What Is Price Discrimination, and How Does It Work?

• Price discrimination is a pricing method where identical or similar products are sold at different prices
• There are three types of price discrimination: first, second, and third-degree discrimination
• AI makes price discrimination more efficient, but companies still stick to traditional methods

Have you ever wondered why colleges have in-state and out-of-state rates, why companies such as Groupon exist, and why you receive coupons on certain products in your email box? The quick answer is firms know how sensitive their customers are to price and charge different prices to different customers. This practice is called price discrimination.

Price discrimination is a pricing method where a seller charges customers different prices based on the seller’s belief of how much each group of customers is willing to pay. Such belief is often based on demographic factors, such as age, education, and marital status. For example, a car insurance company is more likely to provide a better deal to someone with a family and ten years of work experience rather than a recent college graduate. However, demographics is only one of the factors. In theory, price discrimination has three levels: first-degree price discrimination, second-degree price discrimination, and third-degree price discrimination.

First-degree price discrimination is the most extreme example. Under this practice, the seller charges each individual a different price, and every customer pays the highest possible price he is willing to pay. An example would be a doctor from a small town who knows the financial situation of each family in the town and charges each family as much as the family is willing to pay. From the economic standpoint, it implies that the seller captures 100% of the trade welfare.

Second-degree price discrimination is based on what choices customers make. As customer demographic data is not always available, companies can still divide customers into groups based on the customer’s behavior. For example, a customer who takes an additional step to search for a discount code before making a purchase is likely to be more price-sensitive. Therefore, a company may want to provide such a customer with a coupon to make the trade possible. Coupon platforms, such as Groupon and RetailMeNot, help companies make more sales by giving coupons to price-sensitive customers who would not make a purchase otherwise.

Third-degree price discrimination is based on observable factors such as demographics. For example, the Isabella Stewart Gardner Museum in Boston sells tickets to students for $13, adults for $20, and senior citizens for $18. Likewise, the tuition that US colleges charge their students is different for in-state and out-of-state students.

The rise of business intelligence tools and the abundance of customer data on the Internet creates great potential for firms to analyze the price sensitivity of their customers more accurately and set up prices accordingly. According to the economic paper published by researchers from the University of Liège, Belgium, in 2020, AI has empirically proven its effectiveness in increasing profits through more accurate pricing models. However, most of the companies today still use traditional price discrimination methods. The authors expect this to change in the future once more research becomes available.