Price discrimination

1. It allows the firm to convert some consumer surplus into extra profit.
2. Economists distinguish first, second and third degree price discrimination.

Conditions for discrimination

1. The firm must be a price maker with some market power to set price above marginal cost.
2. Consumers must be separable into groups with different price elasticities of demand.
3. There must be no resale between the groups, or the cheaper buyers would undercut the dearer ones.

First-degree price discrimination

1. The firm charges each consumer the maximum they are willing to pay for each unit.
2. This captures the entire consumer surplus as profit.
3. It is rare because the seller needs to know each buyer's willingness to pay, as in individual bargaining or auctions.

Second-degree price discrimination

1. The price varies with the quantity bought or the version chosen.
2. Consumers effectively sort themselves by how much they buy.
3. Examples include bulk discounts and block tariffs for electricity or water.

Third-degree price discrimination

1. The firm splits the market into identifiable groups by age, time of use or location, each with its own demand.
2. It sets a higher price in the inelastic sub-market and a lower price in the elastic sub-market.
3. In each sub-market the firm produces where MC = MR, sharing a common marginal cost.

Two sub-market example

1. A firm supplies one good to two separable markets at a constant marginal cost of £2 per unit.
2. Market A has the less elastic demand P = 20 − Q, while market B has the more elastic demand P = 12 − Q.
3. With a single price the firm maximises profit at £9, selling 11 units in A and 3 units in B, for total revenue of £126.
4. By discriminating it instead sets MR = MC in each market separately.
5. This gives a higher price of £11 in the less elastic market A and a lower price of £7 in the more elastic market B.
6. Total output is unchanged at 14 units, yet total revenue rises from £126 to £134.

Consequences of price discrimination

1. The firm earns higher profit by converting consumer surplus into producer surplus.
2. Consumers in the inelastic group lose surplus by paying more, while those in the elastic group may pay less.
3. Cross-subsidy can keep a service running that a single price would make unprofitable, widening access.
4. The extra profit may fund investment and innovation, but it also reduces consumer surplus and can be seen as unfair.

Is price discrimination against the consumer interest?

1. It can clearly work against consumers because it transfers surplus from buyers to the firm: first-degree discrimination extracts the whole consumer surplus, and even third-degree discrimination forces the inelastic group, often those with the least choice such as peak commuters, to pay more, which many regard as inequitable.
2. But it can also serve consumers, because price-sensitive groups such as students, off-peak travellers or lower-income buyers gain access at lower prices they would not otherwise be offered, and cross-subsidy can keep running a service that a single price would make unprofitable, so total output and access can be greater than under uniform pricing.
3. The extra producer surplus is not necessarily wasted either, since in industries with high fixed costs it may fund investment and innovation (dynamic efficiency), though this benefits consumers only where competition or regulation stops the profit being retained as pure excess.
4. On balance, price discrimination is not automatically against the consumer interest; whether consumers gain depends on the degree of discrimination, which group a consumer is in, whether the good is essential or one they can do without, whether cross-subsidy genuinely widens access and raises output, and whether the higher profit is reinvested rather than simply pocketed.