Degrees of Price Discrimination

The extent to which a firm can engage in price discrimination is classified into three major categories. Under first-degree price discrimination, the firm extracts the maximum amount each customer is willing to pay for its products. Each unit is priced separately at the price indicated along each product demand curve. Such pricing precision is rare because it requires that sellers know the maximum price each buyer is willing to pay for each unit of output. Purchase decisions must also be monitored closely to prevent reselling among customers. Although first-degree price discrimination is uncommon, it has the potential to emerge in any market where discounts from posted prices are standard and effective prices are individually negotiated between buyers and sellers. When sellers possess a significant amount of market power, consumer purchases of big-ticket items such as appliances, automobiles, homes, and professional services all have the potential to involve first-degree price discrimination.

Second-degree price discrimination, a more frequently employed type of price discrimination, involves setting prices on the basis of the quantity purchased. Bulk rates are typically set with high prices and markups charged for the first unit or block of units purchased, but first-degree price discrimination

Charging different prices to each customer second-degree price discrimination

Charging different prices based on use rates or quantities purchased third-degree price discrimination

Charging different prices to each customer class progressively greater discounts are offered for greater quantities. Quantity discounts that lead to lower markups for large versus small customers are a common means of discriminating in price between retail and wholesale customers. Book publishers often charge full price for small purchases but offer 40 percent to 50 percent off list prices when 20 or more units are purchased. Public utilities, such as electric companies, gas companies, and water companies, also frequently charge block rates that are discriminatory. Consumers pay a relatively high markup for residential service, whereas commercial and industrial customers pay relatively low markups. Office equipment such as copy machines and servers (mainframe computers) are other examples of products for which second-degree price discrimination is practiced, especially when time sharing among customers is involved.

The most commonly observed form of price discrimination, third-degree price discrimination, results when a firm separates its customers into several classes and sets a different price for each customer class. Customer classifications can be based on for-profit or not-forprofit status, regional location, or customer age. Barron's, Forbes, The Wall Street Journal, and other publishers routinely offer educational discounts that can be in excess of 30 percent to 40 percent off list prices. These publishers are eager to penetrate the classroom on the assumption that student users will become loyal future customers. Auto companies, personal computer manufacturers, and others also prominently feature educational discounts as part of their marketing strategy. Many hospitals also offer price discounts to various patient groups. If unemployed and uninsured patients are routinely charged only what they can easily afford to pay for medical service, whereas employed and insured medical patients are charged maximum allowable rates, the hospital is price discriminating in favor of the unemployed and against the employed. Widespread price discounts for senior citizens represent a form of price discrimination in favor of older customers but against younger customers.

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