Third-Degree Price Discrimination

Third-degree price discrimination occurs when a firm charges different prices to different groups of consumers for an identical good or service, even though the costs of production are the same. The differences in prices arise because each group of consumers has a different price elasticity of demand (PED). The firm identifies which groups are relatively price elastic (more responsive to price changes) and which are relatively price inelastic (less responsive to price changes), and then sets higher prices for those with inelastic demand and lower prices for those with elastic demand. This enables the firm to convert a greater proportion of consumer surplus into producer surplus.

Conditions Required for Price Discrimination

For a firm to be able to practise third-degree price discrimination, three key conditions must be satisfied.

Firstly, the firm must possess some degree of monopoly power. This means that it must face a downward-sloping demand curve and therefore have the ability to set prices rather than being a price taker. Firms in perfectly competitive markets cannot discriminate because they must all sell at the prevailing market price.

Secondly, the firm must be able to separate the market into distinct groups of consumers. These groups could be based on observable characteristics such as age, occupation, geographical location, or time of purchase. For instance, cinemas can easily identify whether someone is a child, student, or pensioner, while train companies can segment between peak and off-peak travellers.

Finally, the firm must be able to prevent or limit resale, also known as “arbitrage,” between groups. If consumers who pay a lower price are able to resell the product to those who would otherwise face a higher price, price discrimination will collapse. For example, airlines prevent resale by linking tickets to the passenger’s name and identification.

In practice, firms split their consumers into at least two identifiable groups. One group will typically have relatively inelastic demand, meaning that these consumers are less sensitive to price changes and are therefore willing to pay more. Examples include business travellers who must travel at short notice regardless of price. The second group will usually have relatively elastic demand, meaning that these consumers are much more responsive to price changes. For example, students or leisure travellers are often more willing to adjust the timing of their travel to secure a lower price.

The firm sets a higher price for the inelastic group and a lower price for the elastic group. By doing this, it maximises revenue from each group separately. The logic is that charging a uniform price across all consumers would either miss out on revenue from the inelastic group (if the price is set too low) or exclude many elastic consumers who would otherwise have purchased at a lower price (if the price is set too high).

When drawing diagrams, it is important to show each consumer group separately. Each group has its own demand curve and corresponding marginal revenue (MR) curve. The firm equates marginal cost (MC) with marginal revenue in each sub-market to determine the profit-maximising price and quantity for that group.

The total quantity sold is the sum of the outputs across the groups. The price charged in each market is determined by the willingness to pay of that group, which depends on their elasticity of demand. This means that in diagrams, the relatively inelastic demand group will show a higher equilibrium price and smaller output, while the elastic demand group will show a lower price and larger output.

Real-World Examples

There are many real-world cases of third-degree price discrimination:

Transport: Train operators often charge higher fares to business commuters travelling at peak times but offer discounted fares to students or leisure travellers who travel off-peak.

Cinemas and Theatres: Ticket prices are commonly lower for children, students, and pensioners, but higher for adults during peak times.

Airlines: Advance-purchase tickets tend to be much cheaper than last-minute tickets, as business travellers usually book late and are less sensitive to price.

Advantages of Third-Degree Price Discrimination

One potential advantage is that it allows firms to increase total revenue. By capturing more consumer surplus, the firm’s profits can rise, which may in turn be used to finance investment, research, and development. This can create dynamic efficiency in the long run.

A second potential benefit is that total output is often higher than it would be under a uniform monopoly price. If the firm had to charge a single price, some consumers with elastic demand would be excluded. With price discrimination, the firm can serve these consumers at a lower price while still charging more to inelastic groups. This means that more people gain access to the good or service.

Thirdly, there may be equity-related arguments in favour of discrimination. For example, student discounts or lower prices for pensioners can make goods and services affordable for lower-income groups who would otherwise be priced out. This is particularly relevant in markets for education, transport, or cultural goods.

Disadvantages of Third-Degree Price Discrimination

The main disadvantage is that price discrimination often results in allocative inefficiency. In each market segment, the price charged typically exceeds marginal cost (P > MC), meaning resources are not allocated in a way that maximises total welfare. This leads to a deadweight loss.

There is also a concern about consumer exploitation. Inelastic groups, who may have fewer alternatives, are charged higher prices and therefore lose out. For example, business travellers have little flexibility and therefore pay significantly more.

In addition, there are administrative costs involved in enforcing market segmentation. Firms must spend resources on monitoring, identification, and preventing resale, which adds inefficiency to the system. Finally, equity concerns can arise if certain groups are unfairly excluded from lower prices. For instance, not all low-income consumers are students or pensioners, yet they may still be charged higher prices simply because they do not belong to a favoured category.

Evaluation and Exam Insight

A high-level evaluation must consider that third-degree price discrimination does not always reduce welfare. Compared with a single monopoly price, it can actually increase total output and allow more consumers to access the good or service, even if some consumers pay more. The overall effect depends on the relative size of the efficiency gains from higher output and the distributional effects of surplus shifting from consumers to producers.