Introduction
Liu & Serfes (2014) define 3rd-degree price discrimination as a strategy that firms and sellers use to charge higher prices in solid markets and lower costs in weak markets. The scheme aims to increase the firms’ revenue by assigning the same product at different prices depending on the buyer’s willingness and ability to pay. The firms initially conduct market research by observing the previous purchase behaviour of buyers, thus allowing them to segment the buyers and result in price discrimination. The strategy differs from 2nd-degree price discrimination in that second-degree price discrimination, sellers segment customers by the quantity of purchase; a customer who buys more will get a considerable discount compared to customers who buy less. Industries in the oligopolistic and monopolistic market structures are primarily likely to venture into 3rd-degree price discrimination since fewer firms in the sectors and the barriers to entry prevent other firms from verging into the business hence allowing the existing firms to price discriminate without incurring losses due to competition. Firms that practice 3rd-degree price discrimination include; airlines, hotels, theme parks, museums, movie theatres and retail businesses.
Industries that practice 3rd-degree price discrimination
In hotel businesses, 3rd-degree price discrimination is employed by charging different rates to customer segments characterized by age, profession and affiliation with various organizations. Kim et al. (2020) observed that hotels set higher rates during peak seasons, such as holidays, and lower rates during off-peak seasons resulting in higher profits for the businesses. Further, the hotels offer loyalty cards to frequent customers and customers from affiliations such as a particular football club, thus encouraging them to stay in the hotels more often and advertise them on their social media accounts. The American Hotel and lodging association in 2018 observed that 62% of hotels in the United States offer loyalty cards to their customers. Lastly, hotels offer discounts to last-minute customers to fill the empty rooms.
Pharmaceutical companies have been observed to practice third-degree price discrimination due to their oligopolistic nature. The bias is practiced in various ways, such as; geographical price discrimination in which the companies charge different prices in geographical regions depending on the country’s purchasing power. Rojas (2009) discovered that pharmaceutical prices were higher in developed economies such as US and Europe and lowest in developing economies such as Ghana and India. Further, the companies offer discounts to specific groups such as hospitals, health insurance companies and the government depending on the volume of purchases. Lastly, the companies engage in patent strategies where they file different patents, thus discouraging the entry of firms into the industry hence reducing competition. The design allows the companies to practice 3rd-degree price discrimination without fear of losses due to competition.
Criteria for 3rd-degree price discrimination
3rd-degree price discrimination has been termed by Liu & Serfes (2014) as one of the most effective strategies for increasing revenue by boosting sales. However, not all firms can adopt the strategy due to different criteria that should be employed before adopting the approach. Such includes; market segmentation; before a firm adopts the system, they should first segment the market based on factors such as age, income, physical location, gender, preference and the nature of the product. Kim et al. (2020) found that firms in the hotel business segment their customers based on seasonality, loyalty programs, group bookings, and last-minute bookings. Secondly, the elasticity of demand, the elasticity of demand determines which forms of discrimination would work for a firm. For instance, lower-income earners prefer products with lower prices; hence they have an elastic order, while high-income earners are ready to spend more and have an inelastic demand. This criterion allows the pharmaceutical industries to practice 3rd degree of price discrimination in developed and developing economies. Additionally, the strategy should be profitable for 3rd-degree price discrimination to be effective. Price discrimination aims to generate more revenue by selling more of a firm’s product. Price discrimination should only be practiced if it results in more profit. Thus, even though 3rd-degree price discrimination is effective, it should be practiced after extensive research and analysis of the market; otherwise, it would result in enormous losses for the firms.
Motives for price discrimination
The business world is competitive, and for firms to survive, they need to employ strategic policies that will allow them to compete favourably and earn more profit. One of these strategies is price discrimination. Price discrimination will enable firms to capture the consumer surplus, the difference between what consumers are willing to pay and what they produce. Businesses would always prefer to charge the optimal price. However, this is only sometimes possible hence the need for price discrimination which allows them to set the optimal price in specific segments (Dana & Williams, 2020).
Further, price discrimination maximizes firm revenue by allowing firms to charge customers based on their willingness to pay, capturing the consumer surplus and translating to more profits. Additionally, price discrimination allows firms to respond to market conditions. For example, the market is constantly in flux with peak and off-peak seasons. Price discrimination makes it possible to charge higher prices during peak seasons and lower rates during the off-peak seasons hence avoiding losses during the off-peak seasons (Kim et al., 2020). Lastly, price discrimination reduces the surplus inventory. Firms practice price discrimination in various ways, such as through discounts and loyalty cards. The availability of discounts makes it possible for firms to clear out excess inventory while attracting more customers. Thus, price discrimination benefits firms, so most firms widely practice it.
The elasticity of demand, willingness to buy, consumer surplus and price discrimination
The elasticity of demand refers to the degree of responsiveness of demand due to changes in prices. Firms practice price discrimination by charging more prices to customers who exhibit inelastic demand elasticity and charging fewer prices to customers who exhibit elastic demand elasticity hence earning more revenue from the customers exhibiting inelastic demand and retaining customers who exhibit elastic demand. Willingness to pay refers to the maximum amount a customer is willing to spend on a product. High-income earners are always ready to spend more compared to low-income earners. Therefore, firms charge more to high-income earners and less to low-income earners. Consumer surplus is the difference between what consumers are willing to pay and what they pay. Businesses would always prefer to charge the optimal price. However, this is only sometimes possible hence the need for price discrimination which allows them to charge the optimal price in specific segments (Dana & Williams, 2020). Thus, firms can earn more revenue and retain more customers by determining the demand elasticity, willingness to pay and the consumer surplus of a customer.
The ethical perspective of price discrimination
The ethical perspective of price discrimination has been the subject of demand for a long time, with the proponents arguing that; it promotes economic efficiency by allowing firms to charge more to high-income earners and less to lower-income earners; further, price discrimination rewards loyal customers by offering incentives. On the other hand, the opponents argue that price discrimination promotes unfairness and discrimination as it allows some customers to pay more just because they belong to a specific segment, as is the case with pharmaceutical companies who charge more in developed countries without regard for the income segment of the different individuals. Further, price discrimination creates market disturbances by reducing competition and limiting consumer choice. Thus, even though price discrimination has various advantages and benefits, the benefits are more firm-oriented than consumer-oriented, thus giving the firms a means to exploit the consumers indirectly; as observed by Forbes, the reason why pharmaceutical industries Exploit consumers is that the consumers allow them.
Works Cited
Liu, Q., & Serfes, K. (2013). Price discrimination in two-sided markets. Journal of Economics & Management Strategy, 22(4), 768–786. https://doi.org/10.1111/jems.12038
Kim, J., Jang, S., Kang, S., & Kim, S. H. (J. (2020). Why are hotel room prices different? Exploring spatially varying relationships between room price and hotel attributes. Journal of Business Research, 107, 118–129. https://doi.org/10.1016/j.jbusres.2018.09.006
Rojas, M. (2009). Price discrimination by pharmaceutical companies across Central American countries. International Journal of Pharmaceutical and Healthcare Marketing, 3(2), 118–136. https://doi.org/10.1108/17506120910971704
Dana, J., & Williams, K. (2020). Intertemporal price discrimination in sequential quantity-price games. https://doi.org/10.3386/w26794
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