The concept of price discrimination is a well-defined concept in microeconomics. In fact, the theory explains the pricing mechanism where one supplier among different buyers transacts similar good or services at differing prices. In essence, the model is applied depending on the willingness of the buyers to pay as well as their demand elasticity. Therefore, instead of the manufacturing firm selling a given quantity of goods or services at one price across the market, the supplier offers different prices to the various consumers. It is worth noting that certain conditions apply under the price discrimination theory. Firstly, the supplying firm must set the price of their commodities or services across the different market segments. Secondly, the firm has to fragment the market into different groups depending on the respective demand elasticity, as well as their willingness to pay at the set prices. Finally, the supplier must ensure that the resale of the sold products in another market is prohibited. While the conditions would appear challenging to realize, price discrimination has been a common phenomenon in nearly all markets involving automobiles, movies, utilities, and airline tickets among other areas. Therefore, it will be noted that monopolists employ the theory of price discrimination as influenced by the price elasticity of demand, as well as the concept of varying price discrimination as explained by first, second , and the third-degree price theory and their differences in microeconomic.
First Degree Price Discrimination
The first degree of price discrimination is also referred to as the perfect price discrimination where the selling firm charges the maximum amount based on the buyer’s willingness to pay. Therefore, the supplier should determine with precision the maximum price a buyer would be willing and able to pay for the goods or the services (Escobari and Paan 4). Particularly, the position is well reflected by the demand curve shown below.
Figure 1: First-degree price discrimination
Therefore, as is the case with all other kinds of price discriminations, the firm chooses an optimal point of production where marginal revenue equals the marginal cost (MR=MC). However, whenever the firm can have the buyer pay the maximum of the willingness, then the marginal revenue becomes the price as dictated by the demand curve. Accordingly, the point where the MC crosses the demand curve becomes the price that the firm sells the product. At this point, the firm realizes no consumer surplus because all the consumers would be willing to buy at the maximum price. (Bergemann and Stephen 922). Accordingly, the firm extracts all surpluses as the output amount is at the efficient level as obtained at the perfect competition.
However, it is worth noting that for a firm to assess the maximum willingness to pay by all buyers, the process would be very expensive. Therefore, obtaining the first-degree price discrimination has been challenging to realize or implement. The best example of first-degree price discrimination is witnessed through the efforts of auctioneers to establish the maximum price a consumer would be willing to pay for a product.
Second Degree Price Discrimination
The second degree is also regarded as block pricing because the prices vary according to the quantities demanded. Accordingly, bulk buyers enjoy the advantage of relatively lower prices per unit bought. In essence, the second-degree pricing mechanism is often observed with the industrial customers where the bulk buyers realize higher discounts on their purchases (Weyl, Glen, and Michal 31). Another feature with the second-degree price discrimination is that the sellers are not in a position to differentiate between the different consumers. Therefore, the sellers will set prices that will force the consumers to differentiate themselves according to their preferences, especially through the non-linear pricing or quantity discounts (Bergemann and Stephen 922).
Accordingly, the supplier would be able to capture a large section of the market surplus and different groups of buyers. The application of the second-degree pricing mechanism is often found in the service industry where the quality and quantity would vary depending on the consumer preferences. For example, the airline industries often apply the second-degree discrimination of prices with the different classes of travel seats (Nicholson and Christopher 23). For instance, the first class passengers enjoy more privileges such as wines and beers while in the economy class; the passengers would only access juices.
In the second-degree price discrimination, the seller charges higher prices per unit for the fewer purchases and lower prices for the bulk purchases. In a similar manner to the first-degree price discrimination, the firms in the second degree have the production level at a point where the price charged covers all the marginal costs of the production (Bergemann and Stephen 922). The illustration below depicts a firm that charges different prices for one product. When the buyer decides to purchase Q0 quantity of the product, then the price becomes P0. Similarly, a higher quantity such as in Q1 would attract a much lower price such as at P1 hence depicting the second-degree type of price discrimination.
The diagram illustrated shows the dimensions of the second-degree discrimination of prices as studied in microeconomics.
Figure 2: Second-degree price discrimination
Third Degree Price Discrimination
The third type of price discrimination is unique in its ability to have the firm segment the market into separate divisions with each of the markets being defined by the unique characteristics of demand. Therefore, some of the markets would be least in the concept of price sensitivity (otherwise considered price inelastic) as compared to other markets where the quantity demanded depends more on the changes in price (price elastic) (Cowan 334). At times, the firm could note that by setting the price at P1 and selling Q1 quantity, in one market and then lowering prices at ‘P2‘ for the sale of Q2 in the second market, then the company would realize higher profits than selling at a single price P*.
Firms are known to attract the third-degree price discrimination by ensuring that the third parties do not interfere with the pricing mechanisms (O’Brien 92). Accordingly, the different markets would have to remain different and separate. Indeed, the third-degree price discrimination is also known to be the most frequent kind of pricing mechanisms that relates to the consumer’s willingness as well as the ability to pay for services and goods. However, the prices that are charged to the units of production fail to relate to the costs incurred in the production process, as is the case with the other kinds of price discrimination (Liu and Konstantinos 770). The geographical and time separation of the markets often applies in the third-degree discrimination of prices. For instance, when exporters sell products to overseas markets which are considered more inelastic, the prices charged may be higher than the prices in the local markets.
Another way of which the third-degree price discrimination is illustrated is through setting a two-part tariff policy for the consumers (Cowan 334). As such, the firm defines a fixed price while a supplementary price that is variable is imposed on the units consumed. Particularly, practical examples of such two-part tariffs are on the amusement park charges and taxi fares. Similarly, the discrimination would occur with varying the fixed charges set for the different market segments served and then varying the prices of the marginal units bought.
The graphical illustrations below show the varying elements of the third-degree price discrimination concept.
The Relationship between Prices set by the Monopolist and Price Elasticities of Demand
Among other conditions that are set to allow discrimination regarding prices is the differences in the demand’s price elasticity. Accordingly, every group of consumers would be expected to possess different demand price elasticity. Therefore, the monopolist sets the price at the highest level for the firm that indicates a more inelastic demand while charging relatively lower prices to the groups possessing a more elastic demand (Zhelobodko et al. 2765). The aim of the price discrimination is to allow the firm to realize the highest profit levels while increasing total revenues and lowering the production costs. In fact, such an objective is realized when the firm achieves a higher level of surplus as a producer. Besides, the firm ensures that the marginal revenue is set at the same level with the marginal cost for every market segment served to maximize the profits.
By definition, “price elasticity of demand” (PED) is an economic measure that indicates the responsiveness of quantities of goods or services to changes in the respective prices at ceteris paribus (Fitzgerald and Stefanie 762). Therefore, the value gives the percentage change in the quantities demanded while responding to a percentage change in the prices. It is worth noting that negative signs denote the price elasticity although the analysts might overlook the negative symbol. However, for the case of such commodities as the “Giffen” goods, the price elasticity recorded would be positive, as the kinds of products do not conform to the law of demand (Fitzgerald and Stefanie 762). In essence, the price elasticity of demand is of great fundamental while determining the effects of changing prices on the quantities demanded in particular market segments. Furthermore, the price elasticity determines the revenues collected by firms after applying price changes.
It is worth noting that the price elasticity of Demand (PED) can be defined as inelastic, elastic, perfectly inelastic, and perfectly elastic. For the elastic PED, the coefficient calculated is less than one. Indeed, when the coefficient is greater than one, the PED is said to be elastic. On the other hand, a zero coefficient indicates a perfectly inelastic PED while an infinite coefficient indicates a perfectly elastic PED (Zhelobodko et al. 2765). Consequently, the importance of the measure of PED in monopolistic markets is that it indicates the connection between prices and average revenues, marginal revenues and the total revenues, as well as the average revenue and marginal revenue. Moreover, the PED explains the reaction of the total revenue as output levels rises.
In a monopolistic market structure, the firms utilize product differentiation as a strategy to gain control of the market by adjusting the market prices. Specifically, the behavior of the monopolistic market can be understood by comparing it with the operations in the perfectly competitive market. In fact, a monopolistic market structure resembles what would be considered as a vertical adaptation of the perfect competition market (Tucker 15). The explanation given indicates that while a perfect competitive market depends on elastic demand, the monopolistic market relies much on a less elastic PED. However, a monopoly has the primary advantage of operating as the only controller on the market. Accordingly, the prices set by the monopolists have a critical relation with the price elasticity of demand. While some market segments served indicate higher rates of responsiveness to changes in the prices, there are other marketplaces that indicate minimal or no response at all (Tucker 15). However, one would appreciate that the levels of quantities demanded would be influenced by the respective changes in the corresponding prices. Therefore, when the monopolist applies the third-degree price discrimination by segmenting the industry, one market structure would be likely to realize higher quantities in sales while another would realize higher revenues. In essence, the monopolist would be influenced by the rate of responsiveness indicated by the consumers to price changes in determining the willingness and ability to pay for the commodities. Under those premises, the third parties are not allowed to interfere with the determination of price elasticity of demand, and therefore have no influence on the prices set.
The above discussion highlights the major elements distinguishing the first, second, and the third-degree price discrimination. Essentially, the common feature of the concept of price discrimination is the ability of the firm to charge different prices for similar goods and services to different buyers as influenced by the willingness and ability to pay. However, the pricing feature in the third-degree price discrimination depends on the price elasticity of demand. At times, the determined coefficient in PED would be termed as elastic, inelastic, perfectly elastic, or perfectly inelastic.