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On a general level, price discrimination refers to the practice of charging different prices to different consumers or groups of consumers without a corresponding difference in the cost of providing a good or service.
Conditions Necessary for Price Discrimination
In order to be able to price discriminate among consumers, a firm must have some market power and not operate in a perfectly competitive market. More specifically, a firm must be the only producer of the particular good or service that it provides. (Note that, strictly speaking, this condition requires that a producer be a monopolist, but the product differentiation present under monopolistic competition could allow for some price discrimination as well.) If this were not the case, firms would have an incentive to compete by undercutting competitors' prices to the high-priced consumer groups, and price discrimination would not be able to be sustained.
If a producer wants to discriminate on price, it must also be the case that resale markets for the producer's output do not exist. If consumers could resell the firm's output, then consumers who are offered low prices under price discrimination could resell to consumers who are offered higher prices, and the benefits of price discrimination to the producer would vanish.
Types of Price Discrimination
Not all price discrimination is the same, and economists generally organize price discrimination into three separate categories.
First-Degree Price Discrimination: First-degree price discrimination exists when a producer charges each individual his or her full willingness to pay for a good or service. It is also referred to as perfect price discrimination, and it can be difficult to implement because it's generally not obvious what each individual's willingness to pay is.
Second-Degree Price Discrimination: Second-degree price discrimination exists when a firm charges different prices per unit for different quantities of output. Second-degree price discrimination usually results in lower prices for customers buying larger quantities of a good and vice versa.
Third-Degree Price Discrimination: Third-degree price discrimination exists when a firm offers different prices to different identifiable groups of consumers. Examples of third-degree price discrimination include student discounts, senior citizen discounts, and so on. In general, groups with higher price elasticity of demand are charged lower prices than other groups under third-degree price discrimination and vice versa.
While it may seem counterintuitive, it is possible that the ability to price discriminate actually reduces the inefficiency that is a result of monopolistic behavior. This is because price discrimination enables a firm to increase output and offer lower prices to some customers, whereas a monopolist might not be willing to lower prices and increase output otherwise if it had to lower the price to all consumers.