Individualized Variable Pricing/First Degree Price

14th November 2021 0 By indiafreenotes

First-degree price discrimination is where a business charges each customer the maximum they are willing to pay. This price can vary from customer to customer as the business charges the very maximum in order for the customer to purchase their goods. As a result, the firm is able to capture all consumer surplus and keep this as economic profit instead.

Exercising first degree (or perfect or primary) price discrimination requires the monopoly seller of a good or service to know the absolute maximum price (or reservation price) that every consumer is willing to pay. By knowing the reservation price, the seller is able to sell the good or service to each consumer at the maximum price they are willing to pay, and thus transform the consumer surplus into revenues, leading it to be the most profitable form of price discrimination. So the profit is equal to the sum of consumer surplus and producer surplus. The marginal consumer is the one whose reservation price equals the marginal cost of the product. The seller produces more of their product than they would to achieve monopoly profits with no price discrimination, which means that there is no deadweight loss. Examples of this might be observed in markets where consumers bid for tenders, though, in this case, the practice of collusive tendering could reduce the market efficiency.

First-degree price discrimination is more of a theoretical concept than a reality. It is something for businesses to aim towards than their actual ability to achieve. After all, being able to charge each customer the absolute maximum they are willing to pay is near on impossible.

Some firms are able to implement some form of specific pricing strategy – for example, coupons which verges on first-degree price discrimination. Whilst firms will be unable to charge the absolute maximum, they will be able to charge different values which vary depending on their willingness to pay.

Traditionally, sellers would try and maximise their sales through individual observation and negotiation. For example, when most trade was done via markets, sellers would make assumptions based on an individual’s age, gender, and attire – anything that would signal the consumer’s willingness and ability to spend. Often, negotiations would depend on these initial assumptions. For example, individuals who are well-dressed are more likely to be charged higher prices based on their assumed ability and willingness to pay.

The issue with this age-old approach is that it is a time-consuming and a flawed process. Not every individual in a suit is rich, nor is everyone in a tracksuit poor. On top of this, it is a very inefficient method, particularly for big companies that sell millions of goods. It would be impossible to do this for each customer and for each item they buy.

Examples:

Airlines

Most airlines operate a form of price discrimination by using dynamic pricing. This is simply where prices fluctuate depending on current demand. For instance, if tickets are selling quickly, then prices will start to rise. If tickets are hardly selling, then the prices may fall to attract more customers.

Whilst this form of price discrimination doesn’t necessarily maximize revenue from the consumer, it does increase the firm’s profits by taking advantage of some consumer’s higher willingness to pay. For example, those consumers who are price-sensitive are more likely to book when the tickets come out and are at their cheapest. By contrast, those who are not so sensitive to prices may book last minute when prices may be significantly higher.

Therefore, airlines are able to segment between more price-sensitive consumers and those who are not. For instance, those who need to travel for last-minute business will have a higher willingness to pay than a family of four looking for a holiday.

Business to Business Services

It is much easier to use price discrimination in the service industry as the firm has more control over who can access these as opposed to physical goods that can be resold. This is why businesses are freely able to use price discrimination to sell between different clients. Not every business has the same budget for the goods they are selling.

For instance, a big firm like Walmart will have a far bigger budget than a small firm such as Barry’s Bicycles. So, the willingness to pay is going to differ dramatically between businesses.

Some firms will offer different packages based on the size of the organization. For instance, if a company requires 100+ users, then they will pay a higher fee than those who only need 5 users. Even though the set-up cost is the same, they are able to charge different prices in order to attract custom from each business which has different budget constraints.

Utilities

Utility firms usually offer fixed-term contracts over a year or two by which the consumer is offered a lower rate. However, once this term expires, consumers are put onto a higher variable rate. Yet a significant number of consumers will remain on this variable rate, paying a higher fee each month.

More price-sensitive consumers will get in contact and either switch providers, or move onto a cheaper tariff. By contrast, those consumers who are less price-sensitive may stay with the same utility provider and variable rate, thereby paying a higher fee for the same service.