Third-Degree Price Discrimination under Monopoly

Price discrimination is a pricing strategy that allows businesses to charge different prices to different customers for the same product or service. Among the various forms of price discrimination, third-degree price discrimination is one of the most commonly used strategies. This article will clarify the definition, provide specific examples, and discuss the implications of third-degree price discrimination, helping you grasp this pricing approach.

Definition of Third-Degree Price Discrimination

Third-degree price discrimination happens when a company charges varying prices to different groups based on how much they are willing to pay. This strategy relies on the understanding that different customer segments are affected by price in different ways. By recognizing these differences, businesses can increase their profits by charging lower prices to those who are more sensitive to price and higher prices to those who can afford to pay more.

Real-Life Examples of Third-Degree Price Discrimination

Student Discounts

A common example of third-degree price discrimination is student discounts. Many businesses, including movie theaters, software providers, and restaurants, offer discounts to students. These discounts aim to attract a group known for having limited financial resources. Research shows that around 20% of students report seeking out businesses that provide discounts. By catering to this demographic, businesses can expand their customer base while still charging full price to more affluent customers.

Senior Citizen Discounts

Similarly, numerous businesses extend discounted prices to senior citizens. This strategy acknowledges that many seniors live on fixed incomes and may be more sensitive to price changes. Offering discounts encourages loyalty among this group, fostering repeat visits. According to studies, about 70% of seniors consider discounts an important factor when choosing where to shop.

Geographic Pricing

Geographic pricing is another form of third-degree price discrimination. Companies might set different prices based on the consumer's location. For instance, a coffee shop may charge $5 for a latte in a city with higher living costs while setting the price at $3.50 in rural areas. This approach allows businesses to tailor their prices to meet local demand and income levels effectively.

Airline Pricing

Airlines often utilize third-degree price discrimination when pricing tickets for the same flight. For example, a business traveler who books a last-minute flight may pay up to 70% more than a leisure traveler who books well in advance. On average, travelers who book their tickets at least 21 days ahead save about 15% compared to last-minute bookers. This strategy allows airlines to capture revenue from various market segments, maximizing their income.

A Closer Look at Third-Degree Price Discrimination

The success of third-degree price discrimination depends on accurately identifying and segmenting customers. By understanding the specific needs and price sensitivities of different groups, businesses can customize their pricing strategies. To make third-degree price discrimination successful, a few conditions must be present:

Identifying Market Segments

To effectively implement third-degree price discrimination, companies must first identify distinct market segments. This process may involve market research, customer surveys, and studying purchasing behaviour. With clear segments defined, businesses can then create targeted pricing strategies that meet the unique needs of each group.

Setting Prices

Once market segments are established, companies need to set appropriate prices for each group. This requires analyzing factors such as demand elasticity, competitor pricing, and the perceived value of the product. Research indicates that businesses can boost revenues by as much as 25% by optimizing prices according to customer willingness to pay.

Preventing Resale

A crucial component of third-degree price discrimination is the ability to limit or prevent the resale of products among different customer groups. If consumers can buy discounted products and resell them to those who do not qualify for discounts, it undermines the strategy's effectiveness. Businesses can address this by implementing verification processes, such as requiring student IDs or senior citizen cards for discounts.

Graphical Illustrations

Suppose a monopolist sells a product in two separate markets (market 1 and market 2) with different demand elasticities. Demand curves for the markets are given as follows - Market 1 Demand: P₁=20−2Q₁ and Market 2 Demand: P₂=16−Q₂. Further assume the Marginal Cost (MC) is constant at ₹4. Illustration is given in the graph below.

Graphical Illustration of Third-Degree Price Discrimination. Remember slope of Demand Curve is half of the slope of MR curve.

             We know monopolist's profit maximization condition is MR=MC. Now if the monopolist wants to set different prices in each market according to the sensitiveness to prices (that are reflected by the demand curves) of the consumers, it will follow the following conditions:

• At Market 1: TR₁ = P₁ × Q₁ = (20−2Q) × P₁

  MR₁ = 20−4Q₁ = MC = 4

  Or, 20−4Q₁ = 4

  Or, Q₁^* = 4

  Substituting Q₁^* in the equation of MR₁ we get P₁^*=12.

• At Market 2:  TR₂ = P₂ × Q₂ = (16−Q₂) × P₂

  MR₂ = 16−Q₂ = MC = 4

                         Or, 16−2Q₂ = 4

                         Or, Q₂^* = 6,

                         Substituting Q₂^* in the equation of MR₂ we get P₂^*=10.

             This means the monopolist charges ₹12 in Market 1 and ₹10 in Market 2 — reflecting the difference in prices based on willingness to pay.

Implications of Third-Degree Price Discrimination

Although third-degree price discrimination can enhance profits, it comes with important implications businesses must consider.

Increased Revenue

One of the main advantages of this pricing strategy is the potential for higher revenue. By charging different prices to various segments, companies can capture more consumer surplus. Industries with significant fixed costs, such as airlines and technology firms, particularly benefit from this increased revenue stream.

Customer Segmentation

Implementing third-degree price discrimination prompts businesses to deepen their understanding of their customers. By segmenting customers based on personal characteristics and preferences, companies can customize their marketing approaches. This, in turn, leads to improved customer satisfaction and better-targeted product development.

Ethical Concerns

Despite its advantages, ethical issues can arise. Many consumers perceive it as unfair for companies to charge different prices based solely on demographic factors. Businesses must manage these perceptions carefully to maintain a positive brand image and foster customer trust.

Legal Considerations

In some regions, price discrimination might face legal challenges. Companies need to ensure their pricing strategies comply with relevant laws to avoid issues. This precaution is particularly critical in highly regulated sectors, including telecommunications and utilities.

Final Thoughts

Third-degree price discrimination allows businesses to maximize profits by setting different prices for various consumer segments. By better understanding its definition, real-life examples, and implications, businesses can make informed decisions to boost their profitability while meeting their customers' diverse needs.

             As markets evolve, effectively using third-degree price discrimination will continue to be a powerful tool. By focusing on market segmentation, pricing strategies, and ethical considerations, businesses can leverage this approach for sustainable growth.