Answer to Question #25288 in Macroeconomics for Jimmy Vo

Question

Define price discrimination. Why would a firm charge different prices to different consumers?

Answer 1

Price discrimination or price differentiation exists when sales of identical goods or services are transacted at different prices from the same provider. In a theoretical market with perfect information, perfect substitutes, and no transaction costs or prohibition on secondary exchange (or re-selling) to prevent arbitrage, price discrimination can only be a feature of monopolistic and oligopoly markets, where market power can be exercised. Otherwise, the moment the seller tries to sell the same good at different prices, the buyer at the lower price can arbitrage by selling to the consumer buying at the higher price but with a tiny discount. However, product heterogeneity, market frictions or high fixed costs (which make marginal-cost pricing unsustainable in the long run) can allow for some degree of differential pricing to different consumers, even in fully competitive retail or industrial markets. The effects of price discrimination on social efficiency are unclear. Output can be expanded when price discrimination is very efficient. Even if output remains constant, price discrimination can reduce efficiency by misallocating output among consumers. Price discrimination requires market segmentation and some means to discourage discount customers from becoming resellers and, by extension, competitors. This usually entails using one or more means of preventing any resale: keeping the different price groups separate, making price comparisons difficult, or restricting pricing information. The boundary set up by the marketer to keep segments separate is referred to as a rate fence. Price discrimination is thus very common in services where resale is not possible; an example is student discounts at museums: In theory, students, for their condition as students, may get lower prices than the rest of the population for a certain product or service, and later will not become resellers, since what they received, may only be used or consumed by them. Another example of price discrimination is intellectual property, enforced by law and by technology. In the market for DVDs, DVD-players are designed and produced- by law- with hardware or software to prevent inexpensive copying or playing of content purchased legally elsewhere in the world (for example legally purchased in India) from being used in a higher price market (like in the US or Europe). The Digital Millennium Copyright Act has provisions to outlaw circumventing of such devices to protect the enhanced monopoly profits that copyright holders can obtain from price discrimination against higher price market segments. Price discrimination can also be seen where the requirement that goods be identical is relaxed. For example, so-called "premium products" (including relatively simple products, such as cappuccino compared to regular coffee with cream) have a price differential that is not explained by the cost of production. Some economists have argued that this is a form of price discrimination exercised by providing a means for consumers to reveal their willingness to pay.