Price discrimination is also known as value pricing, depending on who you talk to, whether they are buying or selling, how much they value the item being sold, etc. Price discrimination is, essentially, selling things to different consumers at different prices. There are a number of different variations, depending on the severity of the discrimintation.
Note: lecture starts here. Seller will be referred to as the firm, buyer will be referred to as, well, the buyer.
First-degree price discrimination:
Under first-degree price discrimination, the firm is able to sell each unit of output at a price exactly equal to the buyer's maximal willingness to pay for that unit. In addition to clearly setting prices that differ across consumers, this also entails selling different units to the same consumer at different prices. If I, the buyer, am willing to pay one million dollars for the first widget, but only fifty thousand for the second, the first-degree price discriminating widget manufacturer would sell them to me at those prices (assuming their marginal cost is less than or equal to what I am willing to pay). This level of discrimination is also known as perfect price discrimination. While real world firms almost never know enough about their customers to engage in this extreme practice, it serves as a useful polar case.
As the firm(s) selling the widgets can attest to, engaging in perfect price discrimination results in all of the surplus going to the firm in the form of profits. In other words, there is no consumer surplus. Because the firm can set the price to the maximum you are willing to pay for each unit of output, you cannot buy any goods in this market at less than your top price. That maximum price is also known as your reservation price. From an efficiency standpoint, the market with no price discrimination and the market with perfect price discrimination, all else being equal, are the same. However, when looking at the equity, or distribution of surplus, there is a significant difference. Whether one or the other is better probably depends on whether you own this theoretical widget maker described above.
Second-degree price discrimination:
The goal, again, is to attempt to remove all of the consumer surplus from the consumer, and put it into the pocket of the firm. No firm can observe every buyer's reservation price; however, there may be something about the buyer which the seller can use/see that reveals information about the customer's willingness to pay. When a firm uses such methods, it is second-degree price discrimination.
The classic method is to use a two-part tariff, where a buyer pays a fixed fee for a basic use/service, and then a per-instance price for the true product. Many instances abound in nature:
- A cover to get into a bar or party
- This fits when the cover fee only applies during certain times: 'No cover before ten': those who are not willing to pay the fee, but will come early are effectively charged one price, while those who come later pay an overall higher price because for both groups the beer is not free. (see: amortized analysis)
- All of the varying cellular phone plans
- Some charge a higher flat fee, and with a lower per-minute cost, while other plans have a low basic fee, and high use costs.
- Disneyland, at one time, charged an admission to get into the park, and a per-ride fee.
I should just leave this space blank. The math is beyond me. It results, usually, in more of your hard-earned consumer money going to business. This isn't always a bad thing.
Third-degree price discrimination
When the firm is able to break up the aggregate demand for its products into groups of potential buyers, and can set the price separately for each group, it is called third-degree price discrimination. This is an important phenomenon in the marketplace. One standard example is computer software: businesses can charge one price for the goods to other business users, and a different price to students or home users.
When a firm breaks up the buyers into groups, the price for all groups cannot possibly rise from an original total demand. If it could, then the price would have been higher before the demand was split. Likewise, the price consumer groups pay could not fall across the board. If the firm would have sold output to multiple groups without any price discrimination, then some prices rise and some fall when third-degree price discrimination is practiced. Who is better off and who is worse off is variable, depending on the specifics of the market. If less output is produced then there will be a smaller total surplus (less efficient). If there is a larger total surplus, it will still be less than efficient, but the welfare effect is ambiguous.