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You book a flight six weeks out and pay $320. Your seatmate booked last night and paid $590. You both fly in identical seats on the identical plane. The airline didn't set one price — it set thousands of prices, dynamically calibrated to each buyer's timing, flexibility, and inferred willingness to pay. This is third-degree price discrimination operating at industrial scale, and it's what makes airline economics work. The same logic appears in software tiers, student discounts, pharmaceutical pricing across countries, and coupons — any market where a seller can separate buyers by their willingness to pay and prevent them from reselling to each other.
In plain terms
Price discrimination occurs when a seller with market power charges different prices to different buyers for the same (or nearly identical) good, based on differences in their willingness to pay. Three preconditions are required: the seller must have market power (some control over price), the ability to identify or separate buyers by their valuations, and the ability to prevent arbitrage (buyers at the lower price reselling to buyers at the higher price).
First-degree price discrimination
(Perfect price discrimination): the seller charges each buyer exactly their maximum willingness to pay. Every unit of surplus is extracted from buyers; consumer surplus is zero. The seller produces the socially efficient quantity (because every unit where MB ≥ MC gets sold), so there is no deadweight loss. This is theoretically the most efficient form of discrimination even though it is the most extractive for consumers. Automobile dealerships and some professional service negotiations approach first-degree discrimination through individualized bargaining.
Second-degree price discrimination
The seller charges different prices based on quantity purchased or product version, not individual buyer identity. Volume discounts (price per unit falls with quantity) and versioning (software basic/pro/enterprise tiers, airline economy/business/first) are the main forms. The seller doesn't know each buyer's exact valuation — it creates a menu of options that buyers self-select into based on their own preferences and willingness to pay.
Software companies use versioning extensively — the FTC's technology market research documents how tiered pricing structures extract consumer surplus across segments with different willingness to pay.
Third-degree price discrimination
The seller charges different prices to identifiable groups (students, seniors, geographic markets, professional vs. consumer buyers) based on differences in price elasticity. Groups with more inelastic demand (less price-sensitive) pay more; groups with more elastic demand (more price-sensitive) pay less.
Pharmaceutical companies charge dramatically different prices for the same drug in different countries — the Congressional Budget Office's international drug pricing comparisons document the U.S. paying two to three times what comparable countries pay for identical brand-name drugs. This reflects third-degree price discrimination across national markets with different regulatory environments, income levels, and negotiating structures.
Why it matters
Price discrimination is not inherently illegal or inefficient. Third-degree discrimination can expand access (student discounts bring buyers into the market who otherwise couldn't afford it) and can increase total output. It does transfer surplus from consumers to producers, which is why regulators scrutinize its use in essential goods. The legal standard turns on whether the discrimination forecloses competition (illegal under antitrust law) or simply exercises existing market power (generally legal).
