Conditions of Price Discrimination

The necessary conditions under which price discrimination is possible are:

• The total market for the product must be divided into clear – cut sub – markets with different price elasticities.
• There must be effective separation of this sub – markets so that buyers in the low price sub – markets are not in a position to resell this product in a high price market.

The price discrimination would be profitable only when elasticity of demand is lower in one market and higher in other, only then the price discrimination would pay. Let the elasticity of demand be low in Market I and high in Market II. Because of the lower elasticity demand, Market I will not respond much to the changes in the price, and even a substantial rise in price would not make much loss of demand and revenue. Similarly, Market II having of the price would lead to a large extension of demand. More can be sold and revenue increased by lowering the prices slightly. Under these conditions it is profitable to raise the prices in Market II, which would now absorb much larger amount of goods. The net result of this would be an increase in the profits.

If, on the other hand, the elasticity of demand in two markets is the same, then price discrimination will not make any difference to the profits. A rise in the price in Market I will reduce the demand to some extent. The output which remains unsold in Market I because of price rise will be transferred to Market II. This would reduce the prices in Market II. Because the elasticity of demand is the same in both the markets, the gain from one market will be counter balanced by a loss in the other and hence the total amount of profit would remain the same.

A fundamental assumption behind price discrimination is that goods sold in one market cannot be resold in the other. There should be either natural or artificial barrier which restrict the movement of goods from one market to another. In the absence of such restriction, the goods which are sold cheap in one market would be resold to the other market. The prices in this market would rise, while they will fall in the other, until they become equal. Hence, price discrimination would cease to exist.

Thus, separation of sub – markets is necessary for price discrimination. The separation could be because of geographical distance which involves a high cost of transposition of goods from one market to another. It could also be because goods are non – transferable so that they are consumed the moment they are purchased such as to why price discrimination is easier to apply with consumable goods like transport, electricity, medical services, etc.