Direct price discrimination arises when the market can be segmented into sub populations on the basis of readily observable characteristics. Each of the segments has a different elasticity of demand and subsequently is charged a different price. Arbitrage must be prevented for this type of discrimination to be applicable. Profits are maximized by equating the marginal revenue from the two consumers for the same marginal cost.
Indirect price discrimination arises when a seller cannot observe the buyers characteristics, and hence cannot determine the optimal price to charge the buyer relevant to their demand elasticity. The seller offers different kinds of services or differential pricing and lets the consumers choose as per their preference with hopes to segregate the high class consumers from the low. The pricing technique developed to induce the high class consumer to reveal themselves must satisfy the incentive compatibility constraint.
When facing two types of consumers, ideally a firm would like to charge the maximum it can to both types. However, if the firm is unable to segregate the consumers based on quality or demand preferences, pricing products for the consumers becomes relatively difficult. Firms engaging in pricing only catering only to one group will not be able to maximize its profits thereby loosing sales to the other group. The high quality/ more inelastic elastic (rich) consumer can exercise personal arbitrage and to pretend to be a low quality/ more elastic (poor) consumer if the option is viable, thereby concealing their identity and preventing the firm from maximizing profits.
The rich consumers will never overtly display their preference and hence need to be induced to reveal themselves. If there is not much value realized for the high quality good in comparison with the lower quality, the rich...