In Economics, Price Discrimination is an important concept. Price Discrimination occurs when the same product is sold at more than one price.
For example, an airline may sell tickets on a particular flight at a higher price to business travelers than to college students. Even if the products are not precisely the same, price discrimination is said to occur if very similar products are sold at prices that are in different ratios to marginal costs.
Thus, if a firm sells boxes of candy with a label saying, “Premium Quality” in rich neighborhoods for $12 and sells the same boxes of candy without the label in poor neighborhoods for $5, this is discrimination. The mere fact that differences in prices exist among similar products is not evidence of discrimination; only if these differences do not reflect cost differences is there evidence of this kind.
For a firm to be able and willing to engage in price discrimination, the buyers of the firm’s product must fall into classes with considerable differences among classes in the price elasticity of demand for the product and it must be possible to identify and segregate the product easily from one class to another, since otherwise persons could make money by buying the product from the low-price classes and selling it to the high-price classes, thus making it difficult to maintain the price differentials among classes.
The differences among classes in income level, tastes or the availability of substitutes. Thus, the price elasticity of demand for the boxes of candy may be lower for the rich than for the poor.
If a firm practices discrimination of this sort, it must decide two questions: how much output should it allocate to each class of buyer, and what price should it charge each class of buyer?
Suppose that there are only two classes of buyers. Also, for the moment, assume that the firm has already decided on its total output and consequently that the only real question is how it should be allocated between the two classes. The firm will maximize its profits by allocating between two classes in such a way that marginal revenue in one class is equal to marginal revenue in the other class.
For example, if marginal revenue in the first class is $25 and marginal revenue in the second class is $10, the allocation is not optimal, since profits can be increased by allocating 1 less unit of output to the second class and 1 more unit of output to the first class. Only if the two marginal revenues are equal is the allocation optimal.
(1+ 1/n2) ÷(1+ 1/n1)
If the marginal revenues in the two classes are equal, the ratio of the price in the first class to the price in the second class will equal n1 is the price elasticity of demand in the first class and n2 is the price elasticity of demand in the second class. Thus, it will not pay to discriminate if the two price elasticities are equal. Moreover, if discrimination does pay, the price will be higher in the class in which demand is less elastic.
Turning to the most realistic case in which the firm must also decide on its total output, it is obvious that the firm must look at its costs as well as demand in two classes. Specifically, the firm will choose the output where the marginal cost of its entire output is equal to the common value of the marginal revenue in the two classes.
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