Second Degree Price Discrimination
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Firms with some market power can increase profits by practicing either direct price discrimination or indirect price discrimination.
Direct price discrimination arises when the market can be segmented into sub populations on the basis of readily observable characteristics. Each of the segments has a different elasticity of demand and subsequently is charged a different price. Arbitrage must be prevented for this type of discrimination to be applicable. Profits are maximized by equating the marginal revenue from the two consumers for the same marginal cost.
Indirect price discrimination arises when a seller cannot observe the buyers characteristics, and hence cannot determine the optimal price to charge the buyer relevant to their demand elasticity. The seller offers different kinds of services or differential pricing and lets the consumers choose as per their preference with hopes to segregate the high class consumers from the low. The pricing technique developed to induce the high class consumer to reveal themselves must satisfy the incentive compatibility constraint.
When facing two types of consumers, ideally a firm would like to charge the maximum it can to both types. However, if the firm is unable to segregate the consumers based on quality or demand preferences, pricing products for the consumers becomes relatively difficult. Firms engaging in pricing only catering only to one group will not be able to maximize its profits thereby loosing sales to the other group. The high quality/ more inelastic elastic (rich) consumer can exercise personal arbitrage and to pretend to be a low quality/ more elastic (poor) consumer if the option is viable, thereby concealing their identity and preventing the firm from maximizing profits.
The rich consumers will never overtly display their preference and hence need to be induced to reveal themselves. If there is not much value realized for the high quality good in comparison with the lower quality, the rich consumer will be more inclined to purchase the lower quality. Hence the firm must design different versions of the good and let the consumer pick as per their preference such that segregation of the two groups can be achieved based on the quality and pricing. The ideal strategy would be to charge the poor consumer maximum for the low quality good and determine the price for the rich consumer by profit maximizing strategy that must satisfy the self-selection (incentive compatibility) constraints.
A firm engages in indirect pricing through a variety of pricing techniques. Either it offers discounts or imposes fare restrictions. Intricate pricing techniques like commodity bundling, quantity discounts or two part-tariffs are also a form of indirect pricing to induce revelation of the rich consumer.
Saudi Aramco, the national oil producing entity in Saudi Arabia, sells oil to international buyers are made under long-term contracts linked to spot prices in North America, Europe and Far East (Asian) markets on the basis of pricing formulae as shown below.
The marker for each region is highlighted in the figure below.
The local Asian oil production is not sufficient to fully cover regional demand. Hence imports from outside the region are required. Middle East is the closest supplier, since other alternative sources such as West Africa have to travel much further than the Middle East and hence would be at a disadvantage