When is Price Discrimination Effective?

“Discrimination” is a charged and highly sensitive word in the English language, but is it really that bad when it comes to pricing?  First, let’s review what price discrimination is: it is the practice of charging different prices to different buyers for the same product.

This practice is differentiated into three degrees.  First-degree price discrimination is the ability to charge each individual customer a different price; second-degree price discrimination is charging different prices based on quantities purchased; and third-degree price discrimination is charging different prices to different groups of customers, separated by some or other factor such as location or industry segment.

We see second and third degree in practice all the time at places like the movie theatre (different ticket prices for adults, students, and seniors) and at the grocery store (price per ounce for a gallon of milk vs. a single-serving carton or bottle).

Producers use price discrimination in an attempt to maximize profits and increase sales—and in many cases, it works.

So, when is price discrimination effective?  It is effective whenever it works in practice.

Each individual customer has a maximum price he/she is willing to pay for a particular item.  If customers are able to purchase a service or product for less than the top amount they would part ways with for the item in question, we call the money they “saved” their consumer surplus.  Ideally, a producer would like to capture as much of this consumer surplus as possible in order to increase revenue.  If a seller could figure out each individual customer’s willingness to pay, then the seller could practice first-degree price discrimination across the board, but this is not easy as it is time consuming, costly, and hard to practice, especially given most goods/services must have advertised prices.

Instead, we typically see third-degree price discrimination working out quite well for a lot of sellers.  When a seller can find a way to segregate its customers without those customers feeling and/or knowing that they are being segregated, then the seller will be able to effectively use price discrimination.

Although they are aware that the senior citizens a few rows down are paying less for the same exact movie ticket, most adults still willingly purchase the full-priced movie ticket.  These customers in the higher price tag group are willingly paying this higher price, so this scenario holds as an example of successful price discrimination.

Is price discrimination unfair?  Well, would you willingly purchase things if you thought you were being charged an unfair price?  Unless it is something that she absolutely cannot live without (and no, the gold iPhone 5 does not qualify), a rational person would not engage in a transaction that she deemed unfair.  People respond to incentives, therefore they only enter into voluntary exchange if they believe they are trading their hard-earned dollars for something of equal or greater value—and this is why price discrimination can be effective.  If customers sense they are being taken advantage of and charged unfair prices, then they will not purchase and price discrimination will not be effective.

Big data will certainly help shape the future of price discrimination, especially in cases of individual consumers.  Data is constantly being collected on our purchasing habits.  Firms for some time have been tracking consumer information such as purchase histories and Internet browsing data, and we are already starting to see them putting this data to good use.  When you make purchases using your CVS Care card you usually get a receipt that is taller than you are.  The coupons on this receipt vary by customer and it prints them out based on your purchase history.  In the not-so-distant future, we will definitely see more and more companies trying to use big data to help them practice price discrimination, and if they do it correctly, we, as consumers, will most likely not be opposed!