Pricing is an important factor in an organization because the price charged on a product determines the revenue and the profit of the firm. The management of an organization is expected to make a decision regarding pricing for different products offered by the firm under different circumstances. There are simple pricing decisions and complex pricing decisions. Under simple pricing decisions, the firm can decide the price of the product easily after evaluation of the costs and the expected returns. The price is uniformly applied to all consumers. However, Maurice & Thomas (2008, p. 563) note that simple pricing decisions have a major limitation of creating a consumer surplus for every unit sold while reducing the producer surplus. Due to this limitation, organizations came up with price discrimination.
Price discrimination as defined by Maurice & Thomas (2008, p. 563) is a situation in which a firm charges different prices to different consumers consuming a similar product and for the reason of capturing consumer surplus and transforming it into profit. Price discrimination is the solution to uniform pricing because it captures some of the consumer surpluses that are created by uniform pricing. Consumers can be separated into different groups based on their elasticity of demand. Price discrimination occurs under certain conditions such as the same product must be sold at different prices and all costs incurred must be the same for two products. Profitable price discrimination must occur under certain conditions. First, the firm must have some market power and the firm must be operating in a cost-efficient manner so that it can identify and separate submarkets (Mankiw, 2008, p. 329).
There are different types of price discrimination. First-degree price discrimination, second-degree price discrimination, and third-degree price discrimination. The discrimination that is common with credit cards is third-degree price discrimination. Third-degree price discrimination involves the identification and separation of submarkets amongst the consumers (Mankiw, 2008, p. 330). Each subgroup of consumers is charged a different price for the same product. Third-degree price discrimination does not haggle over the prices to capture the whole consumer surplus. Due to this haggling, some of the consumers end up keeping some of their consumer surpluses. Third price discrimination does not rely on self-selection to generate price differences. Firms can identify consumers in their different submarkets and therefore successfully charge them different prices (Maurice & Thomas, 2008, p. 563).
In the credit card industry, banks and other organizations can easily group the consumers into poor and good credit subgroups based on the credit records of the consumers. Within the subgroups, organizations can charge different prices to different consumers based on individual consumer usage. This is possible because banks use self-selection to determine the price charges on different individual credit card consumers. By using third-degree price discrimination, credit card companies are able to recover the consumer surplus and convert it to profit (Maurice & Thomas, 2008, p. 581). In addition, grouping credit card consumers into poor and good credit subgroups and charging them different prices discourages consumers from a poor credit to become good credit customers so that they can increase their consumer surplus. Despite the different prices charged by credit card companies to capture consumer surplus, some consumers with good credit records still have their consumer surplus. In conclusion, companies are able to charge high prices for poor credit customers and low prices for good credit customers in order to maximize the consumer surplus.
Mankiw, G. (2008). Principles of Microeconomics. 5 Ed. Florence, KY: Cengage Learning.
Maurice, S. & Thomas, C. (2008). Managerial Economics. 9 Ed. New York, NY: McGraw-Hill.