Monopoly - Price Discrimination

Topic: Monopoly - Price discrimination

Third degree price discrimination

The purpose of price discrimination is to increase the total revenue and profits of the one who is supplying the product or service. This strategy helps them to get rid of excess capacity and also to take market share away from competitors. There are certain conditions required for the third degree price discrimination to take place. First, the firm must have some kind of monopoly power (price setting power). Second, the firm must be able to split the market into different groups of consumers (separation of the market) either by geography, time or income. It is important that the producer prevents the good or service of being resold between costumers, because if the opportunity of reselling at a lower price to someone who has the ability of paying a higher fare exists, the power could be lost. Of course, controlling this scenario is much easier in the provision of services rather than in goods.

The third condition consists in the importance of the existence of different price elasticity of demand for de product/service in each group of consumers, allowing the firm to charge a higher price to consumers that have a relatively inelastic demand and charge a lower price to those with a relatively elastic demand. This will permit the firm to be able to extract more consumer surplus, leading it to additional revenue and profit. One must be careful to distinguish between discrimination based on consumer's willingness to pay, and product/service differentiation, case in which price differences could also reflect a different quality or standard of service.

If third degree price discrimination is viable, how should the firm decide the price to be charged to each consumer group? By following the next steps:

1. We know that, regardless of the quantity produced, the total production should be divided among the groups of customers so that marginal revenues are identical for all. Otherwise, the company would not maximize profits. For example, if we have two groups of customers and the marginal revenue of the first group is greater than the one of the second, the company could clearly get better results by transferring production of the second group to the first, by lowering the price charged to the first group and raising the price charged to the second group. Therefore, income must be such that the marginal revenues of the different groups are identical.

2. We know that total output must be such that the marginal revenue of each group of consumers equals the marginal cost of production. Again, if not, the company could make more profit by increasing or decreasing the total production (and lowering or raising their prices to the two groups). Supposing, for example, that the marginal income of consumer groups is equal, but that the marginal