8.4: Third-Degree Price Discrimination

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If the seller can easily identify customers with different demand elasticities, then the seller may be able to employ third-degree price discrimination. There are many examples of third-degree price discrimination. These include senior citizen or student discounts, weekend (weekday) rates, and variable utility rates. Historically, federal marketing orders for agricultural products have been offered as examples of third-degree price discrimination. For example, the federal milk marketing orders reflect differences in demand for milk sold for use as a beverage, soft dairy products (e.g., yogurts and soft cheeses), hard dairy products (e.g., butter and hard cheeses), dry milk (Chouinard et al. 2010). For third-degree price discrimination to work, the following conditions must hold:

The firm can assign customers into distinct groups and enforce differential pricing by group or there is a relatively straightforward mechanism of self selection.
Reselling between consumer groups is not feasible. Otherwise, arbitrage will occur between segments with different demands.
The different groups have different elasticities of demand. Otherwise, there is no point in offering different prices to different segments even if differential pricing by segment is possible.
The deals being offered must be socially benign.

With third-degree price discrimination, bundling or charging access fees are not possible. If it were, the firm would simply offer different bundles or different access fees to each segment and would approximate first-degree price discrimination in each segment. In third-degree price discrimination, the best the firm can do is charge the monopoly price to each segment. As you might recall from Chapter 7, each segment will be charged the price that satisfies $MC = P_{i}(1 + \dfrac{1}{\varepsilon_{i}})$, where $\varepsilon_{i}$ is the elasticity of demand from the $i^{th}$ segment. Table $\PageIndex{1}$ provides an example of three segments, each with a different elasticity of demand. Verify that $MC = P_{i}(1 + \dfrac{1}{\varepsilon_{i}})$ for each segment in the table.

Table $\PageIndex{1}$: Prices charged to different segments under third-degree price discrimination
Value	Segment A	Segment B	Segment C
Marginal Cost	4.00	4.00	4.00
$\varepsilon_{i}$	-2.81	-2.55	-1.87
$P_{i}$	6.21	6.58	8.60

Note that in Table $\PageIndex{1}$, the firm does not face any difference in cost across the different segments. In each case, the marginal cost is $4. However, each segment is charged a different price. The price is based solely on the differences in the elasticity of demand. Note that Segment C pays the highest price. Members of this segment have the least elastic demand. Members of segment A pay the lowest price; they have the most elastic demand.