also, the kinds of discrimination covered in this chapter are discriminatory in that different prices are based on differences in consumer willingness to pay. The different prices are not based on dislike or ill will towards a consumer or group of consumers. For example, in the senior-citizen example, the cafe owner offers the senior discount because seniors have more elastic demands for coffee. Seniors are not given the discount because the cafe owner dislikes middle-aged or young adults.
Objectives for this chapter are as follows:
- Distinguish between first-degree, second-degree, and third-degree price discrimination.
- Explain the logic of bundle pricing and access fees to capture consumer surplus.
- Characterize the self-selection problem inherent in second-degree price discrimination.
- Explain third-degree price discrimination and provide examples encountered in everyday commerce.
- Describe conditions that are necessary for the various types of discriminatory pricing strategies described in this chapter.
- Explain the logic of package pricing (bundling across products), contractual tie-in sales, and captive-product pricing.