Price discrimination is a microeconomic pricing strategy where identical or largely similar goods or services are sold at different prices by the same provider in different market segments. Price discrimination is distinguished from product differentiation by the more substantial difference in production cost for the differently priced products involved in the latter strategy. Price differentiation essentially relies on the variation in the customers' willingness to pay and in the elasticity of their demand. For price discrimination to succeed, a firm must have market power, such as a dominant market share, product uniqueness, sole pricing power, etc. All prices under price discrimination are higher than the equilibrium price in a perfectly competitive market. However, some prices under price discrimination may be lower than the price charged by a single-price monopolist. Price discrimination is utilised by the monopolist to recapture some deadweight loss. This Pricing strategy enables firms to capture additional consumer surplus and maximize their profits while benefiting some consumers at lower prices. Price discrimination can take many forms and is prevalent in many industries, from education and telecommunications to healthcare.
The term differential pricing is also used to describe the practice of charging different prices to different buyers for the same quality and quantity of a product, but it can also refer to a combination of price differentiation and product differentiation. Other terms used to refer to price discrimination include "equity pricing", "preferential pricing", "dual pricing" and "tiered pricing". Within the broader domain of price differentiation, a commonly accepted classification dating to the 1920s is: "Personalized pricing" (or first-degree price differentiation) — selling to each customer at a different price; this is also called one-to-one marketing. The optimal incarnation of this is called "perfect price discrimination" and maximizes the price that each customer is willing to pay. As such, in first degree price differentiation the entire consumer surplus is captured for each individual. "Product versioning" or simply "versioning" (or second-degree price differentiation) — offering a product line by creating slightly differentiated products for the purpose of price differentiation, i.e. a vertical product line. Another name given to versioning is "menu pricing". "Group pricing" (or third-degree price differentiation) — dividing the market into segments and charging a different price to each segment (but the same price to each member of that segment). This is essentially a heuristic approximation that simplifies the problem in face of the difficulties with personalized pricing. Typical examples include student discounts and seniors' discounts.
Theoretical basis
In a theoretical market with perfect information, perfect substitutes, and no transaction costs or prohibition on secondary exchange (or re-selling) to prevent arbitrage, price discrimination can only be a feature of monopoly and oligopoly markets, where market power can be exercised (see 'Price discrimination and monopoly power' below for more in-depth explanation). Without market power when the price is differentiated higher than the market equilibrium consumers will move to buy from other producers selling at the market equilibrium. Moreover, when the seller tries to sell the same good at differentiating prices, the buyer at the lower price can arbitrage by selling to the consumer buying at the higher price with a small discount from the higher price.