Price Discrimination

This essay has a total of 2410 words and 12 pages.

Price Discrimination





Define, discuss, and account for the existence of price discrimination. Compare and exemplify the first, second, and third degrees of such discrimination.

Overview
Price discrimination is the practice of setting different pricing formulas in different virtual markets, while still maintaining the same product throughout. The prices are based upon the price elasticity of demand in each given market. In more practical terms, that means that during “Ladies Night” at M.P. O’Reilly’s, it costs more for me to have a beer than if I were a female simply because this particular saloon sees fit to charge members of the female species less as a means to draw more such females to the establishment on such a night.

Price discrimination is rampant in many areas of the commercial and business world. Movie theatres, magazines, computer software companies, and thousands of other entities have discounted prices for students, children, or the elderly. One important note, though, is that price discrimination is only present when the exact same product is sold to different people for different prices. First class vs. coach in an airline (though sometimes just differing in how many free drinks you can get) is not an example of price discrimination because the two tickets, though comparable, are not identical.

Price discrimination is based upon the economic premise and practice of marginal analysis. This conceptualization deals specifically with the differences in revenue and costs as choices and/or decisions are made. A good example is illustrated in the textbook by the Hartford Shoe Company model. The most important portion of the model, however, is on page 201. Here, it is calculated that if the company raises the prices of the shoes from $60 to $65, their revenue and number of shoes sold will shrink…but their actual profit margin will raise slightly due to that higher profit margin more than just offsetting in the loss in sales. Profit maximization is achieved neither where the number of products sold is the highest, nor where the price is the highest.

Profitability
Price discrimination is only profitable if and when the given target groups’ price elasticity of demand differs to the point where the separate prices yield to profit maximization for each given group in question (where marginal revenue equals marginal cost). Groups that are more sensitive to prices, students and senior citizens for example, have a lower price elasticity of demand and are thus the ones that are often charges the lower prices for the identical goods or services.

The key to price discrimination and utilizing it to fully compliment other economic practices, ultimately achieving the total profit maximization, is the ability to effectively and efficiently collect, analyze, and act upon data gathered about the different groups. First of all, the groups must be accurately identified and the differences between groups must be discerned ahead of time. Children, genders, and senior citizens are easily singled-out by appearance, while military personnel, college students, and other groups must carry some sort of identification. Firms typically will advertise the highest prices in publications, and then offer discounts to qualified groups.

The three basic conditions for price discrimination to be effective are as follows:
1) Consumers can be divided into and identified as groups with different elasticities of demand.
2) The firm can easily and accurately identify each customer.
3) There is not a significant resale market for the good in question.

First Degree Price Discrimination
The premise behind the practice of first degree price discrimination is that the firm has enough accurate information about the end consumer that products can be sold each time for the maximum amount that the consumer is willing to pay. The two most prevalent examples of first-degree price discrimination are called “price skimming” and “all-or-none offers”, both of which are described below.

Skimming here refers to the demand function, as firms take the top of the demand of a given good to maximize profits on the per diem sale. This, of course, requires that the firm know the actual demand for the good that it produces. Furthermore, the firm must divide its customers into distinct, independent groups based upon their respective demands for the good. The firm wants to first sell to the group who will pay the highest price for the new product. It then reduces the cost slightly and sells to another group with only slightly less demand for the good. This process is replicated on numerous occasions until the marginal revenue dips to equal marginal cost.

While this example may seem similar to other examples of price discrimination, it should be noted that the most significant difference here is that there are a virtually limitless number of possible prices that, charged sequentially, will yield profit maximization over the long haul. The firm must, of course, be on the ball and must make constant reassessments of the demand and thus, the price for the good at any given time after the initial price is set and a number of units are sold.

Firms practicing price skimming, then, will generally start their pricing schedules where the demand schedule has its vertical intercept. From there, as demand at any given price shrinks, the firm readjusts the price of the good to spur more sales. As before, the firm maximizes profits where the marginal revenue is equal to marginal cost. The firm will not continue to sell the good below this threshold. The equality here is unlike a scenario where a single profit-maximizing price scheme is practiced.

The trick to price skimming is that the consumers do not become accustomed to the process and thus “wait” for the prices to drop, hence skewing the demand uncharacteristically. Customers may be upset about paying a higher price initially, and this may lead to the same customer not becoming a return customer next time, or simply that the customer who bought at a high price this time will hold off on a purchase next time, anticipating a price reduction. Price skimming is no longer effective if the consumers have been conditioned to the process.

The other example of first-degree price discrimination is the “all-or-none” model. This means that the firm will set a price for a given bundle of goods, and no matter what portion of the goods you desire, you pay the same price as if you were to purchase all of them. The diamond industry is a fine example of this, often selling less-than-perfect supplemental gems along with perfect gems in order to move the less-desirable merchandise. The other example, of leasing motion picture reels, is perhaps more easily associated with the general public. No one I knew would have ever wanted to see “Ernest Saves Christmas”, while “The Hunt For Red October” was quite a good flick.

By bundling goods together in a veritable “grab bag”, firms can rid themselves of merchandise that would in all likelihood not sell otherwise, or at least not for the same price. Likewise, firms can sell larger-than-necessary volume sets of certain items, even though no one in his or her right mind would willingly purchas

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