What Is Price Discrimination?

By Thomas Bennett Financial expert at Priceva

Published on January 25, 2023

When it comes to pricing strategies, personalization never hurts because it allows you to generate the maximum income from each particular buyer. A price discrimination strategy is a great option for businesses that want to scale their revenue and market coverage. This guide explains how this pricing approach works, shows different levels of price discrimination, and compares its pros and cons.

Table of Contents
What Is Price Discrimination?
Understanding Price Discrimination
What Are the Types of Price Discrimination?
Requirements for Successful Price Discrimination
Price Discrimination Examples
Advantages and Disadvantages of Price Discrimination
Conclusion
FAQ

Understanding Price Discrimination

Price discrimination is the practice of charging different prices for the same product depending on the target group. This strategy is based on the seller's belief that certain groups of customers are ready to pay more or less depending on their demographics or how they evaluate the product quality.

Consumers’ ability to pay depends on the relative elasticity of demand for the product. Consumers in a relatively inelastic market can pay a higher price, while customers in a relatively elastic market expect to pay less.

What Are the Types of Price Discrimination?

Depending on the basis for price differentiation, the strategy can be implemented in different ways and degrees. Let’s check them out in detail.

First-Degree Price Discrimination

First degree type represents the pinnacle of pricing strategy. In this model, the seller charges each customer the maximum price they are willing to pay, ensuring no consumer surplus remains. This approach, while theoretically maximizing profits, is rarely practical due to the difficulty in determining each buyer's highest willingness to pay. However, advancements in data analytics and personalized marketing are bringing businesses closer to this level of pricing precision. Examples include car sales negotiations or personalized online shopping, where prices can be adjusted based on a customer's browsing and purchasing history.

Second-Degree Price Discrimination

This pricing strategy involves charging a different price depending on the quantity or amount. For example:

Mobile operators charge more for minutes used on top of a prepaid package.
Membership cards provide shoppers with discounts on future products.
Most brands use bundle pricing and allow consumers to purchase a certain amount of goods with a discount.

Third-Degree Price Discrimination

Third degree type segments the market based on observable characteristics like age, location, occupation, or time of purchase. Different consumer groups are charged different prices for the same product, based on their differing price sensitivities or elasticities. Examples include student or senior discounts, geographical pricing variations, and peak vs. off-peak pricing. This type of price discrimination allows businesses to maximize revenue by tapping into different willingness to pay across diverse market segments. For instance, airlines often charge price discrimination higher prices for business travelers compared to leisure travelers, and movie theaters offer discounted tickets to students and seniors.

Requirements for Successful Price Discrimination

A price discrimination strategy is not equally suitable for all businesses and retailers. There are several conditions that should be met for this pricing approach to work.

Imperfect Competition

It typically occurs in markets characterized by imperfect competition. In such scenarios, firms possess a certain degree of market power or pricing authority, which is essential for setting different prices for similar products or services. Unlike in perfectly competitive markets, where prices are dictated by market forces, companies in imperfectly competitive markets can influence prices and customer perceptions. For instance, a software company may have the leeway to charge different prices in different countries or for different user segments based on its unique market position and brand strength.

Market Segmentation

Segmenting the market is crucial for price discrimination to work. A retailer should be able to divide the market depending on certain factors, such as demographics (age, gender, etc.), geography, customer preferences, time, and so on. This division is helpful for dynamic pricing as well.

Note that market segments should not be mixed if your price discrimination is direct: customers will be frustrated, because some will end up paying more than others. Besides, you shouldn’t let one market seep into another because it would make resale possible.

Prevention of Resale

When a company offers bulk purchase discounts, it needs to ensure that buyers will not resell these items or services at a higher price. Otherwise, the original seller will start losing direct customers to resellers. Furthermore, some customers will have to pay a higher price for the same thing, which might cause frustration and affect brand loyalty.

Elasticity of Demand

The effectiveness of discrimination heavily relies on understanding and exploiting the elasticity of demand in various market segments. In essence, elasticity refers to how sensitive consumers in a market segment are to changes in price. For a successful price discrimination strategy, it's vital to identify segments with different elasticities and adjust prices accordingly. For instance, a business might implement third-degree discrimination by charging higher prices in an inelastic sub market, where consumers are less sensitive to price changes (such as life-saving drugs). Conversely, in more price-sensitive or elastic sub markets, like luxury goods or non-essential services, the same business might set lower prices to attract price-conscious consumers. This strategic differentiation between elastic and inelastic sub markets is key to optimizing both sales volumes and profit margins through tailored discrimination strategies.

Price Discrimination Examples

A price discrimination strategy can be executed in different ways. Here are some examples that will help E-commerce projects make their pricing more flexible and effective.

Coupons

It’s safe to assume that customers who use coupons are more price-sensitive than those who don’t. By introducing coupons, a retailer can attract more buyers from lower market segments and sell at a higher price to upper market segments.

Premium Pricing

Premium products are sold far beyond their marginal value, and they can be offered not only by luxury brands. For example, clothing brands produce premium-quality clothes aside from their regular offerings, and charge different prices for them.

Retail Practices

Retailers use different incentives such as bulk selling, rebates, seasonal discounts, etc. It helps them attract more customers, get a bigger market share, or raise the profit on certain products.

Discounts for Certain Groups of Customers

Some businesses offer discounts for certain target groups, for example, seniors, veterans, large families, etc. This strategy can be useful if some of your customers are price-sensitive.

Airlines and Booking Time

Airlines are notorious for employing price discrimination based on the time of booking. Customers who book flights well in advance often pay lower prices than those making last-minute bookings. This strategy reflects different price elasticities between leisure travelers (more price-sensitive) and business travelers (less price-sensitive).

Discounted Movie Tickets

Many movie theaters use third degree price discrimination by offering discounted tickets to specific consumer groups like students, seniors, or military personnel. This strategy allows theaters to attract a wider audience while maximizing revenue from regular-priced tickets.

Software Tiered Versions

In the software industry, second degree price discrimination is common with companies offering basic, standard, and premium versions of their products. Each version is priced based on the features and capabilities offered, allowing customers to choose a product that best fits their needs and budget.

Advantages and Disadvantages of Price Discrimination

Price discrimination can be very effective in terms of boosting profit, but it comes with risks and might fail if it’s used in a very competitive market. Weigh its pros and cons before you decide whether it fits your business.

Advantages

Here are the major benefits of using a price discrimination strategy:

You can maximize your profit when a price is justified for specific market segments. The consumer surplus will generate more income.
You can scale your business, because you increase sales by attracting new consumers entering the market.
Efficient usage of space. Price discrimination can help you get rid of existing product stock. As a result, you can use your store, warehouse, and/or factory space more efficiently.
Controlling customer flow. When a business introduces “happy hours” and similar time-bound discounts, it can predict customer flow and avoid traffic overload during busy hours.

Disadvantages

At the same time, price discrimination comes with a few drawbacks as well. Sometimes it’s not attractive from the consumer’s point of view, and here’s why:

Customers overpay in an inelastic market. For example, they have to buy expensive airplane tickets during holiday seasons and periods of high demand. That affects loyalty to the brand.
Price discrimination can spoil the company’s image if the same products are available at lower prices from other sellers. It evokes a sense of unfairness in consumers, some of whom might stop buying the brand’s products.
Consumer surplus becomes lower because price discrimination transfers it to the manufacturer. As a result, customers believe they got less value than they expected for the price they paid.
Lower choice of goods. In the case of a market with imperfect competition, monopolies can take advantage of a discrimination strategy. They set high entry barriers for other brands and capture the majority of the market share. As a result, competitors can’t launch their own products, customers have a poor choice of goods, and some customers can’t even afford the high prices charged by the market leader.
It implies extra administration expenses. To carry out price discrimination, a company needs to prevent customers from reselling goods on the same market. That means paying employees in the back office to monitor the situation.

Conclusion

If your company is seeking ways to improve profit margins and make pricing more flexible, pricing discrimination may be a great strategy. It does not imply any changes to the product or service delivered – you just need to divide your target audience into groups and find out who can be charged more, and who would generate more sales if you offered discounts. That means price discrimination can be equally effective among different market segments.

However, this strategy is risky to implement if you don’t know your market well. If you are unsure about how much to charge, consider implementing price optimization software by Priceva. It allows you to test different pricing scenarios and provides price suggestions based on real-time data.

FAQ

Is price discrimination illegal?

No, price discrimination is neither illegal nor unethical. It refers to companies that charge dynamically as market conditions change, or that offer different prices for different groups of customers. That does not violate any U.S. laws.

However, the Robinson-PatmanAct of 1936 bans large companies from discriminating against small businesses in pricing, promos and ads. It prevents wholesalers from pushing smaller businesses out of the market by making suppliers charge the same prices to all clients.

Also, some US states (such as California) prohibit price discrimination based on gender, nationality or religion.

How do you calculate profit in perfect price discrimination?

You need to figure out where marginal costs meet demand. At this point, a company no longer produces goods, and instead counts total profits. They are calculated by finding the area between the demand and marginal cost curves.

What companies use price discrimination?

According to economists, a company should meet three conditions for price discrimination to work properly. Firstly, it should have enough market power. Secondly, it should be able to differentiate customer segments. Thirdly, the company should be able to prevent customers from reselling the product.

What type of price discrimination do airlines use?

Airline companies use third-degree price discrimination because they sell economy and business class tickets, thus dividing buyers into two groups. This distinction is based on customer behavior and purchasing ability.

What is Price Discrimination in Perfect Competition?

In a perfectly competitive market, discrimination is virtually impossible, as all firms are price takers. This means they cannot set different prices for identical products due to the abundance of competitors and the availability of perfect information. In such markets, products are homogenous, and no single firm possesses the market power needed to influence prices or practice price discrimination.

Why Price Discrimination is Never Perfect?

Perfect price discrimination, where a seller charges each customer the maximum they are willing to pay, is almost impossible to achieve in reality. It requires detailed and specific knowledge of each individual customer's willingness to pay, which is often impractical and economically unfeasible to ascertain. Moreover, achieving such a level of market segmentation and personalized pricing is often hindered by logistical, ethical, and legal constraints.

What is an Example of First Degree Price Discrimination?

A classic example of first degree price discrimination is an auction. In an auction, buyers reveal their maximum willingness to pay for an item, and each buyer potentially pays a different price based on their highest bid. This form of price discrimination allows the seller to capture the maximum possible price from each buyer.

Is Price Discrimination Efficient?

Economically, price discrimination can lead to a more efficient allocation of resources. It allows for increased production and distribution of goods and services by aligning the price more closely with the consumer's willingness to pay. This can lead to an overall increase in consumer satisfaction and potentially lower prices for certain consumer groups, although it might also raise prices for others. By tapping into different market segments, firms can generate increased sales and potentially improve consumer access to products and services.