Types of price discrimination

We have already introduced ourselves to the idea of price discrimination in other videos, and in this video, we're going to try to classify the different ways that a firm might engage in price discrimination.

So first of all, just as a review of what it is, this is when a firm charges different prices to different consumers in order to capture as much of the consumer surplus as possible. In other videos, we visualize that by showing the consumer surplus and showing how a firm might visually try to eat into that consumer surplus.

But let's talk about the different types. The first type of price discrimination is known as first degree. First degree price discrimination, often known as perfect price discrimination, is really the most theoretical of all of the ones we're going to talk about.

In first degree or perfect price discrimination, the firm is able to essentially capture the entire consumer surplus by charging each individual exactly what they are willing to pay. Now, in order to pull this off, you would have to magically be able to know what someone is willing to pay when they show up. You say, "Oh, I'm gonna charge you five dollars," because you can read their mind that they're willing to pay exactly five dollars. The next person to walk in, you say, "I'm gonna charge you four dollars," because you know they could—that's exactly what they're willing to pay.

Now, in the real world, we can't get to that level of precision, but firms can try to get there. Now, a general principle that's true, that needs to be true to do first degree price discrimination or really any type of price discrimination, is the different users shouldn't be able to know what the other person is getting it for, and they shouldn't be able to trade between them.

So there's one principle when we're talking about price discrimination where there is no arbitrage. Arbitrage is just a fancy word for, if I know something is I can buy it for five dollars over here and if I can sell it for seven dollars over here, well then it would be very natural for someone to buy it for five and sell it for seven.

So, if there were a firm that were out there doing first degree price discrimination but if people knew about it, well then they could say, "Hey, you over there, you're willing to pay five, and that's what the firm is charging you, but I know a place because the firm is willing to sell it to me for three, so I'll buy it for three and sell it to you for five."

So, in order for price discrimination in general to happen, especially something like perfect or first degree price discrimination, you need to have no arbitrage. Now the next type of price discrimination is known as—and this is no surprise—second degree price discrimination.

This is a situation where a firm is going to charge different folks different prices based on the quantity that they are going to buy. You might have seen this where you might have things like bulk discounts. Bulk discounts are a way of differentiating to some degree. It's unlikely that the firm is able to capture the entire consumer surplus, but you could say, "Hey, you know the big contractor that needs to buy a lot of wood, they might have a lower willingness to pay, so let's give them a lower price based on volume. While the hobbyist who just needs to buy a little bit of wood, we can charge them a higher price based on their lower volume."

So here, you're talking about price versus quantity. And then you could go to—and once again, no surprise—third degree price discrimination. Third degree price discrimination is when you are looking at a characteristic of the consumer.

So, consumer—or I should say, maybe buyer characteristics. The classic example of third degree price discrimination is when you go to a museum. There might be—they might have a different price for seniors or for young children versus for adults. The reason why they do that is they might say, "Hey, seniors might have a lower willingness to pay, but we want them to come anyway." They might do it for other reasons as well, just for good social values or whatever else.

But it could also be—it is by definition a form of price discrimination; you're giving a different price to different people based on who they are. Now, in the real world, what firms try to do is some combination of various types of price discrimination, and they could also vary the actual products a little bit so that they aren't perfectly identical.