What Is Price Discrimination, and How Does It Work?

What Is Price Discrimination?

Price discrimination is a selling strategy that charges customers different prices for the same product or service based on what the seller believes it can get the customer to agree to. In pure price discrimination, the seller charges each customer the maximum price they will pay. In more common forms of price discrimination, the seller segments customers into groups based on certain attributes and charges each group a different price.

Understanding Price Discrimination

Price discrimination is practiced based on the seller's belief that customers in certain groups can be asked to pay more or less based on certain demographics or on how they value the product or service in question.

Price discrimination is most useful to sellers when the profit they earn as a result of separating the markets is greater than the profit that they would have earned had they kept the markets combined. Whether price discrimination works and how long the various groups will be willing to pay different prices for the same product depends on the relative elasticities of demand in the sub-markets. Consumers in a relatively inelastic sub-market may pay a higher price, while those in a relatively elastic sub-market pay a lower price.

In applying price discrimination, companies try to identify different market segments, such as domestic and industrial users, with different price elasticities. For example, Microsoft makes its Office 365 software available for a lower price to educators and educational institutions than to other users.

Markets must be kept separate by time, physical distance, or nature of use for price discrimination to be effective. Otherwise, consumers who purchase at a lower price in the elastic sub-market could resell at a higher price in the inelastic sub-market. Companies that dominate a particular market and use price discrimination strategies within their various sub-markets are known as discriminating monopolies.

While price discrimination has a long history, new tools, such as artificial intelligence, are changing the speed and effectiveness with which it is applied. As a 2021 article in the Harvard Business Review noted, "We're in a new era of supercharged price discrimination, made possible by two major scientific and technological trends. First, AI algorithms—often trained on highly detailed behavioral data—enable organizations to infer what people are willing to pay with unprecedented precision. Second, recent developments in behavioral science—often invoked with the tagline "nudge"—provide organizations greater ability to influence their customers' behaviors."

Types of Price Discrimination

There are three types of price discrimination: first-degree or perfect price discrimination, second-degree, and third-degree. These degrees of price discrimination are also known as personalized pricing (first-degree pricing), product versioning or menu pricing (second-degree pricing), and group pricing (third-degree pricing).

First-Degree Price Discrimination

First-degree discrimination, or perfect price discrimination, occurs when a business charges the maximum possible price for each unit consumed. Because prices vary among units, the firm captures all available consumer surplus for itself or the economic surplus. Many industries involving client services practice first-degree price discrimination, where a company charges a different price for every good or service sold.

Second-Degree Price Discrimination

Second-degree price discrimination occurs when a company charges a different price for different quantities consumed, such as quantity discounts on bulk purchases.

Third-Degree Price Discrimination

Third-degree price discrimination occurs when a company charges a different price to different groups of consumers. For example, a theater may divide moviegoers into seniors, adults, and children, each paying a different price when seeing the same movie. This type of price discrimination is the most common.

Examples of Price Discrimination

Many industries, such as the airline industry, the arts/entertainment industry, and the pharmaceutical industry, use price discrimination strategies. Examples of price discrimination include issuing coupons, applying specific discounts (e.g., age-based discounts), and creating loyalty programs for repeat customers.

In the airline industry, for example, people buying airline tickets several months in advance typically pay less than those purchasing at the last minute. When demand for a particular flight is high, airlines raise ticket prices in response.

By contrast, when tickets for a particular flight are not selling well, the airline will reduce the cost of available tickets to try to generate sales and fill any empty seats. Because many passengers prefer flying home late on Sunday, those flights tend to be more expensive than flights leaving early Sunday morning. Airline passengers will typically pay more for additional legroom, too.

The Bottom Line

Price discrimination is a widespread practice across many different industries and is often invisible to the consumer. The buyers of a particular product or service may be unaware that the price they are paying is higher or lower than the one the seller is charging other buyers for it.