The term differential pricing is also used to describe the practice of charging different prices to different buyers for the same quality and quantity of a product, but it can also refer to a combination of price differentiation and product differentiation. Other terms used to refer to price discrimination include equity pricing, preferential pricing, dual pricing and tiered pricing. Within the broader domain of price differentiation, a commonly accepted classification dating to the 1920s is:
In a theoretical market with perfect information, perfect substitutes, and no transaction costs or prohibition on secondary exchange (or re-selling) to prevent arbitrage, price discrimination can only be a feature of monopolistic and oligopolistic markets, where market power can be exercised. Otherwise, the moment the seller tries to sell the same good at different prices, the seller at the lower price can arbitrage by selling to the consumer buying at the higher price but with a tiny discount. However, product heterogeneity, market frictions or high fixed costs (which make marginal-cost pricing unsustainable in the long run) can allow for some degree of differential pricing to different consumers, even in fully competitive retail or industrial markets.
The effects of price discrimination on social efficiency are unclear. Output can be expanded when price discrimination is very efficient. Even if output remains constant, price discrimination can reduce efficiency by misallocating output among consumers. That´s why reducing prices of ice creams in summer, is inefficient, or offering an 2x1 strategy selling on a very cheap product becomes a craziness.
Price discrimination requires market segmentation and some means to discourage discount customers from becoming resellers and, by extension, competitors. This usually entails using one or more means of preventing any resale: keeping the different price groups separate, making price comparisons difficult, or restricting pricing information. The boundary set up by the marketer to keep segments separate is referred to as a rate fence. Price discrimination is thus very common in services where resale is not possible; an example is student discounts at museums: In theory, students, for their condition as students, may get lower prices than the rest of the population for a certain product or service, and later will not become resellers, since what they received, may only be used or consumed by them. Another example of price discrimination is intellectual property, enforced by law and by technology. In the market for DVDs, laws require DVD players to be designed and produced with hardware or software that prevents inexpensive copying or playing of content purchased legally elsewhere in the world at a lower price. In the US the Digital Millennium Copyright Act has provisions to outlaw circumventing of such devices to protect the enhanced monopoly profits that copyright holders can obtain from price discrimination against higher price market segments.
Price discrimination can also be seen where the requirement that goods be identical is relaxed. For example, so-called "premium products" (including relatively simple products, such as cappuccino compared to regular coffee with cream[dubious ]) have a price differential that is not explained by the cost of production. Some economists have argued that this is a form of price discrimination exercised by providing a means for consumers to reveal their willingness to pay.
Exercising first degree (or perfect or primary) price discrimination requires the monopoly seller of a good or service to know the absolute maximum price (or reservation price) that every consumer is willing to pay. By knowing the reservation price, the seller is able to sell the good or service to each consumer at the maximum price he is willing to pay, and thus transform the consumer surplus into revenues. So the profit is equal to the sum of consumer surplus and producer surplus. The marginal consumer is the one whose reservation price equals to the marginal cost of the product. The seller produces more of his product than he would to achieve monopoly profits with no price discrimination, which means that there is no deadweight loss. Examples of where this might be observed are in markets where consumers bid for tenders, though, in this case, the practice of collusive tendering could reduce the market efficiency.
In second degree price discrimination, price varies according to quantity demanded. Larger quantities are available at a lower unit price. This is particularly widespread in sales to industrial customers, where bulk buyers enjoy higher discounts.