This document discusses price discrimination, which is when a firm charges different prices for the same good or service. There are three types of price discrimination: first degree, second degree, and third degree. The document analyzes the conditions needed for price discrimination to be successful, provides examples of each type, and discusses the advantages and disadvantages from the perspectives of both firms and consumers. While price discrimination allows firms to maximize profits, it can also exploit captive consumer markets who face inelastic demand. The growth of technology may limit opportunities for price discrimination over time.

1. Name
Muhammad Zeeshan
Registration No
W1F18MCOM0017
Subject
Managerial Economics
Submitted To
Prof. Umar Khattab
Assignment No
04

2. Price discrimination
Price discrimination is the practice of charging a different price for the same good or
service. There are three types of price discrimination – first-degree, second-degree, and
third-degree price discrimination.
First degree:
First-degree price discrimination, alternatively known as perfect price discrimination,
occurs when a firm charges a different price for every unit consumed.
The firm is able to charge the maximum possible price for each unit which enables the
firm to capture all available consumer surplus for itself. In practice, first-degree
discrimination is rare.
Second degree:
Second-degree price discrimination means charging a different price for different
quantities, such as quantity discounts for bulk purchases.
Third degree:
Third-degree price discrimination means charging a different price to different consumer
groups. For example, rail and tube travellers can be subdivided into commuter and
casual travellers, and cinema goers can be subdivide into adults and children. Splitting
the market into peak and off peak use is very common and occurs with gas, electricity,

3. and telephone supply, as well as gym membership and parking charges. Third-degree
discrimination is the commonest type.
Necessary conditions for successful discrimination:
Price discrimination can only occur if certain conditions are met.
1. The firm must be able to identify different market segments, such as domestic
users and industrial users.
2. Different segments must have different price elasticity’s (PEDs).
3. Markets must be kept separate, either by time, physical distance and nature of
use, such as Microsoft Office ‘Schools’ edition which is only available to
educational institutions, at a lower price. Time based pricing - also
called dynamic pricing - is increasingly common in goods and services sold
online. In this case, prices can vary by the second, based on real-time demand
related to consumers' online activity.
4. There must be no seepage between the two markets, which means that a
consumer cannot purchase at the low price in the elastic sub-market, and then
re-sell to other consumers in the inelastic sub-market, at a higher price.
5. The firm must have some degree of monopoly power.
Diagram for price discrimination:
If we assume marginal cost (MC) is constant across all markets, whether or not the
market is divided, it will equal average total cost (ATC). Profit maximization will occur at
the price and output where MC = MR. If the market can be separated, the price and
output in the relatively inelastic sub-market will be P and Q and P1 and Q1 in the
relatively elastic sub-market.

4. When the markets are separated, profits will be the area MC, P,X,Y + MC1,P1,X1,Y1. If
the market cannot be separated, and the two submarkets are combined, profits will be
the area MC2,P2,X2,Y2.
If the profit from separating the sub-markets is greater than for combining the sub-
markets, then the rational profit maximizing monopolist will price discriminate.
Market separation and elasticity:
Discrimination is only worth undertaking if the profit from separating the markets is
greater than from keeping the markets combined, and this will depend upon the relative
elasticity’s of demand in the sub-markets. Consumers in the relatively inelastic sub-
market will be charged the higher price, and those in the relatively elastic sub-market
will be charged the lower price.
The effectiveness of price discrimination will be weakened if the costs of preventing
seepage are significant, and reduce the profits accruing from discrimination. For
example, it might be necessary to introduce costly monitoring and enforcement systems
to ensure that consumers do not break any conditions of sale which exist to keep
markets separate. Employing ticket inspectors or other security systems adds to the
cost of preventing seepage in public transport.
Note:
In the above example we are assuming that the price at which consumers in
the relatively elastic sub-market (students, for example, looking to travel into a major
city) are prepared to enter the market is lower than those in the relatively inelasticsub-

5. market (commuters, for example). This gives the combined demand (AR) curve an
outward kink, and the combined MR curve a discontinuous portion (indicated by the
vertical dotted line.) If, however, both types of consumer are prepared to enter the
market at the higher price then the combined demand (AR) curve is simply shifted
further to the right, and will not have the kink. This is illustrated in the diagram below:
In all cases it should be noted that that profit maximization must occur where MC = MR.
This means that profit maximizing equilibrium for the discriminating monopolist must
occur where MR is positive, which means that, irrespective of the gradient of the
demand curves in the submarkets, the price will always be set in the elastic portion of
the demand curve (individually, and when combined).
Evaluation of price discrimination:
Advantages:
From the firm’s perspective:
From a firm’s perspective price discrimination can offer many advantages, making it one
of the commonest pricing strategies used by local, national and global companies.
Benefits to firms include:
Profit maximization:
Firstly, matching prices to the specific characteristics of the market, and its various
segments, is a profit maximizing strategy (see above), where the firm can extract some

6. (or even all) of the consumer surplus available in the market, and turn it into producer
surplus (i.e. profits).
Economies of scale:
Given that charging different prices can increase sales volume, especially as a result of
new consumers entering the market, attracted in by the discounted prices, firms can
benefit from the economies which arise from increased output and production.
Efficient use of infrastructure:
Price discrimination can benefit firms with high costs associated with the building of
infrastructure, and its maintenance. This includes natural monopolies such as gas,
electricity supply, and transport services. For example, having more passengers on a
train that is going to run anyway provides additional revenue to the train operators. This
revenue may be used to add to profits (given that the marginal cost of one extra
passenger is virtually zero) or to cover new fixed costs, such as track or safety
improvements.
Better use of space:
Similarly, price discrimination may also enable manufacturing and retail firms to clear
their existing stocks quickly when required - hence making better use of their shop or
factory space.
Managing the flow customers:
Price discrimination according to the time of day means that the flow of customers into
retail stores can be managed more effectively, which might provide a better experience
for shoppers and spread out the work for staff. For example, having a ‘happy hour’ or
‘early bird’ prices may encourage shoppers to adjust their shopping times so that
queues are shortened at more peak times, as well as ensuring that staff are better
employed throughout the day.
Understanding the market:
Firms may wish to trial new products in different locations, and may match their prices
to the specific demand conditions found in those local markets. Also, firms can offer
discounts in order to get consumer feedback on these trialed products, and on existing
ones.
Similarly, price discrimination may enable firms sell to export markets, basing their
prices on what consumers are prepared to pay in each territory – which can vary

7. considerably from country to country. From a macro-economic perspective, international
trade is likely to be created by price discrimination.
Enables survival:
As a result of generating additional revenue, price discrimination can enable firms to
survive. For example, small cinemas might be better able to survive if they can offer low
priced off-peak cinema tickets to the over-65s for day-time screenings.
From the consumer’s perspective:
Possibility of lower prices:
From the consumer’s point of view, some, especially those in the highly elastic sub-
market, may gain consumer surplus as a result of lower prices. Lower prices could also
result from the application of scale economies (as above).
Benefits to groups of consumers:
If we look specifically at goods and services consumed by children, but where adults are
needed to accompany them, it can be argued that charging children a much lower price
enables families as a whole to benefit, and gain increased group utility. For example, if
cinemas or theme parks set low prices for children (or even zero price for those under a
certain age), or offer with family discounts, more parents will be able to attend, and
accompany their children. This means that, in the longer term, cinema chains and
theme parks will increase their revenue and profits. The same logic can be applied to
travel and holidays, with child and family discounts encouraging demand and helping
generate revenue.
Enables flexibility:
Having different prices may enable consumers to match their purchasing and shopping
to their own free time. For example, ‘early bird’ prices can benefit individuals who are
retired, or who work flexible hours.
Generating positive externalities:
We can extend the analysis to consider the role of price discrimination in
reducing market failure, such as enabling wider consumption of merit goods. For
example, if ‘private’ schools charge relatively high tuition fees for those who can afford
them, and where demand is inelastic, the revenue generated allows them to cover their
costs and run classes. With fixed costs covered, they can then offer places at
discounted fees (to cover the variable costs only) to those who cannot afford them.
Given that the demand for private education by less well-off parents is likely to be price

8. (fee) elastic, the lower price will encourage greater demand. The benefit to ‘society’ is
that more education is ‘consumed’ and more positive externalities generated.
Survival:
Consumers can also gain from the fact that firms can more easily survive, so that future
generations can derived continued benefit.
Disadvantages:
Exploitation of captive markets:
However, it could be argued that consumers in a captive sub-market are being unduly
exploited due to their inelasticity. This is especially relevant when we look at transport,
and the high ticket prices charged for peak travel, compared with off-peak. The same
could be said for energy prices, where existing and loyal customers often pay higher
prices, which subsidies the discounts available to ‘new’ customers.
Limitations:
Ultimately, the ability to price discriminate may be limited because the conditions
necessary are not fully met. In other words, there are limits on the extent to which
different prices can be applied.
Conclusion:
Clearly, with global commodities, world markets tend to settle on one price at any one
time, given the process of arbitrage.
The growth of new trading and selling technologies, apps, online auction bidding, and
price comparison websites mean that consumers have increasing information, which
may reduce the possibility of price discrimination. However, the widespread use
of dynamic pricing models by online sellers means that time-based pricing in
increasingly common.
So, at one extreme, price discrimination is still highly possible with locally provided
services, and where technology can provide flexible pricing, while at the other, globally
traded commodities are subject to the ‘law of one price’, where price differences are
very quickly eroded away. Manufactured and branded goods fall somewhere between
these two extremes, with price discrimination possible - especially in terms of new
online pricing models - but where price differences may also be eroded through
technology, trade and arbitrage.
The effects of arbitrage:

9. Arbitrage is a process where traders, acting as either buyers or sellers, can exploit price
differences for identical products - buying where the price is lower and selling where it is
higher.
The effect of this is to make prices converge, given the different effects of buying and
selling in the market.