Price Discrimination
...tion 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 purchase such large quantities of certain goods (e.g. 10-packs of household 3-in-1 oil). This format of “moving” merchandise in a way where the amount or items purchased aren’t necessarily discretionary is especially popular at auctions. Second Degree Price Discrimination A tiered form of price discrimination, second degree is the practice of selling incremental amounts of a good for incremental prices. The first 12 pairs of shoes are $80, the next 12 pair are $72, and so on. The customers, like in discrimination of the 3rd degree, are grouped together in the corresponding tiers so to speak, and since the tiers all pay the same price, the marginal revenue is constant within each tier and its purchases. Like 3rd degree price discrimination, the 2nd degree often allows the firm to sell more quantity that they would ordinarily. The catsup example is a fine one, making prices variable due to the size of a given container of goods. This example also illustrates how the consumers must be self-selective, based upon their lifestyle and/or preferences. Customers with the higher demand prices will tend to buy smaller quantities at higher average unit prices, while those with lower demand prices will more often purchase the larger quantities at a lower unit cost. Second degree price discrimination generally leads to a situation where more quantity per unit is sold. Sam’s Club is the 2nd degree price discrimination heaven. Mr. Walton’s little warehouses across the land plainly aim for a consumer that is willing to buy more at a lower price per unit. While the price may, in fact, be a bit lower, it still troubles me to see people purchasing 256 ounces of Ivory dish washing detergent at a single time. Finally, 2nd degree price discrimination yields itself well to a process called “product bundling”. This should not be considered the same as the “Ernest Saves Christmas” and “Hunt For Red October” scenario, but instead where tow copies of the same film (to show it on two screens) is far less than just leasing two copies of the same film reel. Product bundling is prevalent in the personal computer industry. System packages are bundled together with the most popular software and hardware alike, and this reduces possible haggling over certain items. No one can argue about the value of not including a CD-ROM or video card. Third Degree Price Discrimination Third degree price discrimination deals with separating customers into distinct groups based upon their difference in elasticity of demand. Based upon this elasticity, you then charge a higher price to the group whose demand is less elastic. Marginal revenue is the change in the total revenue that is the result of a small change in the sales of the good in question. Therefore, price must, too, have changed slightly. The model in the book (Hartford Shoe Company student discounts) illustrates this phenomenon extremely well. When the non-student group of consumers experiences a price increase of $5, this group purchases 625 fewer pairs of shoes. Interpolation yields the concept that for every $1 that the price increases, sales will fall by 125 units. Likewise, when the student price for the shoes in question falls $5, 625 additional pairs of shoes will be sold. This again can be interpolated to mean that every dollar less the shoes are priced, 125 more units will be sold. Thus, a change of just $1 makes students and non-students alike change their purchasing preferences by 125 pairs of shoes. We can use this observation to generate the ideal price and sales figures necessary to achieve the ideal situation...