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Price discrimination
University tuition fees
William Bohanna discusses whether a university can practise third-degree
price discrimination with the new fee structure
There has been much controversy over
the government’s plans to lift the cap on
university tuition fees. Ministers have voted
to allow universities in England to charge
tuition fees up to £9,000 per year. Following
recommendations by Lord Browne — who
led the independent review of higher education
funding — this measure comes in light
of budget cuts to aid the national economy
and UK budget deficit. However, has the
government made the market for university
education more accessible to practise thirddegree
price discrimination?
As economics students, it is always good
to question the way in which price discrimination
can be carried out in various
markets, and as such whether the market
for higher education could practise price
discrimination.
What is price discrimination?
When a firm has power over a market (a
degree of monopoly power), it may be able
to increase its total profits by charging different
prices for the same good or service
in different markets. This is known as price
P
a
p
0
Figure 1 Consumer surplus
e
S
D
Q
discrimination, which is selling the same
product or service at different prices in situations
where such differences do not result
from differences in costs.
Price discrimination can take advantage
of the concept of consumer surplus.
Consumer surplus is the difference between
what a consumer is willing to pay for a
good or service and the price they actually
pay. It represents the excess, or surplus,
Consumer surplus = ape.
The demand curve represents what people are willing to pay
for a good. It represents their valuation of the satisfaction that
they will receive from the consumption of the good. As each
person is different some will value the same good differently.
P is the equilibrium or market price. It is what all consumers
must pay if they want this good. However, there are some
people who would have been willing to pay more (a to e on
the demand curve). These individuals will experience consumer
surplus, i.e. excess benefit over and above what they have paid
for. The total of all these individual consumer surpluses is equal
to the area ape between the demand curve and the price line.
8 Economic Review

P
Q 2
0
Q 1
Q
Where one price is charged (P 1
):
a
Consumer surplus is P 1
ab
Revenue is 0P 1
bq 1
P 2
c
When price discrimination occurs (P 1
and P 2
prices):
Consumer surplus is P 2
ac (P 2
) and ceb (P 1
)
P 1
e b
Revenue is 0P 2
cQ 2
(P 2
) and Q 2
ebQ 1
(P 1
)
D
Figure 2 Price discrimination
satisfaction derived from the purchase over
and above what has been paid for (Figure 1).
Price discrimination occurs due to the
downward sloping nature of the demand
curve — there are always some people who
are willing to pay more for a good or service
than others.
Firms tend to charge one price — the
equilibrium price. As a result, a lot of people
buy goods and services at prices below that
which they are willing to pay. Price discrimination
is a method that firms use to appropriate
all or part of this consumer surplus in
the form of revenue.
Figure 2 shows how the practice of price
discrimination allows for an increase in
revenue of the price discriminator and an
appropriation of consumer surplus. Any
private sector firm would enjoy this situation,
as the potential for increasing profits
is very motivating. This could readdress the
funding problems that struggling universities
have faced for many years.
According to theory, there are three levels
of price discrimination that a firm could
follow.
First-degree price discrimination: this
is where firms persuade all consumers in the
market to reveal the price they are willing to
pay. Here, the firm would be appropriating
the entire consumer surplus — by looking
at the particular point on the demand curve
corresponding to each individual. This
could not be used in the higher education
market, as it would mean each student effectively
bidding for their place. This would be
time consuming and would favour richer
students, so it tends to occur only where the
market is very small — sealed bid auctions,
for example.
Second-degree price discrimination:
this is where the firm sells different quantities
of a good at different prices to the same
consumer. Or, consumers pay different
September 2011
prices based on their consumption level.
This could not occur in the higher education
market because the quantities for a degree
are roughly the same, but it does occur in
energy markets — high-level consumers,
such as firms, may be charged different
prices per unit compared to small users,
such as households.
Third-degree price discrimination: this
is where the firm sells identical products at
different prices to different groups of consumers
(known as market segments). The
following list shows how a market can be
segmented:
■■
Time — peak and off-peak prices
(airlines and rail companies)
■■
Age — lower fares for children, students
and OAPs on buses and trains
■■
Location — bus companies often charge
different prices in different parts of the
country
■■
Income — people on low incomes can
often get concessionary fares
Practising price discrimination
Could the higher education market practise
third-degree price discrimination if it met
certain conditions? There are four conditions
that must be met for third-degree price
discrimination to occur:
1 The firm must be a monopolist — if there
are other firms in the market then they can
undercut the high price and take away customers
from the price discriminator.
2 The monopolist must be able to split
the market into easily distinguishable and
distinct groups of buyers, otherwise how
can it tell who is willing to pay a high or a
low price?
3 The monopolist must be able to keep
the market segments separate at a relatively
low cost. This avoids arbitrage — where
buyers in low-priced segments undercut the
monopolist by reselling the product in the
high-price segment at a lower price. If the
costs of keeping the markets separate are
high then this will negate the extra revenue
earned from the high-priced segment.
4 Each market segment must face different
demand curves, i.e. the elasticity of the
buyers must differ — if it were the same the
monopolist could not charge different prices.
For a university to practise third-degree
price discrimination, these conditions must
be met.
Meeting the conditions
1 The university as a monopolist? The
university offering degree programmes from
their institution is effectively a monopolist
for that set of degree programmes, as no
other university can offer this degree from
this institution. Therefore, the university
has monopoly power over its degree programmes.
Other universities will be offering
similar courses but if you want to do the
degree at a certain university then you have
no choice, and as such the university has
gained a monopoly power.
2 Can the university split the market
into distinct groups of buyers? The
answer to this condition effectively occurs in
the UCAS application system. For example,
a university could offer an economics with
mathematics degree and an economics with
Latin American studies degree. Depending
on the number of applicants that each
degree course attracts, the university has two
groups of buyers. Therefore, the university
can easily split the market and applicants
into distinct groups of buyers: economics
with mathematics applicants and economics
with Latin American studies applicants. This
means that the university has two groups of
buyers for a degree from their university.
3 Can the university keep the different
market segments separate at a relatively
low cost? Again the answer to this condition
occurs in the UCAS application system.
As this is an online system, the university
can keep these two markets of economics
with mathematics applicants and economics
with Latin American studies applicants
separate at little or no cost because this
market does not interact on a face-to-face
level, and covers the whole globe in terms of
applications.
4 Does each market segment face
different demand curves? Effectively yes,
if we assume that we have the two different
markets for degree programmes at a
university of economics with mathematics
9

ZOE/FOTOliA
Rail travel is subject to third-degree price
discrimination
applicants and economics with Latin
American studies applicants, then it would
be fair to say that each market segment
could face a different elasticity of demand.
Economics with Latin American studies
applicants face inelastic price elasticity of
demand (PED) (due to this being a more
unique combination with a fewer amount of
substitutes) and the economics with mathematics
applicants face a relatively elastic
PED (due to this being a more common
combination with a large amount of substitutes).
How would this work?
Let us assume a monopolist at a particular
university (Figure 3). There are two clearly
definable market segments:
Economics and
mathematics applicants
■■
Economics with Latin American studies
applicants. This will have inelastic PED.
■■
Economics with mathematics applicants.
This will have elastic PED.
The segments are easy to keep apart, as
it is difficult to transfer or change an applicant’s
preference for a university place.
For each segment we can identify the
demand curve (AR) and therefore the MR
curve. If the two segments were aggregated,
then the market demand curve would be
produced. On the market diagram, we can
draw the cost curves — which are the same
in each market segment (by definition price
discrimination does not arise due to cost
differences).
The university maximises profits at Q M
where MC=MR. If the university was to
Economics and Latin American
studies applicants
charge a single price, marginal revenue
would be lower for economics with Latin
American studies than for economics with
mathematics, so it would increase profits
if the university was to charge a higher
price (P P
) and take fewer economics with
Latin American studies applicants and take
more mathematics applicants at a lower
price (P O
) where MR is equalised for the
two groups. This would be with Q o
mathematics
and Q P
Latin American applicants.
Notice that:
Q M
= Q O
+ Q P
If we extend the line showing the output
level in each segment up to the AR or D
curve, then we can read off the price for that
segment. Notice the economics with Latin
American studies applicants segment has
Total market
Price
Supernormal profits
Price
Price
MC
AC
P P
P O
AC
MR
MR O
AR O
MR
AR P
MR
AR
Q O
Quantity of places
Q P
Quantity of places
Q M
Quantity of places
Figure 3 Price discrimination with two market segments
10 Economic Review

higher prices (and more inelastic demand)
than the economics with mathematics
applicants segment.
The line showing the level of AC can also
be extended across the segments, as by definition
price discrimination does not arise
due to cost differences. From this we can
determine the level of supernormal profits
in each segment.
If the elasticities were the same in each
segment the demand (AR) curves would
be the same and therefore MR, prices and
profits would also be the same.
Conclusion
By reviewing these conditions, it would be
possible for a university to practise thirddegree
price discrimination. However,
the government has stated that in order
for a university to charge a higher price it
must meet certain conditions. Universities
wanting to charge more than £6,000 would
have to undertake measures — such as
offering bursaries, summer schools and
outreach programmes — to encourage
students from poorer backgrounds to apply.
Therefore, this would alter the nature of the
degree course and so would differentiate the
service and not meet the definition of price
discrimination.
In addition, there is the central problem
of university fees being inequitable for
poorer students and universities minister
David Willetts has said that universities will
only be allowed to charge fees of £9,000 in
‘exceptional circumstances’, for example if
they had high teaching costs or if they were
offering an intensive 2-year course.
Universities charging more than £6,000
will have to commit to ‘access agreements’,
negotiated with the Office For Fair Access
(Offa), to commit them to programmes to
recruit students from poorer backgrounds.
Therefore, the final answer to the question
of whether a university could practise
price discrimination is quite simply no,
but this does not mean that they would not
want to. The age-old problem facing universities
and the government is that demand for
university places outreaches supply causing
a shortage, so perhaps these increased fees
are a way of dealing with that shortage in
order to reduce demand? Either way, universities
will not be able to take advantage of
this measure in the form of price discrimination
and its revenue generating benefits.
Review notes
1 The new system for funding higher
education through student tuition fees
has caused widespread consternation and
controversy.
2 Price discrimination can take place in
markets that have certain characteristics. It
involves setting different prices to different
consumers for what is substantially the
same product.
3 Firms that practise price discrimination
are able to increase their profits at the
expense of consumer surplus.
4 There are different levels of price
discrimination possible, depending on the
characteristics of the market.
5 If the price elasticity of demand differs
for some university programmes then there
may be scope for price discrimination to
be used, although the conditions imposed
on universities wanting to charge a price
above £6,000 may make it more difficult to
implement.
See EconomicReviewOnline for an
update on this market and a video
relating to Figure 3. £
William Bohanna is head of economics and
business studies at the British School of Brussels.
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