Third-Degree Price Discrimination

Third-degree price discrimination is a pricing strategy businesses use to maximize their profits by charging different prices to different groups of customers based on their willingness and ability to pay. This strategy aims to capture as much consumer surplus (the difference between what consumers are willing to pay and what they pay) as possible while still selling products or services in a competitive market.

Firms aim to identify and segment their customer base into distinct groups based on age, income, location, or buying habits. By understanding these segments' preferences and price sensitivities, they can tailor their pricing strategies accordingly. Firms seek to set prices in a way that maximizes their total revenue.

• Third-degree price discrimination involves charging different prices to distinct customer segments based on their price sensitivity, willingness to pay, or other relevant characteristics.
• The primary goal is maximizing the firm's overall profit by tailoring prices to each customer segment's preferences and sensitivities.
• Effective market segmentation is crucial to identify and categorize customer groups with differing characteristics or behaviors.
• Businesses must implement measures to prevent customers from reselling or arbitraging products across segments, which could undermine the pricing strategy.

Third-degree price discrimination, or multi-segment pricing, is an economic concept and pricing strategy businesses employ to charge different prices to distinct groups or segments of customers for the same product or service. The primary aim is to extract as much consumer surplus as possible while maximizing the firm's profit.

Third-degree price discrimination can be traced back to the pioneering work of economist Arthur Pigou in the early 20th century and was further developed by economists such as John Hicks and Joan Robinson. It gained prominence as firms sought more sophisticated pricing strategies in the face of increasing competition. The term "third-degree" denotes the separation of customers into three or more distinct market segments.

How it Works:

1. Market Segmentation: Firms analyze their customer base to identify different segments based on characteristics like income, age, location, or buying habits. These segments exhibit varying levels of price sensitivity.
2. Price Discrimination: Prices are set differently for each segment, often based on their willingness and ability to pay. Customers with a lower price sensitivity are charged higher prices, while more price-sensitive customers receive lower prices.
3. Maximizing Profit: The goal is to maximize overall profit by capturing surplus from each segment. In practice, this involves charging a higher price to the part with a lower price elasticity of demand (i.e., less responsive to price changes) and a lower price to the segment with a higher elasticity of demand.
4. Arbitrage Prevention: To make third-degree price discrimination work effectively, firms may implement measures to prevent customers from arbitraging or reselling products across segments. This can include restrictions, memberships, or location-based pricing.
5. Revenue Optimization: Through this strategy, firms can optimize their revenue, increase their market share, and enhance competitiveness by catering to the diverse preferences and price sensitivities of different customer groups.

Third-degree price discrimination is contingent upon several conditions for its successful implementation. These conditions are essential for firms to effectively charge different prices to distinct customer segments while maximizing their profit:

1. Identifiable Segments: The firm must be able to identify and separate its customer base into distinct segments based on relevant characteristics. Effective segmentation is the cornerstone of this pricing strategy.
2. Segment Price Elasticities: Each customer segment should have a different price elasticity of demand, meaning their responsiveness to price changes varies. Some segments should be less price-sensitive (inelastic demand), while others should be more price-sensitive (elastic demand).
3. Market Power: The firm must possess some degree of market power, allowing it to influence prices. Price discrimination is challenging in a competitive market because firms are price takers.
4. Preventing Arbitrage: Effective mechanisms must be in place to prevent customers from exploiting price differences between segments. This may involve enforcing restrictions or conditions, such as limiting product resale, requiring memberships, or geographically separating markets.
5. No Inter-Segment Resale: Customers from one segment mustn’t resell products or services to customers from another part. This would undermine the discrimination strategy.
6. Cost Structure Variation: The firm should have different cost structures for each segment. Charging higher prices to lower or higher-cost segments can help maximize overall profit.
7. Consumer Knowledge: Ideally, consumers should be unaware of segment price differences. Informational asymmetry can help maintain the effectiveness of price discrimination.
8. Legal and Ethical Considerations: Firms must ensure their pricing strategies comply with legal and ethical standards. Some forms of price discrimination may be prohibited in certain jurisdictions, particularly if they lead to unfair or anticompetitive practices.

Let us explore it better with the help of examples:

Example #1

Imagine a fictional theme park called "Adventure World" that practices third-degree price discrimination. Adventure World identifies three distinct customer segments based on age: children (under 12), adults (between 12 and 65), and senior citizens (65 and older).

1. Children: Adventure World charges children a lower admission fee because they are generally more price-sensitive. The park offers special discounts and freebies, such as free ice cream or access to certain attractions, to make the experience more appealing to this segment.
2. Adults: Adults, the largest customer segment, are charged the standard admission price, which is higher than the children's rate but still affordable. They are offered various entertainment options and premium services, like fast-track access to popular rides.
3. Senior Citizens: Senior citizens, who are often on a fixed income, receive a senior discount. Adventure World offers them reduced admission fees and additional perks, such as complimentary shuttle services within the park.

By segmenting customers by age and tailoring prices and services accordingly, Adventure World maximizes its revenue while accommodating different customer groups' diverse preferences and price sensitivities.

Example #2

In 2019 Livraria Lello, a renowned bookstore in Porto, Portugal, effectively implemented third-degree price discrimination to enhance its business. By segmenting its customer base into distinct groups based on factors like age and residency, the bookstore charges varying prices to different segments. For instance, students and local residents enjoy discounted admission fees, while tourists pay a standard rate.

This tailored pricing strategy has increased revenue and improved the visitor experience. Local residents benefit from exclusive events, while tourists receive guided tours and multilingual services. Livraria Lello's success in leveraging price discrimination showcases the advantages of catering to diverse customer preferences and price sensitivities. It strengthens its financial position and contributes to preserving its cultural heritage by attracting visitors worldwide.

A digram depicting third-degree price discrimination typically illustrates how a firm sets prices for different customer segments to maximize profit. This pricing strategy involves charging different prices to distinct groups of customers based on their price sensitivity or willingness to pay. Here's how the graph works:

Axis Definitions:

1. Quantity (Q): The quantity of goods or services the firm sells. This is typically measured on the horizontal (x) axis.
2. Price (P): The price charged to customers. This is usually measured on the vertical (y) axis.

Graph Components:

1. Demand Curves: In third-degree price discrimination, multiple demand curves represent different customer segments. Each demand curve shows the relationship between the price charged (P) and the quantity demanded (Q) for a specific customer segment. These demand curves typically slope downward from left to right, indicating that as the price decreases, the quantity demanded increases.
2. Marginal Revenue (MR) Curves: Alongside each demand curve, there is a corresponding marginal revenue curve. Marginal revenue represents a firm's additional revenue from selling one more product unit.
3. Optimal Price and Quantity: The profit-maximizing point for each customer segment occurs where the marginal cost (MC) curve intersects the corresponding MR curve. At this point, the firm sets the price (P) and quantity (Q) that maximize profit for that particular segment. The prices charged to each segment will vary, with the least price-sensitive segments paying higher prices and the most price-sensitive segments paying lower prices.
4. Total Revenue and Profit: The firm's total revenue is the product of the price (P) and the quantity (Q) sold to each customer segment. The total profit is the difference between total revenue and total cost.

Here's a representation of the advantages and disadvantages of third-degree price discrimination:

Here's a comparison of first degree price discrimination, second degree price discrimination, and third-degree price discrimination:

This article has been a guide to what is Third-Degree Price Discrimination. We explain its examples, conditions, & comparison with first-degree price discrimination. You may also find some useful articles here -

• Price Stability
• Law of One Price
• Price Transparency