Question

Define the term price discrimination. What conditions must hold for a firm to be able to practice price discrimination? How are consumers affected by price discrimination? Illustrate (graph)

Answer 1

Price discrimination is the pricing strategy where a firm sells the same product at different prices in different market segments. The necessary conditions for successful price discrimination are:

(i) The firm must be able to identify different market segments with different price elasticity of demand, and

(ii) Re-sale of the product from low-priced to high-priced market segment is not possible.

When above conditions hold, the firm will be able to increase total revenue and profit by charging a higher price in the inelastic market segment and lower price in the elastic market segment, in comparison to uniform (single) pricing policy. It is illustrated in following graph.

D1 and D2 are demand curves for two market segments, where D1 belongs to the elastic segment (hence D1 is flatter) and D2 belongs to the inelastic segment (hence D2 is steeper). MR1 and MR2 are corresponding marginal revenue curves. MC is the marginal cost curve common to both segments. In the elastic segment, profit is maximized at point of intersection between MR1 and MC curves, at point A with price P1 and quantity Q1. In the inelastic segment, profit is maximized at point of intersection between MR2 and MC curves, at point B with price P2 and quantity Q2. It is evident that P2 > P1 and Q2 < Q1.