Solution:

What is price discrimination?

• 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 oligopolistic markets, where market power can be exercised.

• Otherwise, the moment the seller tries to sell the same goods at different prices, the buyer at the lower price can arbitrage by selling to the consumer buying at the higher price but with a small 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. Price discrimination also occurs when the same price is charged to customers which have different supply costs.

Conditions for the discriminating price:

Essentially there are two main conditions required for discriminatory pricing:

1) Differences in price elasticity of demand between markets:

• There must be a different price elasticity of demand from each group of consumers. The firm is then able to charge a higher price from the group with a more price inelastic demand and a relatively lower price from the group with more elastic demand.

• By adopting such a strategy, the firm can increase its total revenue and profits (i.e. achieve a higher level of producer surplus). To profit maximize, profit the firm will seek to set marginal revenue equal to marginal cost in each separate (segmented) market.

2) Barriers to preventing consumers from switching from one supplier to another:

• The firm must be able to prevent "market seepage" or "consumer switching" defined as a process whereby consumers who have purchased goods or services at a lower price can re-sell them to those consumers who would have normally paid the expensive price.

• This can be done in several ways and is probably easier to achieve with the provision of a unique service such as a haircut rather than with the exchange of tangible goods.

• Seepage might be prevented by selling a product to consumers at unique and different points in time for example with the use of time-specific airline tickets that cannot be resold under any circumstances.

• The effects of price discrimination on social efficiency are unclear; typically such behavior leads to lower prices for some consumers and higher prices for others. Output can be expanded when price discrimination is very efficient, but the output can also decline when discrimination is more effective at extracting surplus from high-valued users than expanding sales to low-valued users.

• Even if output remains constant, price discrimination can reduce efficiency by misallocating output among consumers.

Objectives of Price Discrimination:

• There are several objectives of price discrimination.

Some areas are given below:

• Firms will be able to increase revenue. This will enable some firms to stay in business that otherwise would have made a loss. For example price discrimination is important for train companies that offer different prices for peak and off-peak.

• Increased revenues can be used for research and development which benefit consumers.

• Some consumers will benefit from lower fares. Eg. old people benefit from lower train companies and old people are more likely to be poor.

• The other objective to the consumer of price discrimination are - price discrimination is likely to increase output and make the good or service available to more people and the increased competition in the market leads to lower prices and more choices.