Table of Contents
Quick Definition: First-degree price discrimination is a pricing strategy which involves a firm charging every consumer the maximum price that they are willing to pay.
Perfect price discrimination; optimal price discrimination
First-degree price discrimination is a theoretical pricing strategy which involves a firm charging every consumer the maximum price that the individual consumer is willing to pay. This results in consumers receiving no consumer surplus, and the firm receiving all gains from the transaction.
A firm is only able to carry out first-degree price discrimination when it has perfect information about every consumer’s ‘willingness to pay’. In reality, perfect information is an impossibility. Thus, the case of first-degree price discrimination is unrealistic and it will never be observed in reality (much like the concept of perfect competition). Despite this, we study first-degree price discrimination because it is used as a benchmark from which to compare other situations.
Effectively, when a firm engages in first-degree price discrimination, they are perfectly segmenting the market. That is to say, each and every consumer is a segment.
The welfare effect of this situation is decidedly negative for the consumer. Each consumer is being charged precisely what they are willing to pay, thus they receive zero consumer surplus. In contrast, perfect price discrimination has a positive welfare effect for firms. The firm is able to extract all gains from the transaction, as there is no consumer surplus and no deadweight loss.
A graphical description of allocative first-degree price discrimination depicts the firm absorbing the entire surplus of the market demand. From the graph we can also observe that there is allocative efficiency (no deadweight loss).
Consumer surplus – The welfare a consumer receives from being charged a price below that which they would be willing to pay.
Market segment – This is a subdivision of the market in which consumers have distinctive characteristics and preferences.
Price discrimination – This is the practice of a firm charging different consumers different prices for the same good or service.