Price Discrimination and the Theory of Contestable Markets
Price discrimination is when a firm with market power charges different prices to different groups of consumers for the same good or service, where the price difference is not explained by a difference in the cost of supplying them.
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Method
- State the three conditions needed for a firm to price discriminate: the firm must have some price-setting power, it must be able to identify and separate consumers into distinct groups with different price elasticities of demand, and it must be able to prevent resale between the groups.
- Learn the standard categories of price discrimination: first-degree, charging each individual consumer the maximum price they are willing to pay; second-degree, charging different prices for different quantities consumed; third-degree, charging different prices to different identifiable groups of consumers.
- Draw the third-degree price discrimination diagram: two separate sub-markets, each with its own demand and MR curve, a single marginal cost curve for the firm; the firm sets MR = MC in each sub-market separately, giving a higher price where demand is more inelastic and a lower price where it is more elastic.
- Explain why price discrimination raises the firm's total revenue and profit compared with a single uniform price: charging closer to each group's willingness to pay captures some of what would otherwise be consumer surplus as extra revenue.
- Evaluate price discrimination for consumers: some consumers, in the low-price segment, gain, others, in the high-price segment, lose out compared with a single uniform price; total output may be higher than under a single price if it lets the firm serve segments it otherwise would not.
- Define a contestable market: one with low barriers to entry and exit, particularly low sunk costs, so a potential entrant can enter, hit and run, with little loss if conditions change.
- Explain the implication of contestability theory: the number of firms currently in a market matters less than how contestable it is, since a credible threat of entry can force even a market with one or two incumbent firms to price close to average cost.
Worked example
A train operator sells peak-time tickets to commuters, whose demand is price inelastic (PED = -0.3), and off-peak tickets to leisure travellers, whose demand is price elastic (PED = -1.8). Using the third-degree price discrimination model, explain which group is charged the higher price and why, and identify one condition that must hold for this pricing strategy to be possible.
- Identify the group with the more price inelastic demand: peak-time commuters, PED = -0.3, size 0.3, well below 1.
- Identify the group with the more price elastic demand: off-peak leisure travellers, PED = -1.8, size 1.8, above 1.
- Apply the price discrimination rule: to maximise revenue and profit, the firm should charge a higher price to the group whose demand is more inelastic, since raising price there causes only a small proportional fall in quantity demanded, so revenue rises; here that is peak-time commuters.
- Conclude the off-peak leisure travellers, with more elastic demand, should be charged a lower price, since a lower price will proportionately raise quantity demanded by more, raising revenue from that segment.
- State a necessary condition: the train operator must be able to prevent resale between the two groups, e.g. by making tickets non-transferable and checked against travel time, otherwise leisure travellers could buy cheap off-peak tickets and use them at peak time, undermining the price difference.
Practice questions
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Q1State the three conditions needed for a firm to price discriminate.Show answer
Answer: The firm must have some price-setting power, be able to separate consumers into groups with different price elasticities of demand, and be able to prevent resale between the groups.
Q2What is third-degree price discrimination?Show answer
Answer: Charging different prices to different identifiable groups of consumers for the same product, e.g. based on age, location or time of purchase.
Q3In price discrimination, which group of consumers is charged the higher price: the group with more elastic or more inelastic demand? Explain.Show answer
Answer: The group with more inelastic demand, because raising price to this group causes only a small proportional fall in quantity demanded, raising the firm's revenue from that group.
Q4Give one real-world example of price discrimination.Show answer
Answer: For example, cinemas charging lower ticket prices to students/children than to adults, or train operators charging more for peak-time than off-peak tickets.
Q5Define a contestable market.Show answer
Answer: A market with low barriers to entry and exit, particularly low sunk costs, so a new firm can enter and leave with little cost, making 'hit and run' entry possible.
Q6What is a sunk cost?Show answer
Answer: A cost that has already been incurred and cannot be recovered if a firm leaves the market, e.g. money spent on advertising or on equipment with no resale value.
Q7According to contestable markets theory, why might a monopolist with only one firm in the market still price close to average cost?Show answer
Answer: Because if barriers to entry are low, charging a price high enough to earn large supernormal profit would attract new entrants, so the credible threat of entry disciplines the incumbent's pricing even without any actual competitors currently present.
Exam-style questions
Written in the style of a A Level Economics exam paper, with a full mark scheme.
Using a diagram, explain how a firm practising third-degree price discrimination sets a different price in each of two separate sub-markets.
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Evaluate the case for and against a firm using price discrimination, from the perspective of both the firm and its consumers.
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