Strategic Economics

Price Discrimination in Three Degrees

Charge different customers different prices for the same thing without either of them leaving — by building fences the low-value customer will cross and the high-value one will not — and understand why the most aggressive version of this is also the one that serves the most people.

  • Advanced
  • 15 min total
  • 14 chapters

What decision this helps you make: Which of the three mechanisms your business can actually operate, what the fence between your tiers has to cost a customer to be worth having, and where the legal and reputational limits sit before you start.

What this topic is

Price discrimination is charging different prices to different customers for something whose cost to serve is the same. Pigou sorted it into three degrees a century ago and the taxonomy has survived because it maps to three genuinely different mechanisms. First degree charges each customer their own maximum. Second degree offers a menu and lets customers sort themselves. Third degree charges by an observable group characteristic — student, enterprise, region, time of purchase.

Why it matters

A single price is a compromise that loses money twice: every customer who would have paid more pays less, and every customer who would have paid something pays nothing. Discrimination recovers both. It is also the reason a great many products exist at all — in the worked example in this lesson, a whole customer segment is served under discriminatory pricing and abandoned entirely under the best uniform price. And the mechanism most people reach for, a discount for whoever asks, is the one version that reliably destroys value.

Who should learn it

Anyone setting prices across tiers, regions, or customer types; subscription and marketplace operators designing plan ladders; sales leaders deciding what discretion to give the field; and readers who want to know why the fair-seeming pricing policy is often the one that serves fewest customers.

What you will understand

  • The three degrees, the three preconditions every one of them needs, and which mechanism your business can actually run
  • The inverse-elasticity rule for group pricing, worked through with real arithmetic
  • Incentive compatibility: why a menu must leave the high-value customer a rent, and what that rent costs you
  • Why total output is the test for whether the practice helped or hurt, and where the legal limits sit

Prerequisites

Common misconception

That charging different people different prices is a way of extracting more from customers, full stop. It is that, and it is also the reason the customer at the bottom gets served at all. Work the numbers in this lesson: at the best single price the firm serves only its business segment at $115 and abandons the consumer segment entirely; allowed to set two prices, it serves the business segment at exactly the same $115 and adds forty units of consumer sales at $40. Nobody pays more, output nearly doubles, and a market that did not exist appears. That is not the universal case — where both segments would have been served anyway, group pricing raises the price to the inelastic segment and the welfare effect is ambiguous at best. But the intuition that discrimination is always extraction gets the most common real case backwards.