First-Degree Price Discrimination

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21 Aug, 2024

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First-degree price discrimination or perfect price discrimination refers to a pricing strategy whereby the companies charge the utmost price that a buyer is willing and capable of paying for every unit of a product or service. This approach aims to maximize the seller's profit.

Such a tactic requires an accurate interpretation of the highest price a client can spend for a specific product or service. Hence, companies often use techniques like data mining to understand past purchasing behavior, budget, price range, income bracket, etc., to project a personalized price to every customer and book profit on available consumer surplus.

What Is First-Degree Price Discrimination?

First-degree price discrimination, also known as perfect or personalized pricing, is a pricing strategy where a seller sets a unique price for each customer based on their willingness and capability to pay for a product or service.
Reservation pricing is a common tactic used in bidding and the airline industry to maximize profits.
However, it is often challenging to implement this strategy because it requires detailed consumer data and significant resources. Moreover, it may deceive consumer perception and trust.
Ethical and privacy concerns may also arise when collecting and using individual consumer data for personalized pricing.

First-Degree Price Discrimination Explained

First-degree price discrimination monopoly is a pricing tactic focused on maximizing revenue from each customer individually. Implementing such a strategy is challenging because it requires access to detailed information about each customer's preferences and their maximum price threshold. Companies with high fixed costs commonly adopt the personalized pricing tactic since they can offset such charges against the increased profits generated through such price discrimination.

Additionally, the business must be capable of identifying its target market segment. Also, the pricing should be such that the customer is unable to resell the product at a higher value. However, it is not commonly used due to its complexity, need for extensive consumer data, and advanced pricing mechanisms. Additionally, ethical concerns related to fairness and privacy often arise when considering reservation pricing strategies.

Moreover, this tactic fails when numerous buyers and sellers are in the market. Companies nowadays use a similar version of personalized pricing by charging premium or add-on charges from willing customers. Most businesses even employ second or third-degree price discrimination strategies, which involve categorizing consumers into groups and offering different prices or discounts based on characteristics such as age, location, or purchase history.

Conditions

The implementation of a first-degree price discrimination strategy requires the fulfillment of several prerequisites, as discussed below:

Comprehensive Consumer Information: The seller needs access to detailed data about each consumer, including their willingness to pay for the product or service. It is crucial to analyze this data for the perfect pricing of products.
Monopoly Market: The company must possess substantial market power to set prices without significantly influencing competition.
Price Discrimination Mechanism: The seller should be able to distinguish and set various prices for different consumers based on their willingness to pay. Hence, it necessitates a pricing system that can adapt prices in real-time or for individual transactions.
Preventing Resale Opportunities: Consumers must not have opportunities to resell the product or service at a profit. Thus, it prevents individuals from exploiting personalized pricing by reselling at a higher value.
Legal and Ethical Compliance: The practice of first-degree price discrimination must adhere to relevant laws and regulations. Price discrimination based on specific personal characteristics such as race or gender is illegal in various jurisdictions.

Examples

One of the first-degree price discrimination examples in real life can be observed in the healthcare sector, where patients with different insurance plans may be billed at varying prices for the same medical procedure. The other one can be in personalized marketing, where online retailers use customer data to offer different prices to individual shoppers. Some other first-degree price discrimination examples in real life are discussed below:

Example #1

Airline Tickets: Airlines often employ pricing models that consider variables such as booking time, demand, travel history, and location to set personalized fares. Frequent fliers might receive special offers, and prices can significantly differ among passengers on the same flight.
Car Dealerships: Car sales representatives often engage in price negotiations with customers individually, taking into account factors like the buyer's budget, trade-in value, and financing options. This can lead to different prices for the same car model.
Entertainment and Events: Ticket prices for concerts, sports events, and theaters can exhibit significant variation based on factors like seating location, demand, and membership status (e.g., fan clubs or season ticket holders).

Example #2 - Netflix's Personalized Pricing

A Washington Post article provided insight into the possibility of Netflix subscription pricing based on individual customers' willingness to pay. By charging some customers slightly more and others a bit less, Netflix could potentially expand its customer base and revenue. The primary challenge lies in accurately predicting what each customer is willing to spend.

For this purpose, the streaming business would combine the traditional demographic data with users' web browsing habits to significantly enhance the accuracy of predictions, ultimately leading to higher profits through a pricing approach known as first-degree price discrimination. This method was found to be effective in simulations; however, it is not yet implemented.

Graph

Representing first-degree price discrimination monopoly graphically can be challenging, as it hinges on each customer's specific demand and pricing information. In this strategy, there exists a distinct demand curve for each customer. These demand curves depict the highest price each customer is willing to pay for a given quantity of the product. These individual demand curves can vary significantly among customers.

Let us go through the following graph for a better understanding:

Here:

CS₀ is the consumer surplus,
PS₀ is the producer surplus,
P_M is the monopolistic price,
P_C is the competitive price,
Q_M is the monopolistic quantity demanded,
Q_C is the competitive quantity demanded,
D is the demand curve,
AR is the average revenue and
MC is the marginal cost.

Hence, we can interpret the following from the above diagram:

The marginal revenue curve for each customer's demand curve will also differ. This is because the seller strives to maximize profit for each customer separately, making each customer's marginal revenue equivalent to the slope of their demand curve.
The seller sets a price for each customer at the point where their marginal cost intersects their demand curve. Consequently, customers are charged distinct prices based on their willingness to pay.
The seller's objective is to maximize profit by determining the optimal price for each customer. It results in higher profits for the seller compared to other pricing strategies.

Advantages And Disadvantages

First-degree price discrimination can be a lucrative pricing strategy for businesses that can implement it effectively, but it has potential drawbacks.

Advantages	Disadvantages
Profit Maximization: It maximizes profits by extracting the maximum possible consumer surplus, resulting in higher overall earnings than fixed pricing.	Complexity: Implementing perfect price discrimination often requires sophisticated data analysis and pricing strategies.
Efficient Resource Allocation: This pricing strategy can lead to a more appropriate distribution of products and services. Consumers who value a product the most are willing to pay higher prices, ensuring that resources are distributed to those who value them most, which can enhance economic efficiency.	Regulatory and Legal Challenges: Some regions have laws and regulations against discriminatory pricing practices, making it difficult for businesses to implement such tactics legally.
Customer Segmentation: The perfect price discrimination enables a business to segment its customer base effectively. Companies can better cater to diverse consumer needs and preferences by tailoring prices to individual preferences and income levels.	Reduced Consumer Surplus: While personalized pricing maximizes seller profits, it can significantly reduce consumer surplus, leaving some consumers worse off regarding economic welfare.
Revenue Enhancement: A seller can increase their total revenue through reservation pricing compared to using fixed prices.	Data and Privacy Concerns: Effective first-degree price discrimination relies on the availability of extensive consumer information. This may raise concerns about consumer privacy and necessitate a significant data collection and analysis investment.
	Customer Discontentment: Customers may feel cheated if they discover that others are paying less for the same product or service. This perception of unfairness can lead to customer resentment and damage a brand's reputation.
	Expensive and Time-Consuming Affair: Collecting relevant data for adopting such a tactic can be costly and time-consuming for businesses.

Frequently Asked Questions (FAQs)

1. How to calculate first-degree price discrimination?

To ascertain the perfect pricing discrimination, follow the given steps:
1. Collect detailed consumer information about their willingness to pay, preferences, income, etc.
2. Create individual price-demand curves for each consumer based on this data, showing their potential purchase quantity at different price levels.
3. Evaluate the price that maximizes profit for each consumer by finding the point on their demand curve (where marginal cost = marginal revenue).
4. Charge each consumer the price so determined based on their specific demand curve.

2. Is first-degree price discrimination illegal?

Personalized pricing is generally not illegal in most jurisdictions. However, it is subject to various regulations and laws that vary by country and industry. For instance, in the United States, price discrimination can be legal if it doesn't violate federal or state antitrust laws or other specific regulations. In some cases, there may be restrictions on particular industries, such as utilities, to prevent unfair pricing practices.

3. Is there a consumer surplus in first-degree price discrimination?

The first-degree price discrimination approach allows the seller to capture all consumer surpluses for themselves. Hence, the consumers end up paying the maximum price they can for a product or service.