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Difficulty: MediumMonopoly: Price Discrimination Conditions, Types, and Effects

A software company operating as a monopoly sells its proprietary structural analysis software to both commercial engineering firms and academic institutions. The company sets a price of 1,200perlicenseforcommercialfirmsand1,200 per license for commercial firms and 300 per license for academic institutions, preventing any resale between the two consumer groups. Which of the following economic conditions justifies charging the higher price to commercial engineering firms under third-degree price discrimination?

  1. A
    Commercial engineering firms exhibit a higher price elasticity of demand than academic institutions.
  2. B
    Lowering the license fee for academic institutions causes an outward shift in the software demand curve.
  3. The price elasticity of demand for the software is relatively inelastic among commercial engineering firms compared to academic institutions.Answer
  4. D
    The software monopolist completely eliminates consumer surplus in both market segments, reducing it to zero.

Answer

The price elasticity of demand for the software is relatively inelastic among commercial engineering firms compared to academic institutions.
Under third-degree price discrimination, a profit-maximizing firm divides consumers into separate sub-markets based on differing price elasticities of demand. The firm charges a higher price in the sub-market with relatively inelastic demand because buyers there are less responsive to price increases, whereas it charges a lower price in the sub-market with relatively elastic demand.

Step-by-Step Solution

1
Identify the conditions governing third-degree price discrimination.
Third-degree price discrimination requires market power, clear segmentability into distinct sub-markets, prevention of resale (arbitrage), and differing price elasticities of demand across sub-markets.
A profit-maximizing monopolist equates marginal revenue across all sub-markets to its overall marginal cost (MR1=MR2=MCMR_1 = MR_2 = MC).
2
Relate pricing strategy to price elasticity of demand.
The relationship between price (PP) and price elasticity of demand (EdE_d) is given by MR=P(1−1∣Ed∣)MR = P(1 - \frac{1}{|E_d|}). Setting MR1=MR2MR_1 = MR_2 implies that the sub-market with lower elasticity (∣Ed∣|E_d|) yields a higher price.
Commercial firms have fewer substitutes and higher necessity for professional work, making their demand inelastic, allowing the firm to charge 1,200comparedto1,200 compared to 300 for price-sensitive academic institutions.

Key Concept

Third-degree price discrimination and sub-market elasticity pricing rule
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Topics

Monopoly: Price Discrimination Conditions, Types, and Effects

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