First, second and third degree price discrimination

First, second and third degree price discrimination

In this video we’ll explore first, second
and third degree price discrimination. First I’ll explain what it means, then we’ll
look at why firms do it and then analyze three separate diagrams of the differing degrees. Finally, we’ll look at the economic impact
on the consumer. Let’s begin with the definition. Price discrimination occurs when a firm charges
consumers different prices for an identical good or service. You’ve probably experienced this at the
cinema as a student. In many places, students are charged less
for tickets than adults. Now let’s try and get a better understand
as to why firms price discriminate. There are several potential benefits to firms
of price discrimination. First, it allows firms to sell more of their
products and increase their revenue. This can lead to higher profits. If an airline has empty seats on a flight
in the next few days, it would benefit them to sell the tickets at a lower price just
to fill them as opposed to continuing the flight with some seats empty. This also allows them to make better use of
spare capacity. Finally, as they increase output firms are
also possibly able to benefit from economies of scale. This can be the case for a firm producing
medicines and selling them domestically and globally. Being able to charge higher prices in richer
countries and lower prices in others, allows them to increase output and lower average
costs. Now let’s take a look at the diagrams of
each of the three. First degree price discrimination is when
a seller charges each consumer the maximum price they are willing to pay. Every consumer pays the maximum they are willing
to pay. This would essentially transfer all consumer
surplus to the producer. While this diagram is how a competitive market
would typically look in equilibrium, we have to change it for first degree price discrimination. This is how producer surplus looks like after
first degree price discrimination after the consumer surplus has been transferred due
to price discrimination. Now let’s move on to second degree price
discrimination. For second degree price discrimination, the
producer offers different prices to different groups of consumers. Unlike first degree price discrimination,
consumers are broken into groups that receive different prices based on the quantity they
purchase. If they purchase more, or bulk buy, they will
pay P4. If they purchase less, say Q1, they will pay
a price of P1. Next up is third degree price discrimination. For third degree price discrimination to take
place, these conditions must hold true. We’ll consider each condition in turn. First, the firm must be able to segment their
markets by elasticity at minimal cost. In the UK, you can purchase train tickets
for off-peak and peak travel. The cost to separate the markets is minimal. I’ve experienced this first hand when I
travelled in the UK during peak hours with a non peak ticket. A ticket officer walked up and down the aisles
checking tickets and I was asked to pay the full fare. I mistakenly thought I was traveling during
off peak hours. Peak travelers are likely to have inelastic
demand whereas off-peak travelers who have more flexibility are more sensitive to price
changes. Second, the firm has to have a high degree
of market power. If they don’t, charging higher prices will
just turn consumers away to their competition. Third, they need to be able to prevent arbitrage. This means that a buyer cannot buy in one
market and resell to the other. In the case of pharmaceutical drugs, they
are sometimes sold at lower prices overseas than domestically to provide affordable access
to consumers in less economically developed countries. However, it has happened in the past that
these same drugs purchased overseas are resold into domestic markets. The producer must be able to prevent such
a thing from happening. Now let’s see how the diagram looks. If these conditions are met, a firm can move
away from the pricing model we’ve seen above of the profit maximiser, towards something
quite different. We’ll take this market of Q* and break it
into two segments. One segment with inelastic demand and another
with elastic demand. Assume the previous market output is being
produced of Q*. We’ll use the corresponding marginal and
average costs from before. If you’re curious as to why, what we’ve
done is split the Q* quantity into separate markets, one with inelastic demand and the
other with elastic demand. The sum of the total quantities in the two
markets will equal Q*, thus we apply marginal and average cost across from our previous
diagram. Firstly, we have the inelastic market. We look for the intersection of MC and MR
and follow up to our demand curve to establish price. The price here is higher than the price charged
by the firm with the markets combined. Here the area labeled SNPi is the supernormal
profit from this specific market. Now we do the same in the elastic market and
get our supernormal profits there, SNPe. This price is lower than the previous price
charged by the firm. These two areas combined should be greater
than our initial supernormal profits if this firm has discriminated successfully. We can check that on the next slide. To help visualize this further, I’ve cut
and pasted each of the areas of supernormal profits from the previous three diagrams. The supernormal profits generated from the
inelastic market plus the supernormal profits generated from the elastic market are greater
than the supernormal profits in the unsegmented market. Let’s make it even clearer. I’ll place the original supernormal profits
at the bottom and place the others on top. You can see that the supernormal profits from
the segmented markets are greater than the original one. It may seem like the benefits mostly fall
to the producers of price discrimination. However, some consumers will benefit. Those who are charged lower prices obviously
benefit. This allows for greater choice for some consumers. Since those with inelastic demand are faced
with higher prices, firms can charge lower prices and thus offer their product to a market
that may not have been able to afford the product under the profit maximizing condition. That completes this extensive examination
of price discrimination. If you have any questions or comments, please
leave them below or email me at [email protected]

One Reply to “First, second and third degree price discrimination

  1. Very clear explanation, I had a question though,
    Is third degree price discrimination generally benefiting to the firm?

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