Second Degree Price Discrimination

Published on :

21 Aug, 2024

Blog Author :

Edited by :

Reviewed by :

Second-degree price discrimination is a selling strategy in which companies sell a product or service at different prices based on the quantity. The aim of this price discrimination is primarily to increase the overall revenue and profit for a business by capturing a more significant portion of the consumer surplus.

It is a common pricing strategy mostly opted by warehouse sellers. Besides, trying to take advantage of bulk manufacturing and economies of scale. Though there are many ways to implement it, the method is either done by offering a discount for buying a commodity in bulk or by bundling two interlinked products selling for less than the sum of two product prices. Moreover, it focuses on attracting customers and profit maximization.

What Is Second-Degree Price Discrimination?

Second-degree price discrimination is a technique of discount selling and setting different prices for different quantities or units of products.
Businesses offer discounts on bulk quantities or bundle products together to sell more, also called product versioning or menu pricing.
Moreover, this price strategy captures a portion of the consumer surplus, whereas first-degree price discrimination aims to capture the entire consumer surplus.
The technique is usually adopted by companies with high profit margins on the first unit sold.

Second Degree Price Discrimination Explained

Second-degree price discrimination is a pricing strategy in which a business charges different prices to different groups of customers based on specific observable characteristics. Therefore, this technique helps elevate profit margins, attract new customers through different pricing strategies, and ensure customer satisfaction and loyalty. Moreover, one common form of this price discrimination is offering quantity discounts. Customers who buy larger quantities receive a lower per-unit price.

Furthermore, second-degree price discrimination is the practice of charging different prices for different units of products or quantities. It is loosely based on the idea that when people see a relative price difference between the same products being sold with a price gap, customers opt for a higher quantity bundle because buying it rather than a small quantity makes more sense. At the same time, the businesses that already have mass production tend to benefit from economies of scale and register profit even after giving discounts.

Therefore, 2nd degree price discrimination definition states that it is not limited to bundled products and offers discounts on bulk buying. Still, other methods, such as rewards, coupons, special offers, membership fees, loyalty points, etc., are used by different industries at different times. When applying this method, sellers know that different consumer groups belong to different demand curves.

Therefore, the quantity is adjusted so that the products fall into categories, and consumers can self-select them accordingly, maximizing the firm's profit. Hence, this strategy allows businesses to capture more consumer surplus and maximize overall revenue. Likewise, there are three types of price discrimination: first, second, and third-degree price discrimination. Each has its advantages and limitations that run in the market.

Examples

Below are two distinct examples of second-degree price discrimination -

Example #1

Imagine Tyler opened a clothing store and sold men's apparel, primarily shirts and jeans. Tyler was selling premium quality clothes, setting the price slightly higher than usual. At first, the sales were reasonable. Hence, he was making a profit, but over time, in the same market, multiple stores for men's clothing opened up, and Tyler observed a decline in sales.

The competitors were selling jeans at a lower price compared to Tyler. Hence, at first, Tyler was distressed. Later, he came up with the idea of bundling products and selling them at a different price. He made a bundle of two shirts and one pair of jeans and sold it for a relatively lower price than individual shirts and jeans. Moreover, he also introduced another offer in which customers, when buying three shirts, will get one pair of jeans for free.

Soon, the offer spread in the market, and Tyler witnessed a massive increase in sales. Not only the existing customer base but also the new customers. People were skeptical about buying one shirt and a pair of jeans separately at a higher price point. Moreover, these customers were more interested in buying the bundled package of two shirts and one pair of jeans. It is a simple 2nd degree price discrimination example concerning bundled products.

Example #2

Consider a financial institution PNC Financial Service in the US implementing second-degree price discrimination through personalized mortgage rates. The bank recognizes that potential homebuyers vary in their financial profiles and risk tolerances. Therefore, utilizing this information, the bank offers different interest rates for its mortgage products. Customers with excellent credit scores and a stable financial history might qualify for the "Prime Rate Mortgage," featuring the lowest interest rates.

Those with slightly lower credit scores but still considered low risk. These would be eligible for the "Standard Rate Mortgage" at a moderately higher interest rate. For individuals with higher perceived risk, the bank introduces the "Risk-Adjusted Rate Mortgage" with a higher interest rate but additional risk mitigation measures. Through this strategy, the bank tailors its pricing to the risk profiles of different customer segments. Hence, the bank effectively practices this price strategy to optimize revenue while accommodating diverse financial situations.

Graph

Let's look at the following graph to understand the concept better:

In the above second-degree price discrimination diagram, nonlinear pricing is observed; the graph represents quantity on the x-axis and price on the y-axis. As a business sets different prices for different quantities, it is beneficial for price-sensitive customers, but at the same time, mass production is justified. It may be lowering the profit margin, and the seller incurs a loss by offering a discount. Still, on the contrary, it increases their sales, and because of economies of scale, they are also taking advantage of bulk production and selling.

Advantages And Disadvantages

Here are the main advantages and disadvantages of second-degree price discrimination:

Advantages

The primary benefit is increased revenue because of such offers and sale discounts; companies can sell more than before.
Another advantage is capturing market share and attracting new customers who are not interested in buying a product because of the high price for a single unit.
When businesses apply second-degree price discrimination, they become competitive in the market, inducing competition with other businesses operating in the same industry.
Bulk production is justified, as the technique increases the profit margins.
Hence, by applying the specific pricing technique, the business bundle products and cater to consumer preferences.

Disadvantages

The complexity of selling products increases and leads to customer confusion.
Businesses may face legal issues as price discrimination is not legal, and they must ensure that the pricing model complies with the laws and regulations to avoid penalties.
Moreover, customers may find price discrimination unfair and customer exploitation, eventually leading to market negativity and loss of reputation.
When businesses apply such techniques, they may be able to elevate the sales of a particular bundle of products but, at the same time, may lose on individual selling.
It can be challenging to accurately identify and categorize consumers into meaningful segments based on observable characteristics.

Second Degree Price Discrimination vs First Degree Price Discrimination

The key difference between second degree and first degree price discrimination is -

Second-degree price discrimination offers discounts on bulk buying, but first-degree price discrimination refers to charging the maximum possible price for a single product unit.
It is related to packaging or bundling products to offer preferences, but in first-degree price discrimination, customers have no preference.
Businesses generate more revenue and profit through first-degree price discrimination, whereas, with 2nd degree price discrimination, firms can attract more customers and extend to a broader audience.
First-degree price discrimination is often more complex to implement due to the need for individualized pricing strategies. In contrast, this price discrimination can be more straightforward as it involves pricing for segments of consumers.
Moreover, the former aims to capture a portion of the consumer surplus rather than the entire surplus. And, the latter aim is to capture the entire consumer surplus.

Frequently Asked Questions (FAQs)

1. How is second-degree price discrimination different from third-degree price discrimination?

The main difference between second-degree and third-degree price discrimination is that in the former technique, the exact product has different prices for its varying quantities, allowing customers to self-select. Still, in the latter, the seller divides the consumers into groups and charges prices accordingly.

2. Does second-degree price discrimination have a deadweight loss?

A deadweight loss refers to the supply and demand imbalance caused by market inefficiency; it also happens when there is an inefficient resource allocation. When a seller applies 2nd degree price discrimination, they offer different quantities at different prices; while doing so, the seller allows customers to self-select based on their willingness to pay, the same reason deadweight loss gets created.

3. How Can Businesses Implement Second-Degree Price Discrimination Successfully?

Successful implementation involves:
- Careful market segmentation.
- Transparent communication with customers.
- Ensuring that the pricing strategy aligns with legal and ethical standards.
Businesses should also consider the simplicity of the pricing structure to avoid confusion among consumers.