By Kelvin Tai - Economics and Management Student @ Harris Manchester College, Oxford
A monopolistic producer often cedes some ground to consumers, allowing them to gain consumer surplus (the added utility gained by consumers from paying a lower price than their reservation price). This is because they can maximise profits at a certain price point even if a few consumers might be willing to pay more for their offerings as raising the price would cause them to lose more revenue from a larger segment of customers.
Some businesses have found ingenious ways to extract more of this surplus from consumers, however. Instead of implementing a single price for the entire market, they slice and dice their customers into different segments. Received a student discount? The business knows that students have lower purchasing power and hence lowers the price for them without changing it for working adults. This is known as price discrimination.
Other products often have reduced features and are sold at a discount, so that the fully functioning product can be sold at a premium. However, economies of scale mean that it would be cheaper for the company to produce one type of product rather than two to avoid having to retool their manufacturing processes. Thus, some companies would rather impair their own products to price discriminate. Intel disabled the math coprocessor in the 486DX processor and sold it as the 486SX for cheaper. This means that the 486SX essentially cost more than the 486DX since they had to add in the additional step of disabling it. Still, this allowed them to sell to customers who were unwilling to pay for the 486DX while giving an incentive to those who could pay a premium for the 486DX through increased functionality.
More specifically, the activities listed above are known as third-degree price discrimination. First-degree price discrimination on the other hand, is when the producer fully extracts the consumer surplus, so consumers pay the maximum of what they are willing to. Perfect first-degree price discrimination was practically impossible to achieve (if you station someone in a shop to ask each customer to pay what they value the item at, most people are going to understate their willingness to pay). However, the prevalence of online shopping and the collection of big data by e-commerce platforms has opened up that lucrative possibility. Different people can be charged an individualised price dictated by an algorithm based on their past viewing and shopping history. After all, the allure of online advertising for retailers lies in the ability to put products in front of the audience that is likely to respond through purchasing by estimating their willingness to pay.
The last type of price discrimination (second-degree) refers to charging a different price for the consumption of different quantities. For instance, reward cards that grant frequent buyers a discount effectively provide a lower cost to those who would make more purchases, hence luring them away from the competition since these customers have a higher lifetime value. Such discounts would not be worth providing for infrequent buyers who would likely have a higher willingness to pay. Tiered water pricing is another example, where consumers using water past a certain threshold could be charged higher for the quantity in excess of that threshold. This would mean that most consumers who use an average amount of water for daily activities are charged a lower rate than one who might use the water to fill a swimming pool and can likely afford a higher rate.
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