What this lesson teaches
I can explain the strategies firms use to raise revenue or cut unit costs: growth, pricing, price discrimination, innovation, marketing and collusion.
Syllabus 9570, 2.2.3(a). Firms' Decisions and Strategies: Firms make decisions and engage in pricing, cost and product differentiation strategies aimed at raising revenue and/or lowering unit costs. These include:; growth, diversification and shut-down; price competition; third degree price discrimination; innovation, research and development; marketing; collusion with other firms
Make a guess
A cinema charges adults $14 and students $9 for the same seat. Why does it make more profit than charging everyone $12?
- Adults are richer, so the law lets cinemas charge them more.
- Serving students costs the cinema less.
- Students' demand is more price elastic than adults'.
Show the answer
Students' demand is more price elastic than adults'.
Adults keep coming at $14, so the cinema earns more from them. The low student price fills seats that would otherwise be empty.
Charging different groups different prices for the same product can raise profit, if the groups have different PEDs and cannot resell.
Third-degree price discrimination means charging different groups of customers different prices for the same product, where the difference is not due to cost. Student cinema tickets and senior citizen fares are examples.
It needs three conditions. The firm must have some market power. It must be able to separate the groups, for example by checking student cards. And customers must not be able to resell to each other.
The firm charges a higher price to the group with inelastic demand (adults) and a lower price to the group with elastic demand (students), which raises total profit.
Some consumers gain: students may now afford to go. Others lose: adults pay more. The overall effect on consumers is mixed.
- Conditions
- Market power, separable groups, different PEDs, no resale.
- Prices
- Higher for inelastic groups, lower for elastic groups.
| Pricing | Tickets sold | Revenue | After variable cost |
|---|---|---|---|
| One price, $10 | 30 adult + 10 student | $400 | $240 |
| $12 adult, $8 student | 25 adult + 20 student | $460 | $280 |
Worked example: Adult and student tickets
A cinema's cost per extra ticket is $4. At one price of $10, it sells 30 adult and 10 student tickets. With $12 for adults and $8 for students, it sells 25 adult and 20 student tickets.
- One price: revenue $400, variable cost $160, so $240 towards fixed costs and profit.
- Two prices: revenue $300 + $160 = $460, variable cost $180, so $280.
- Profit rises by $40, since fixed costs are unchanged.
- Students gain (more of them go, at a lower price). Adults lose (they pay $2 more and 5 fewer attend).
Watch out for this
Price discrimination means charging more to customers who cost more to serve.
Price differences based on cost are not price discrimination. It is charging different prices for the same product with the same cost.
Check your understanding
Which condition is needed for price discrimination to work?
- Customers in the low-price group cannot resell to the high-price group.
- The two groups of customers must have the same price elasticity of demand.
- The market must be perfectly competitive, so each firm accepts the market price.
Show the answer
Customers in the low-price group cannot resell to the high-price group.
Right. Otherwise students would buy cheap tickets and sell them to adults.