Price Discrimination: Charging Different Customers Different Prices

Price discrimination happens when a firm sells the same product to different customers at different prices, where the difference is not explained by any difference in the cost of serving them. Student discounts, senior citizen fares, cheaper matinee film tickets, and airline seats that cost far more when booked the day before a flight are all everyday examples. The idea behind all of them is the same: different buyers have different willingness to pay - the highest price each would accept - and a firm can earn more by charging each group closer to what it is willing to pay.

What a firm needs to price discriminate

Not every business can do this. Three conditions usually have to be met. First, the firm needs some market power, meaning it can set its price rather than simply accept the market price. A tiny farm in a perfectly competitive market cannot charge anyone more than the going rate, because buyers would simply go elsewhere. Second, the firm needs a way to tell customers apart, or to get them to sort themselves into groups, such as by age, time of purchase, or location. Third, the firm must be able to prevent arbitrage - the resale of the product from low-price buyers to high-price buyers. If students could buy discounted tickets and resell them to everyone else, the discount would collapse.

Three common forms

Economists often describe three types. In the first, sometimes called perfect price discrimination, each customer is charged exactly their own maximum price. This is rare in its pure form, though haggling in a market comes close. In the second, the price depends on how much you buy, as with bulk discounts or “buy two, get the third at half price” offers; customers sort themselves by choosing different quantities. In the third, and most common, the firm charges different prices to different identifiable groups - students, seniors, residents of different countries, or people booking at different times.

Is it good or bad?

Price discrimination has mixed effects. It transfers some value from customers to the firm, since the firm captures more of what buyers were willing to pay. But it can also expand output. Groups who would have been priced out at a single high price - students, lower-income customers, people in poorer countries - may be served at a lower price. Many medicines, textbooks, and software products are sold at lower prices in lower-income countries for exactly this reason. Whether the overall effect is positive depends on whether it brings in new buyers or merely extracts more from existing ones.

Some forms are restricted by law. Charging different prices based on characteristics such as race, religion, or disability is widely prohibited, and competition authorities watch for pricing that is used to push rivals out of a market.