Third—degree price discrimination

17 November 2008

1 Definition
• Third degree price discrimination refers to the situation where the firm charges
different groups of consumer different prices.

• For example, the franchise bus companies charge elderly and school—age passen-
gers lower fares than others. Textbooks are sold at different prices in different
countries. Cable-TV charges a higher tariff to Karaoke restaurants than private
households. PCCW charges businesses a higher tariff than private households.
The universities in the HK charge non-local students higher tuitions than local
students.

2 Conditions for third degree price discrimination

• When the firm does not have enough information to identify each customer’s de-
mand and determine what each one is willing to pay, it is unable to practice first
degree (perfect) price discrimination. The firm may have, however, enough in-
formation to imperfectly price discriminate. It can practice third degree (group)
price discrimination if it can determine whether a particular customer belongs
to one group rather than another where the demand elasticities for the aggregate
demand curves of the two groups differ.

• If it is possible to prevent resales between the two groups, and if the firm knows
the aggregate demand curve of each group, then it is profitable to set different
prices for the two groups.

• In all the examples given above, identifying which group a customer belongs to is
rather obvious. Sometimes, it may be necessary to use more sophisticated means
to sort customers into different groups in situations where the information is
not readily discernible.

1
 • Consider airlines. Business travellers usually are willing to pay more than people
travelling for leisure. But a customer will not walk into the airline office with a
label stuck on her head telling whether she is a business traveller or a vacation
traveller! How can then the airline identify which group she belongs to? A
common practice in the industry is to charge higher fares to customers buying
tickets on a short notice and lower fares to customers buying well in advance.
Since business travellers usually have to travel on a short notice, and people
travelling for vacation usually plan well ahead, such a pricing structure helps
sort customers into the appropriate group.
• Consider the software industry. Customers who already own an older version
of a software usually pay a lower price for the new version (upgrades) than
customers buying the software for the first time. The demand for the latest
version of the software of the first group should be lower than the second group
since they can always fall back on the older version if the price of the upgrade
is excessive. Software companies price discriminate by identifying whether a
particular sale is an upgrade or a first-time purchase.

3 Elasticity of demand
• Suppose there are two groups of consumers, and the aggregate demand curves
of the two groups are given by
q = D1 (p) ,
q = D2 (p) .

respectively. If the firm can practice third degree price discrimination, it will
charge different prices in the two markets to maximize profit:
max {(p1 − c) D1 (p1 ) + (p2 − c) D1 (p2 )} . (1)
p ,p
1 2

• The usual condition for profit maximization that the firm should sell up to
where marginal revenue is equal to marginal cost applies to each market:
M R1 = c,
(2)
M R2 = c.
• Recall that marginal revenue can be written as
µ ¶
1
MR = p 1 + ,
ε
where ε is the elasticity of demand. Applying this condition to (2) :
³ ´
1
p1 1 + ε1 ´
= c,
³ (3)
1
p2 1 + ε2
= c.

2
 Figure 1: Inefficiency of third—degree price discrimination

• These formulae imply that the firm will charge the group with a lower demand
elasticity a higher price than the group with a higher demand elasticity. This
makes sense. The group with a lower demand elasticity is less sensitive to prices.
That is, they will cut back purchase less with the same price hike. Naturally,
they firm should charge them a higher price to maximize profit. Notice that so
long as the demand elasticities are different, there is room for the firm to price
discriminate between the two groups. And the profit must rise above the profit
that may be earned when the firm is restricted to sell at a uniform price across
the two markets. To see this, note that in the profit—maximization defined in
(1), the firm is always at liberty to charge the same price across the two markets
by setting p1 = p2 . That it chooses to charge two different prices implies that
there must be greater profits to be earned in doing so.

4 The (in)efficiency of third degree price discrim-

ination
• Unlike perfect price discrimination, third degree price discrimination in general
does not attain first best efficiency. First the wedge between the market price
and marginal cost that distorts the output level in a single—price monopoly
away from PO remains with third degree price discrimination. This can be seen
from the conditions in (3) , which imply that the price for each group is above
marginal cost.

• In fig.1, the firm chooses a single price to maximize the profit in each market,
resulting in the usual output deviation from the efficient level where P = M C.

3
 The first best allocation is only attained when output is expanded all the way
up to q1∗∗ and q2∗∗ in markets 1 and 2 respectively.

• There is a further inefficiency arising from consumers in the two markets being
charged different prices. To understand why it is inefficient for the consumers
in the two markets to pay different prices, recall that the price on the demand
curve is how much consumers in the market is willing to pay for the last unit.
Suppose we have p∗1 = 10 and p∗2 = 8. This means that the last consumer in
market 2 can sell a unit of the good at a price above $8 but below $10 to the
last consumer in market 1, making both consumers better off. The assumption
in third degree price discrimination is such that these kinds of resale cannot
take place. The situation of course violates efficiency.

• While third degree price discrimination is definitely not efficient, is it an im-

provement over a single-price monopoly? Since there is an added inefficiency
in third degree price discrimination over a single—price monopoly, the former
must be less efficient than the latter, other things equal. Third degree price
discrimination may only improve upon the single—price monopoly if the aggre-
gate output level of the former is above the level of output in the latter pricing
schemes.

• The output expansion moves the output level closer to the efficient output level,
which is certainly an improvement in efficiency. If output expands sufficiently,
the associated efficiency improvement may overwhelm the inefficiency arising
from consumers in the two groups being charged different prices. Then third
degree price discrimination represents an improvement over the single—price
monopoly.

• In short, a necessary (but not sufficient) condition for third degree price dis-
crimination to improve upon the single—price monopoly is that an expansion in
aggregate output.

• One would tend to think that, as in first degree price discrimination, aggre-
gate output in third degree price discrimination must rise above the single—
price monopoly output level. This apparently intuitive conjecture is not correct
however. First note that if the firm is restricted to charge a single price, the
profit—maximizing price will lie between the two prices in third degree price
discrimination.1 This means that compared to the single—price monopoly, there
will be a higher price in the group with less elastic demand and a lower price in
the group with the more elastic demand. Therefore, there will be a lower output
in the first group and a higher output in the second group, and the aggregate
output in third degree price discrimination need not be higher.
1
Why?

4
 • In fact, it can be easily shown that if the demand curves are linear as in

p = G1 − g1 q,
p = G2 − g2 q,

and the marginal cost is constant at some c, the aggregate outputs in the two
pricing schemes are identical.2 In this case, third degree price discrimination
must be less efficient than the single—price monopoly, with the sum of consumer
surplus and the firm’s profit lower in the former than in the latter.

2
You are asked to show how this is the case.