The Economic Theory of Second and Third Degree Price Discrimination - Essay Example

The Economic Theory of Second and Third Degree Price Discrimination Introduction Price discrimination is a strategy whereby similar products or services are usually charged at different prices are charged different prices in different markets by the same service provider in any given economy. The basic theory which is associated with price discrimination is the theory of the monopoly whereby one firm controls the entire market hence considered a price maker. This firm also has the ability to segment the markets since it has full power in the market. There are several degrees of price discrimination, but in this paper, we are going to discuss the second and the third degree of price discrimination. The second degree of price discrimination also termed as block pricing, is whereby the provider of the service or seller of the good charges different prices for different quantities of the good or service. This elasticity is possible because mostly the commodities with their respective are demanded by different buyers who have different elasticity’s of demand to the commodity. The other type of price discrimination discussed in this paper is the third degree of price discrimination which is the most common type of discrimination. This discrimination occurs when the providers of services or sellers charge different prices in two or more markets or groups in the market who are assumed to have different elasticity’s of demand. The differentiation of the groups who are the targets in this type of discrimination is majorly based on the age of the individuals, their location and their gender. The conditions which are necessary for the operation of these kinds of discriminations are explained in details in this paper with an analytical review of each discriminations with examples showing how the different market segments in which the discrimination is taking place are maintained. Conditions necessary for price discrimination The price discrimination is successful when the seller, or service provider meets the following conditions in the market, to have the control of the market or having market power; identification of different groups of individuals who have different demands for a good or a service and keeping the buyer in one of the market segment from offering the service or reselling the good to another group in the market in order to prevent or limit arbitrage (McAfee, 2008). In the case regarding to market control, the sellers should be able to control the different prices of goods or services in order to succeed in this type of price discrimination. If the firms which are concerned at selling have no market power, then it means that they have no ability to affect the prices, which are charged on the goods they sell and therefore all the goods are going to be charged at one price. Monopolies are the best examples of firms which are skilled in price discrimination because they are price makers. Monopolies have the ability to charge different prices at different markets without any problems. Oligopolies and monopolistic competition firms also can practice price discrimination if they control the prices of goods and services. The other condition necessary for the operation of a monopoly is that the firms must identify the different groups of buyers with each group of buyers in the market assumed to have different elasticity’s of demand related to the price of the commodity. This means that the different buyers found in the different markets are able to pay different prices for the same type of goods existing in the market. The third condition which is necessary for price discrimination is that each group of buyers with their different elasticity’s of demand to be put into the different markets in order to differentiate them. Here the buyers in one market are not able to resell the commodities they have bought to other different markets with the aim of making profit. This means that arbitrage is impossible in this market for price discrimination to occur (Philips, 1983). Under arbitrage, when a consumer is offered a good at a low price by a firm, he has the ability to buy more of the good and then resell the good to consumers who had denied to purchase the good of the firm by reselling the good at a higher price to those consumers. This means that arbitrage exists, but it might be difficult or impossible to exist in the real market conditions due to some several factors There is usually a high transportation cost of goods in order to conduct the resell in the other market segments. Transportation costs can assist in price discrimination in that it is classified as a geographical price discrimination whereby the different firms in the market usually charge different prices to their customers with the transportation cost included. This is classified as a freight absorption whereby the prices to different consumers depends on the transport cost attached to ferrying the commodities to the different consumers. A high cost in transport means that there will be difficulties associated with price discrimination by consumers which makes them to resell the commodities at a very high price in order to make profits; there exists rules and regulations of resale therefore it might prove difficult for the buyers of the commodities to resale the commodities because they might be bound by those regulations; when the products or services are personalized, it might prove difficult to resale because the end buyers won’t buy a good which is personalized or branded in which they can’t work with; there are thin markets existing therefore this creates a problem in the resale of the products; there are informational problems existing in the markets which makes it hard to resale since the buyers don’t have the knowledge of such transactions; contracts and warranties also can limit the resale of a product because without warranties the quality of a product can be put to doubt by the buyers of the product. The third degree price discrimination market situation To illustrate how the third degree price discrimination works, we take an example of a firm named planets cinema, which has twelve cinema screens and it has monopoly powers since it’s the only firm operating in the planets community. Since it operates alone in the market, this gives planets theatre a market power since it operates alone in the market therefore providing a chance for the practice of price discrimination in the society (Nahata, 2006). With this overwhelming control of the market, planets theatre is able to charge different prices to different movie attenders who include young people and the elder people. The young movie goers have a less elasticity in demand because they are going to pay high prices in order to see the movies. In contrast, the elderly people who are aged 50 years of age and above are more selective with the kind of movies they watch therefore they are considered to have a high elasticity in demand of watching the movies. Therefore, they don’t pay high to watch movies. Age is the determining factor in this kind of a market whereby the young people are given tickets to the specific conditions of a movie they want to see which is charged at a specific price and also the elderly people are also given their own tickets at a different price for a movie which suits only the elderly people. Switching of the tickets in this kind of a situation is not possible because they are restricted by age in switching the tickets. Only people with the correct age are allowed to enter into the movies and see the movies in planets theatre. The aim of planets theatre is to maximize profits while minimizing the costs incurred in its operations. Therefore, in order to determine the maximum profits in the firm, planets theatre equates the marginal cost curve and the marginal revenue curve. A graph showing young people demand for movie tickets and its price A graph showing old peoples demand for movie tickets and its price. Because planets theatre has two different types of people demanding the movie tickets, this makes it possible for them to have two different marginal revenue curves, each with different demand curves attached as shown in the diagram above. Price discrimination in this firm is available because planets theatre is able to control the prices charged to each client and also it has the ability to segment the clients according to age in order to charge them differently. For the youngsters there is a steep demand curve, which shows that there is a low elasticity’s in the demand. This means that the youngsters are able to buy the tickets at any price, hence they are considered to be price insensitive. The planets theatre maximizes profits from the youngsters whereby they equate the marginal revenue curve to the marginal cost curve. The charges of the movies are dependent on the prices the youngsters are willing to pay and in this case, they are willing to pay $9 in every ticket. To the elderly people, they have a high elasticity of demand, which is indicated by the flat demand curve. They are sensitive to prices in that, if the price of a movie ticket is increased few will buy the ticket. They maximize profits from this group made by the elderly through equating marginal revenue and marginal costs and then charging at a price which they are willing to pay. In this case they are willing to pay $5.85 on every ticket. This framework shows the third degree of price discrimination whereby the customers are charged different prices due to their different elasticity’s in demand and also they are segmented according to the their age. The second degree price discrimination In explaining about the second degree of price discrimination different aspects are taken into consideration. The firms which practice this type of discrimination usually knows that the rich are willing to pay more than the lower income people. Therefore the market segmentation in this kind of discrimination is usually determined at equilibrium based on the choice of the consumers. Quantity discounts are an example of a second degree price discrimination whereby the sellers usually charge low quantity products highly in terms of price per unit and in the highest quantity products they charge a lower price per unit (Nahata, 2006). In the graph above, it’s showing quantity discounts accredited to different quantities of a given item. The price P0 is charged if the buyer decides to buy Q0 units of the good. A lower price P1 on a greater quantity of unit sold. This shows that as the quantity per unit increases then the price decreases and therefore the decision lies with the consumer in buying the commodity. Therefore the segmentation in the market is brought about when the buyers go for the quantities they need at the given prices of the commodities. The reason as to why the segmentation is usually considered to be set at equilibrium in this kind of market situation is because in this degree the consumers select what they need and in the equilibrium condition, the selection leads to voluntary segmentation of the consumers with high and low demand. In this case of quantity discounts, the consumers are given the mandate to choose what they need or desire through the different discounts offered for the commodity depending on the ability of the consumer to purchase that commodity. Conclusion The theory of monopoly makes the perfect example of all kinds of price discriminations. For the price discrimination to be successful, there must be some conditions which are put on the market, market control, different buyers and segmentation of the buyers. These conditions enable the price discrimination theory to be successful, however, there are conditions which prevent the conditions of having different buyers which makes the process to be hectic in implementation. The second and the third type of price discrimination as seen in the paper have differentiated segmentation in the market with segmentation in the second degree set by choices of the consumer and segmentation in the third degree price discrimination set by factors like age or gender. References Armstrong, M. (1999). Price Discrimination by a Many-Product Firm. Review of Economic Studies, 51-68. Armstrong, M. (2006). Recent developments in economics of price discrimination. Advances in Economics and Econometrics: Theory and applications, 1-15. Chen, Y. (1999). 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