What is Price Discrimination?

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Definition:

Price discrimination is a strategy in which a business charges different prices to different customers for the same goods or services.

🤔 Understanding price discrimination

Price discrimination is the practice of charging different prices to different people for the same goods or services. It’s a way for a business to try to maximize sales, often by targeting its pricing based on how much different people are willing to pay. For example, airlines charge higher prices for flights that are drawing nearer as demand for tickets rises, or for flights at times of the day or week most in demand among travelers. Price discrimination can also be based on the amount of goods sold, as with discounts for bulk purchases, or on attempts to appeal to different groups, as with discounts for senior citizens. The practice is common and usually legal, but antitrust laws in some jurisdictions prevent companies from using price discrimination in certain situations.

Example

Let’s say you run a movie theater. Rather than charge a flat rate for all the tickets you sell, chances are you charge customers different admission prices based on the categories they might fit into. Your regular price might be $10, but you might charge $5 for kids and $7.50 for senior citizens, and you might give students a 10% discount. Charging these different prices for the same ticket is a price-discrimination strategy.

Takeaway

Price discrimination is like a golf club at which members get different treatment…

Everybody can play the same 18-hole golf course whether they’re a member of the club or not. But if you've paid to be a member, you can play without paying another fee, and you’ll probably get a half-price club sandwich in the clubhouse after your round. Non-members will likely be charged a fee for a tee time on the same course, and then they’ll have to pay full price for their post-game lunch.

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What is price discrimination?

Price discrimination is a pricing strategy in which companies charge different customers different prices for the same products.

A company may set different prices for different customers or groups of customers depending on how much the company thinks that a particular customer or a market segment can or should pay, or is willing to pay, for an item.

There are different types of price discrimination - it can be based on whether a company changes prices for each individual or between groups, or it can be based on prices that vary depending on how much of an item a consumer buys.

Price discrimination is common, and considered legal in many instances. But in some areas, laws or regulations prohibit price discrimination because of race, religion, sexual orientation, or gender. In addition, many states prohibit “price gouging,” or raising prices drastically on essential items in high demand during a state of emergency.

In the United States, there are also antitrust laws in place that prevent suppliers from using price discrimination against smaller businesses in wholesale markets.

What are the types of price discrimination?

There are three main types of price discrimination: first-degree, second-degree, and third-degree price discrimination.

First-degree price discrimination

In first-degree price discrimination, also known as perfect price discrimination, a business charges each consumer the greatest amount of money they are willing to pay for an item or service.

Under perfect price discrimination, the seller captures all available consumer surplus — the difference between what a customer pays and what they are willing to pay. In this case, there’s no difference between those two prices, so any benefit the customer might have derived from paying less than they were willing to goes to the seller.

First-degree price discrimination is difficult to impose - how can a business know how much is the most each individual customer will pay? That’s why it often includes elements of haggling. A used-car dealership might be able to use some element of first-degree discrimination - the sale price of a car may be up for negotiation, so a salesperson will often try to sell the vehicle for the maximum price they believe a customer will pay.

Second-degree price discrimination

Second-degree price discrimination, also known as indirect price discrimination, is when customers choose from a menu of different prices. Bulk discounts are an example - customers can choose a different price per unit for an item depending on how many of the item they buy.

For example, a company might charge $2 per item if you order between up to ten units — but if you order 11 or more, the company might charge you a reduced rate of $1.75 per item instead.

Third-degree price discrimination

Third-degree price discrimination is also commonly referred to as group or direct price discrimination. This is when a company charges different prices for the same product based on the demographic group or different market segments that a consumer belongs to. Movie theaters, concert venues, or amusement parks will often charge different ticket prices based on whether the customer is a child, adult, or senior citizen. While each pays a different price, the product they receive - admission to the movie or other event - is the same.

What is the difference between direct and indirect price discrimination?

Direct price discrimination, or third-degree price discrimination, is when you charge customers different prices for the same goods based on identifiable traits. Discounts for senior citizens - an identifiable group based on their age - are an example.

Indirect price discrimination, or second-degree price discrimination, is when you allow customers to choose their own distinct prices. Bulk discounts, where the company charges a lower price per unit when the customer buys more, are an example. The customer “chooses” what price they’re going to pay based on the amount of the item they decide to buy.

When is price discrimination illegal?

Price discrimination is a fundamental sales strategy that's common across a range of industries and typically legal. But various countries, states, and other jurisdictions have outlawed certain types of price discrimination.

In the United States, the Robinson-Patman Act, also known as the “Anti-Price Discrimination Act,” prohibits large companies from discriminating against small businesses in pricing, promotional allowances, or advertising. It helps prevent wholesalers from gaining a competitive advantage over small-volume buyers by making sure suppliers charge the same prices to all businesses — regardless of size. Price discrimination based on traits like gender, race, or religion is illegal in some jurisdictions. California, for example, protects consumers from gender-based price discrimination. Similar laws exist to protect consumers in other countries.

What conditions are needed for price discrimination?

Generally speaking, three conditions must be met for a company to use price discrimination successfully: a market with imperfect competition, prevention of resale, and elasticity of demand.

Imperfect competition

”Perfect competition” means that every business within a market trades on totally equal footing. When a market has imperfect competition, it means that companies can effectively set their own prices for goods and services, without regard to pressure from competitors. A monopoly would be an example of a market with imperfect competition.

Prevention of resale

Companies should ideally be able to prevent resale of their products if they want to sustain a price-discrimination strategy.

If customers can buy goods from a company and then resell those products to other customers at a profit, it undercuts that company’s bottom line. Companies often try to prevent resale by issuing warranties for their products that second-hand sellers can’t typically offer. Companies can also try to bar their customers contractually from trying to resell their products.

Elasticity of demand

To use price discrimination effectively, markets need to keep a degree of price elasticity. Price elasticity refers to how sensitive the demand for an item is to changes in price.

Without relatively widespread demand for an item after its price reaches a certain threshold, it could be very difficult to charge different customers different prices for the same item.

If people are willing to pay more or less for a product based on how badly they want it, it’s much easier to generate added income through price discrimination.

What are the advantages and disadvantages of price discrimination?

For companies, price discrimination is a great way to maximize profits. If it can use price discrimination successfully, a business can generate extra revenue through pricing without having to increase production costs.

Price discrimination also enables companies to develop and maintain economies of scale. When a business identifies the maximum price which various groups of consumers are willing to pay for an item, the company can adjust its prices accordingly to ensure that customers are more motivated to buy. That should then help the company to increase its sales volume, which presents companies with a cost advantage that helps with economies of scale.

Some highly price-sensitive consumers may see lower prices when a company uses price discrimination. But that happens on a case-by-case basis, and an advantage for some customers is a disadvantage for others, who will end up paying higher prices.

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This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Robinhood does not guarantee its accuracy.

Robinhood Financial LLC (member SIPC), is a registered broker dealer. Robinhood Securities, LLC (member SIPC), provides brokerage clearing services. Robinhood Crypto, LLC provides crypto currency trading. All are subsidiaries of Robinhood Markets, Inc. (‘Robinhood’).

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© 2022 Robinhood. All rights reserved.