Price Discrimination and Monopolistic Competition Essay

Introduction

Consumers engage in a comprehensive decision making process in their consumption processes. Some of the elements that consumers are concerned with relate to product quality and price. Consumers have limited income, and thus they select what to purchase and at what price. Boyes (2011) posits, “Consumers are heterogeneous in their preferences between price and quality” (p.29).

The consumers’ decision to purchase a particular product is motivated by the desire to attain a certain desired level of utility. On the other hand, firms provide consumers with a wide range of products and services, which are offered at different prices. Product pricing is subject to different factors; for example, the cost of production, product quality, and the firm’s profit maximisation objective.

According to Hirschey (2009), businesses have an obligation to set optimal product prices failure to which they will not be in a position to achieve their profit maximisation objectives. Despite this aspect, the ability of an organisation to set optimal price is subject to the prevailing level of competition.

According to Varian (2010), the competitive market is characterised by a large number of firms that deal identical products and this aspect limits a firm’s ability to exploit the consumers by selling the product at a high price.

Varian (2010) asserts, “Any attempt by one of the firms to sell its products at a higher price than the market price leads consumers to desert the high-priced firm in favour of its competitors” (p.461). Businesses can adopt different criteria to achieve profitability. One of these strategies includes price discrimination.

Alternatively, a firm may decide to adopt monopolistic competition strategies. This paper intends to explain the concept of price discrimination and monopolistic competition behaviour by firms.

The study takes into account the case of daily and weekly news publications companies like the Financial Times and the Economist. These firms provide students with various types of publications at highly discounted prices through the students-union shops.

Price discrimination

Price is one of the core elements of every market economy. Varian (2010) asserts that the various product characteristics such as timing, options, quantity, and quality amongst others are embodied in the price. In a perfect market, all firms operate as price takers, and this aspect means that the firms do not set the price of their product, but it is rather determined by the market forces.

Varian (2010) further asserts that organisations in most markets engage in price discrimination. Price discrimination refers to a situation whereby consumers are charged different a price for the same product. This phenomenon also occurs in a situation whereby the price differential of a particular product between two consumer groups does not reflect the cost discrepancies.

Varian (2010) asserts that price discrimination is a common phenomenon in most markets such as the transport, travel, services markets, and consumer products markets. Businesses adopt price discrimination in an effort to increase their sales revenue. Sexton (2008) opines that price discrimination is integrated by organisations that are motivated by the need to maximise profit.

Sexton (2008) asserts that not all firms can integrate price discrimination. In order to practice price discrimination, it is essential for organisations to integrate and fulfil a number of conditions. Some of these conditions are explained herein.

1. Monopoly power – Varian (2010) is of the opinion that price discrimination can only occur if a particular firm has a certain degree of monopoly power. Moreover, price discrimination can also occur if firms follow identical pricing policies.
2. Market segregation – a firm can also adopt price discrimination if it has the capability to separate its customers in accordance with their ability to pay.
3. No resale – Sexton (2008) opines that it should not be possible for the buying party to resell the product to other consumers at a high price. If reselling is possible, consumers may take advantage and resell the product at a profit to other consumer groups. Therefore, price discrimination only occurs is there is no market seepage.

Degrees of price discrimination

There are three main degrees of price discrimination, which include:

1. First-degree price discrimination
2. Second-degree price discrimination
3. Third degree price discrimination

First-degree price discrimination – this type of price discrimination is also referred to as perfect price discrimination. Under 1^st degree price discrimination, a firm sells a unit of a particular product to the consumer who mostly values it. The product is sold at the maximum price that the consumer is willing to pay.

Second-degree price discrimination – this type of discrimination is also referred to as non-linear pricing. Under this type of discrimination, the price of a commodity depends on the quantity purchased. Varian (2010) asserts that second-degree price discrimination is mainly applied in setting the price of public utilities such as determining the price per unit of electricity.

Third-degree discrimination – this form is the most common type of price discrimination. It occurs if an organisation sets a different price for a particular consumer group. The individuals within the targeted consumer group pay a similar price for a particular unit of output. Consequently, third-degree price discrimination occurs in a market whereby the consumers can segment the market.

In an effort to serve the market effectively, firms classify their consumers into different categories. The classification may either be based on a not-for-profit status and for-profit status. Other classifications may be based on customer age or geographical location (Hirschey 2009).

Example of third-degree discrimination occurs in learning institutions whereby students are offered products and services at a discount at the University Union shops. The shops command a certain degree of monopoly. Moreover, it is possible for the union shops to identify the students as the targeted consumer group. Consequently, they are in a position to offer products at discounted prices.

Publishing companies such as The Wall Street Journal, Barrons, the Economist, and Forbes offer students huge price discount. Other areas in which third degree price discrimination is applied includes movie theatres whereby the price of movie tickets for adults and children differ. Third-degree price discrimination is also applied in drugstores that provide senior citizens with drugs.

Rationale for the third-degree price discrimination; student discounts

Most publishing companies are committed in attracting and retaining a large number of students to purchase their academic journals and other publications. Consequently, such companies are forced to adopt effective marketing strategies in order to penetrate the learning institutions. One of the strategies adopted relates to price discrimination.

The publishing houses are forced to offer students the publication at a relatively low price. The firms are motivated by the view that offering their publications at a discounted price to students will lead to the creation of future loyal customers. Students and senior citizens are considered as very sensitive to price.

Therefore, in order to attract a large number of students to consume their products, the firms are forced to price-discriminate by integrating a price discount. Therefore, the publishing firms are in a position to maximise their level of profit by marketing to students as one of their essential sub-markets (Varian 2010).

Third-degree price discrimination can also be explained by the view that it contributes to the creation of a welfare effect. Numerous studies have been conducted in an effort to examine the third degree price discrimination. Robbinson was the first person to evaluate the social welfare effect in 1933 and later Schmalensee in 1981 carried out his evaluation too.

The studies revealed that third-degree price discrimination contributes towards the improvement in the social welfare of the targeted consumer group. Muller-Langer (2008) defines social welfare as “the sum of consumers’ surplus under such specific conditions as constant marginal costs, dependent [deterministic] demand, and increasing total output associated with price discrimination as compared to uniform pricing” (p.93).

Varian (2010) further asserts that third-degree price discrimination is more applicable in conditions of probabilistic demand and increasing marginal cost. On the other hand, Muller-Langer (2008) asserts that third-degree price discrimination enables firms to serve markets that would have been difficult to serve through uniform pricing strategy.

Benefits and costs of price discrimination

Incorporating price discount enables a firm to attract low-income consumers. Cowan (2007) asserts, “Third-degree price discrimination enables an organisation to supply to a group of consumers who would not be supplied in the absence of price discrimination” (p. 419).

Therefore, the likelihood of an organisation maximising its sales revenue, and hence its profit is high. By re-investing the gains made, an organisation can improve its operational efficiency, hence enhancing the likelihood of offering its products at low prices.

This move will enable the firm to survive in the end. Third-degree price discrimination increases the likelihood of businesses to maximise their level of output. Consequently, the likelihood of such firms achieving profit maximisation is high.

Despite the welfare benefits associated with price discrimination, Varian (2010) argues, “Price discrimination is a pricing strategy in which producers gain at the expense of consumers through the extraction of consumer surplus” (p.467).

Furthermore, price discrimination may lead to exploitation of some consumers as evidenced by the view that some consumers may be forced to pay a high price for the same product. Therefore, one can assert that price discrimination contributes towards unjustifiable income redistribution by firms, which are price takers and this aspect leads to the reduction in the consumers’ real income.

Monopolistic competition

According to Varian (2010), a monopolistic industry refers to an industry that is characterised by one large firm that has the ability to control the market. Monopolistic competition entails a form of imperfect competition in which the competing firms produce and sell differentiated products.

Therefore, monopolistic competition occurs between firms that produce substitute products. Varian (2010) emphasises that monopolistic competition is the most common type of industry structure. A monopolistically competitive market depicts a number of characteristics as illustrated below.

Every firm has the right to make independent decisions on the level of output and the price at which it will offer its products in the market. However, the price is determined based on the cost of production, the product quality, and the nature of the market. Consequently, firms in monopolistically competitive market are price makers. Therefore, they can charge high or low price in an effort to rival their competitors.

Secondly, all the parties in a monopolistically competitive market are well informed about the prevailing market conditions such as information on alternative product prices. The consumers also have extensive knowledge about brand names and product differences. On the other hand, the competing firms have perfect information about the activities of the other firms, for example their pricing strategies.

Therefore, the activities of firms in a monopolistic competitive market are guided by the activities of the competing firms. However, the market information is not perfect, which means that consumers have an opportunity to review the price offered by different competing firms before making a choice (Varian 2010).

Another major characteristic of a monopolistic competitive market is the existence of product differentiation. Firms in a monopolistically competitive market tend to market their products by exploiting the perceived difference. Therefore, consumers develop a perception that the substitute products available in the market are not the same.

For example, drug stores offer consumers diverse over-the-counter drugs under different brand names. Most of the drugs issued serve the same purpose; however, due to product differentiation, consumers develop diverse levels of product preferences, and thus they may perceive the products offered by their preferred supplier to be of high quality.

Similarly, publishing companies provide students with similar publications such as magazines. The publishing companies have differentiated themselves based on location, which is evidenced by the view that the students can access their publications through the University Union shops at a reduced price.

Sexton (2008) asserts, “Shoppers are not willing to travel long distances to purchase similar items, which is one reason for the large number of convenience stores and service stations and minimarts” (p.396).

Most students have realised that the different brands of publications such as academic journals do not differ; therefore, the accessibility of their product in the market may influence the consumers’ purchasing decision. According to Sexton (2008), product differentiation enables monopolistic competitors to have an influence over the price of their products.

The behaviour of the publishing companies can also be explained by the view that there is a large number of publishing companies. Examples of the competing firms include the Wall Street Journal, Barrons, the Economist, Harvard Business Review, and Forbes amongst others.

Most of these companies target students in different learning institutions as their potential customers. Moreover, there is no law that bars the publishing companies from offering students their products through the union shops. Consequently, the degree of rivalry in such as submarket is likely to be high (Sexton 2008).

In order to attract students, the firms are required to adopt effective market penetration strategies such as providing students with different academic publications through their libraries. However, a large number of sellers limit the firms’ ability to control the market. Despite this aspect, the firms are committed towards improving their competitiveness.

Therefore, the firms are forced to adopt effective competitive strategies, for example by incorporating a price discount or improving their service delivery. For instance, the firms may provide students with an opportunity to subscribe for library services at a reduced price (Sexton 2008). If a particular firm in such a market increases the price of its products, customers have an option to purchase from its competitors.

Another major characteristic of a monopolistically competitive market is that entry to the market is free. Therefore, competing firms can freely enter the market and provide consumers with substitute products. The threat of new entrants tends to reduce the level of economic profit. However, considering the view that the publishing firms are profit-oriented, they are forced to formulate effective strategies in order to survive.

According to Hall and Lieberman (2013), monopolistic competitors are motivated by the need to maximise profit. Therefore, they tend to move along the demand curve up to a point that will lead to profit maximisation. Furthermore, monopolistic competitors have the option of shifting their demand curves rightwards.

This goal is achievable via developing products that are more appealing and adopting strategic locations hence attracting consumers. Other forms of non-price competition include offering product guarantees, better services, advertising to inform the consumers, and free home deliveries.

Adopting non-price competition improves an organisation’s ability to maximise profit. Despite their effectiveness in influencing the consumers’ purchase decision, monopolistic competitors do not have extensive market powers due to the existence of a large number of rival firms, which offer close substitutes.

Most plausible explanation for the pricing strategy

This analysis shows that the aforementioned behaviour by publishing companies such as the Economist and the Financial Times can be explained based on two main frameworks, which include price discrimination and monopolistic competition. However, a number of conditions must be satisfied in order for a firm to adopt any of the two strategies.

For price discrimination to occur, the market must be characterised by some degree of imperfection. Secondly, a firm must be in a position to split the total market into a number of submarkets. Thirdly, the consumers must be characterised by different price elasticity of demand.

These conditions provide the suppliers with an opportunity to set different prices for the same product. Therefore, the firm is in a position to maximise its profit by attracting a large number of customers. In most cases, price discrimination is incorporated with the objective of creating welfare effect on the part of the consumer.

The publishing companies are established with the objective of maximising profit. Consequently, they have an obligation to adopt effective pricing strategies. Moreover, the publishing companies operate in an industry that is characterised by intense competition sue to the many firms in the industry.

In order to survive in such an industry, the publishing companies are forced to offer their products to students at highly discounted prices. This aspect leads to the development of a high level of customer loyalty. The firms are in a position to attract and retain a large number of customers. Therefore, the monopolistic competition framework can best explain the behaviour of the publishing companies.

Conclusion

Price is a critical component in the survival of businesses. Moreover, most markets are experiencing an increment in the intensity of competition.

Therefore, in order to survive in the long term, it is imperative for businesses to adopt effective pricing strategies in order to maximise their profit, which can be achieved by adopting the concepts of price discrimination. Furthermore, firms can also adopt strategies that will set them as effective monopolistic competitors.

Reference List

Boyes, W 2011, Managerial economics, Houghton Mifflin, Boston.

Cowan, S 2007, ‘The welfare effect of the third degree price discrimination with non-linear demand functions’, Journal of Economics, vol. 38 no. 2, pp. 419-428.

Hall, R & Lieberman, M 2013, Economics; principles and applications, Cengage Learning, Mason.

Hirschey, M 2009, Managerial economics, Cengage Learning, Mason.

Muller-Langer, F 2008, Creating R&D incentives for medicines for neglected diseases: An economic analysis of parallel imports, patents and alternative mechanisms to stimulate pharmaceutical research, Gabler, Wiesbaden.

Sexton, R 2008, Exploring economics, Thomson, Mason.

Varian, H 2010, Intermediate microeconomics, University of California, Berkeley.