Price discrimination

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This article describes a pricing strategy used by sellers, typically in markets that suffer from imperfect competition, significant transaction costs or imperfect information.
View other pricing strategies

Contents

Definition

Definition for a single seller and a single good

Price discrimination is the following pricing strategy used by a single seller: selling identical goods (identical in terms of production costs) at different prices to different buyers.

Definition for a single seller and multiple goods

This more general (and somewhat different) definition is due to George Stigler (Theory of Price, 1987): price discrimination is present when two or more goods are sold at prices that are in different ratios to marginal costs.

Relation to the law of one price

Price discrimination is counter to the law of one price and is related to the phenomenon of price dispersion. Price discrimination refers to a single seller selling the same good at different prices, while price dispersion refers to the spread in prices of identical goods across the market, usually across multiple sellers.

Motivation behind price discrimination

Price discrimination practiced for profit

Price discrimination is profitable in situations where different consumers have different demand curves for the same product. Here is a simple illustrative example that assumes a single yes/no decision for purchase rather than a decision on volume. This example illustrates first-degree price discrimination.

Suppose a seller produces a good at a price of money units per piece, and there is no competition. Buyer is willing to pay a maximum of units for the good, and buyer is willing to pay units for the good. In other words, the reservation prices of buyers and are and units respectively.

We first consider the case where and . For instance .

Situation How the seller acts and buyers respond Producer surplus Consumer surplus Social surplus
Single price chosen by seller for all buyers (no price discrimination) Seller prices good at , buys, doesn't.
Separate price for each buyer Seller prices at for and for , both buy.
Perfectly competitive market seller prices at units, both and buy

Note that in practice, the surpluses listed as zero will be slightly greater than zero, because of some lack of perfectness in information and competition.

We next consider the case where and . A numerical example would be .

Situation How the seller acts and buyers respond Producer surplus Consumer surplus Social surplus
Single price chosen by seller for all buyers (no price discrimination) Seller prices good at , and buy.
Separate price for each buyer Seller prices at for and for , both buy.
Perfectly competitive market seller prices at units, both and buy

In both cases, we see that the seller benefits from price discrimination. In the first case, the benefit is through the expansion of the market to buyer . In the second case, the seller benefits by being able to charge more rather than being forced to charge the same as .

Note that although the term profit is used here, price discrimination may well be practiced in the same manner by institutions or firms that are not profit-making, including governmental institutions and private nonprofits.

Price discrimination practiced for non-economic reasons

Price discrimination may be practiced by governmental or private firms for social goals or for taste-based reasons.

Conditions for price discrimination

The main problem with price discrimination strategies is the leakage of the low-price product to customers who might have been willing to pay the higher price. The conditions are summarized in a table and detailed further below.

Condition Why it is necessary
Difference among buyers in willingness/ability to pay Otherwise, there is no basis/criterion along which the seller should price discriminate
Market power for the seller In a perfectly competitive market, price discrimination is undercut as competitors offer lower prices to the customers paying the highest prices under a price discrimination system.
Preventing high-priced customers from choosing low-priced alternatives This is necessary to make the charging of different prices to different customers effective.
Difficult to resell If the low-priced versions are easy to resell, it is more difficult to maintain the high prices.

Differences in willingness/ability to pay

Different buyers need to be different in some meaningful way for price discrimination to make sense. This difference may be in the following ways:

  • Differences in the buyers' reservation price. This may, in turn, be caused by different degrees of (perceived) private benefit they receive, or due to wealth effects or income effects. Note that such differences can exist even in markets with perfect information and zero transaction costs.
  • Difference in the awareness of buyers about alternatives. Different buyers with the same reservation price may effectively be willing to pay different amounts because of different degrees of awareness of alternatives.
  • Difference in the transaction costs imposed on buyers either for that product or for alternatives, which affects their effective reservation prices.

Market power

Further information: Price discrimination requires market power

For a seller to practice price discrimination, i.e., to price the same good differently to different buyers, the seller must have at least some market power. For instance, if a seller has both a low price for some buyers and a high price for other buyers, another seller can come along and offer the same good at a medium price for all buyers. The other seller is thus able to steal the most profitable customers from the original seller, forcing the original seller to lower prices. In this manner, a competitive market erodes price discrimination.

Preventing high-price buyers from choosing low-price alternatives

Price discrimination requires strategies to prevent customers in the high-price segment form choosing the low-price version. The strategies are of many kinds:

  • Requiring certain eligibility conditions to qualify for the low-price product. The eligibility criteria may include geographic location (lower prices in developing and backward areas), time, or demographic characteristics of the buyer (for instance, student discount cards, senior citizen discount cards, clipper coupons).
  • Requiring customers to put in extra work to obtain the low-price product: This includes methods for arranging items in supermarkets so that price-insensitive customers are likely to pick the high-price versions while bargain shoppers are likely to pick the low-price versions.
  • Deliberately sabotaging low-price products at added cost to prevent people willing to pay a higher price from switching to the lower price: This is observed in knowledge goods. Further information: Price discrimination for knowledge goods
  • Using marketing techniques to make high price payers believe that the high-price product is different or superior.

Difficult to resell

Further information: price discrimination requires difficulty of resale

If it is easy for people to resell goods obtained at the low price to buyers willing to pay the higher price, price discrimination is difficult to maintain.

Alternative explanations for apparent price discrimination

If price discrimination seems to be occurring, but the conditions necessary for successful price discrimination are not satisfied, there are likely to be alternative explanations. Alternative explanations to price discrimination usually hinge on hidden costs, such as opportunity costs, greater expectations of customers paying higher prices, and non-obvious differences in quality. Here are some examples:

  • Greater price as a proxy for costs of time, space, or other options that are not directly charged for: For instance, in restaurants, food and drink items that are typically ordered by customers seeking to stay for long may be charged higher, to compensate for the time spent occupying the table.
  • Greater price for clients who are likely to be more demanding: Buyers who are more likely to demand better goods and service, or place other additional demands on the sellers, may be charged more to compensate.

Models of behavior and organization for price discrimination

In perfectly competitive markets with completely rational behavior and no transaction costs

Price discrimination has no place in perfectly competitive markets where transaction costs are zero and everybody has perfect information and is rational.

In non-competitive markets

In a market where some sellers have market power, the conditions for price discrimination (difficult to resell, easy to prevent leakage of low-price versions to high-price buyers) may exist even with completely rational behavior, zero transaction costs and perfect information.

For the extreme case of a monopoly, see determination of price and quantity supplied by price-discriminating monopolistic firm in the short run.

With variable transaction costs and variable degrees of imperfect information

In a perfectly competitive market where all players behave rationally, price discrimination may still exist if different buyers have different transaction costs or different degrees of information, leading to a difference in the prices they are effectively willing to pay. In fact, such a difference may emerge even with very similar reservation prices, and it may even act in a direction opposite to reservation prices. (Thus, rich buyers may also be better informed about alternatives and may thus get lower prices for goods even though their reservation prices may be higher).

However, if the market is sufficiently competitive, these differences tend to remain small, because competing sellers, in conjunction with smart buyers who put pressure on them, help spread information about the cheaper versions even to individual buyers who do not have enough information.

With irrational behavior

Even in the presence of low transaction costs, the complete availability of information, and perfectly competitive markets, irrational behavior on the part of buyers could lead to small amounts of price discrimination. These amounts must, however, remain small because competitors to a seller practicing significant price discrimination can raise awareness of the issue.

In practice, we see price discrimination practiced in situations where there is a reasonable degree of market power (though far from a monopoly), non-negligible transaction costs and lack of perfect information, and further, the techniques used for price discrimination typically try to exploit systemic behavioral biases.

Types of price discrimination

The classification of price discrimination discussed here is that outlined in Pigou's book.

First-degree price discrimination

Further information: First-degree price discrimination

First-degree price discrimination, also called perfect price discrimination is a form of individual targeting. It describes a situation where a seller can charge different prices to different consumers, based on whatever price the seller thinks is best for each consumer. Here, the seller uses various methods to try to determine the reservation price of each consumer (reservation price is the maximum price the consumer is willing to pay) and charge close to that. Thus, the seller can milk the maximum profit from each consumer without ever losing a buyer because of high prices. First-degree price discrimination has huge costs both in terms of the cost needed to gather enough information about buyers to guess reservation prices well, and in terms of the added costs when buyers catch on to the strategy and put moral pressure on the seller or otherwise try to fool the seller.

If the costs of discerning reservation prices are zero, first-degree price discrimination is efficient, maximizes social surplus (at least in the short run), and avoids deadweight loss. However, all the social surplus is captured by the seller, which is the opposite of the situation in perfect competition, which is efficient and where the social surplus is captured either by consumers or by producers who are more efficient than other producers.

First-degree price discrimination includes the related practice of bargaining or haggling.

Second-degree price discrimination

Further information: Second-degree price discrimination

Second-degree price discrimination, also called nonlinear pricing or volume-based price discrimination, describes a situation where the cost per unit is lower the greater the volume a buyer buys. Such price discrimination is useful if it is true that people who are willing to buy larger quantities are also the people who are less likely to be willing to pay higher unit prices. This is usually the case, since consumers buying larger quantities may well be more likely to search for better deals or cheaper alternatives, since more money is at stake. Alternatively, such price discrimination may be explained by the fact that the marginal utility of purchasing additional units of the product is decreasing. Hence, for a given buyer, the reservation price per unit for purchasing a larger quantity is lower.

Third-degree price discrimination

Further information: Third-degree price discrimination

Third-degree price discrimination uses group targeting. Here, prices are set at different levels based on region, demographic group, and other factors. Group targeting thus tries to exploit the different demand curves for different demographic groups. Such price discrimination may again be of two kinds: direct segmentation, where the segmentation is based on rules (such as age and geographic location) and indirect segmentation, which more covertly tries to attract high-paying customers to high-priced versions and low-paying customers to low-priced versions.

Costs and benefits of price discrimination

Price discrimination indicates the existence of sellers with market power, and this is bad news because sellers with market power may set prices and quantities to maximize their own surplus in a way that does not maximize the social surplus. However, the price discrimination itself may well be better than the other options for a seller with market power.

Price discrimination imposes costs of gathering information about reservation prices

Price discrimination imposes costs on sellers, since they need to determine the reservation prices of a larger number of buyers. These costs are highest for first-degree price discrimination, where the reservation price has to be determined for every individual potential buyer. For second-degree price discrimination and third-degree price discrimination, the costs are less.

Price discrimination is good when it expands available markets

Further information: Price discrimination is efficient when expanding available markets

Consider the example discussed earlier: a seller can produce a good at units per piece, and there are two buyers, each of whom has to decide whether to buy the good or not, and their reservation prices are and respectively, with and .

Situation How the seller acts and buyers respond Producer surplus Consumer surplus Social surplus
Single price chosen by seller for all buyers (no price discrimination) Seller prices good at , buys, doesn't.
Separate price for each buyer Seller prices at for and for , both buy.
Perfectly competitive market seller prices at units, both and buy

Thus, price discrimination increases the total social surplus generated. In this situation, price discrimination is preferable for society to the alternative single high price. Nonetheless, it is not preferable to a situation of perfect competition. Perfect competition not only maximizes social surplus but also gives consumers a larger fraction of it.

Price discrimination is inefficient when it redistributes resources among existing buyers

Further information: Price discrimination is inefficient when distributing limited resources

Price discrimination can be bad when it distributes limited resources from people who value them more (indicated by a willingness to pay more) to people who value them less. Examples are discounts for certain groups for seats in flights and trains. Such discounts may end up allowing people who derive relatively less benefit from traveling to travel in place of others who may have benefited more.

Psychology

There are two problems that price discriminators need to overcome in terms of the cognitive/moral/behavioral intuitions and biases of buyers and third parties who might interfere.

  • Perceptions of unfairness: Price discrimination may be viewed as unfair since it violates the moral pricinple of treating all buyers equally. Note that such perceptions of unfairness may be a problem not just with the buyers of the specific goods but also with other third parties who may be buying other goods or interacting with the seller in other ways.
  • Envy: Somebody who bought the good at the higher price may feel envious and resentful of somebody else who bought the good at the lower price.

Price discriminators use other moral dispositions and biases of people to overcome these two related problems.

Using a reference price greater than the maximum price

Generally, the price discriminator sets the list price or reference price as the maximum among the prices charged to all buyers, or sometimes as a price even higher than that. Customers being sold lower prices are then offered discounts through various schemes of discounting that are designed so as to be made less visible to those who are being sold higher prices.

The advantage of this approach is that by the reference price effect, all customers feel they are getting a good deal (since they are comparing the actual price they pay to the reference price) and that they have saved money. This potentially makes them less resentful of others who have saved even larger sums of money.

The disadvantage is that since the reference price is the price that people look at first, people may initially decide not to purchase the good or service even though they would purchase it at the discounted price. The seller thus needs to make sure that even though the reference price is prominent, people are aware that the actual price will be less.

Conflating willingness to pay and ability to pay

Although fairness in the sense of charging the same price to everybody is one moral instinct, another moral instinct shared by many is that people who cannot afford to pay the market price for things that are necessary or highly desirable should be offered these goods at lower prices. This instinct can be exploited by price discriminators.

The goal of profit-maximizing price discriminators is to charge lower prices to people with a lower willingness to pay (which may include both poor people and rich price-sensitive people). In general, there is a significant relationship between the willingness to pay and the ability to pay. Thus, a price discriminator can price discriminate ostensibly on the basis of ability or need and thus win moral and social approval even from those who are paying the higher prices. Price discriminators may choose to discriminate purely based on ability rather than on more precise indicators of willingness both because ability is easier to measure and because it generates more moral and social approval.

Another advantage of this is that people paying higher prices feel less resentful of it since they can take pride in the fact they do not need the lower-priced goods because they are richer or more successful. Thus, the ability to buy the higher priced good becomes a signal of wealth (or of a lack of poverty) and it could possibly be viewed as conspicuous consumption.

Hiding lower prices from the high price buyers

Sellers also use a variety of ways to hide lower prices from buyers who are being charged the higher prices. Lower prices may be advertised only in venues where high price buyers are unlikely to find them.

Making people earn lower prices

Yet another trick to making lower prices palatable emotionally to higher price buyers is to make it appear that those paying the lower prices have earned these prices, either through collecting coupons or by coming to the shop at specific hours. Note that perceptions are not the only reason why coupons or periodic discounting are used -- the main reason is the actual costs imposed that discourages price-insensitive customers from using these options. The emotional aspect of making people feel that the lower priced buyers have earned the lower prices through their efforts is an added bonus.

The political economy of price discrimination

Influence by market actors on politicians to convince them of price discrimination

Some market actors try to convince politicians that their competitors are practicing price discrimination. One self-interested motivation for doing this is if the competitors are in fact providing lower prices to certain segments of the market. In some of these cases, the real price discrimination story may be altogether opposite.

Let us say there are two buyers and and two sellers and . Let us say that for seller the cost of serving buyer is units and the cost of serving buyer is units. For seller , the cost of serving buyer is unit and the cost of serving buyer is units. In a tabular form:

Buyer Buyer
Seller 's cost of serving the buyer 2 6
Seller 's cost of serving the buyer 1 5

Let us say further that seller is charging both buyers units. In this case, seller is engaging in a cross-subsidy -- subsidizing buyer using a large margin from buyer . Such a cross-subsidy can be viewed as price discrimination, under the more general definition of Stigler.

Suppose seller chooses to sell to at units and to at units. Note that is not price-discriminating in any sense of the word, since is setting the price in the same proportion to the cost of production for both buyers. In a tabular form, the prices are:

Buyer Buyer
Price charged by seller to the buyer 5 5
Price charged by seller to the buyer 1.1 5.5

The combined data in a tabular form:

Buyer Buyer Charging different prices to and (naive and incorrect definition of price discrimination)? Charging prices at different proportions to marginal costs (Stigler's sense of price discrimination)?
Seller 's (cost of serving, price charged) (2,5), so price:cost ratio is 2.5 (6,5), so price:cost ratio is 5/6 (i.e., loss) No Yes (different price:cost ratios)
Seller 's (cost of serving, price charged) (1,1.1), so price:cost ratio is 1.1 (5,5.5), so price:cost ratio is 1.1 Yes No (same price:cost ratio)

However, the net result is that is charging a little more than is, and charging a lot less. Also note that since 's production costs for both kinds of customers are higher than 's prices charged, cannot change its prices to become more competitive.

However, can try to convince politicians to crack down on and force to offer uniform prices, despite the difference in costs of serving the two kinds of customers, and also to serve both kinds of customers.

Accusations of price discrimination are often made along with accusations of predatory pricing (lowering prices below production cost to drive out competitors and achieve market control) and other anti-competitive practices.

Confusion and conflation

Often, sellers are accused of using price discrimination for non-economic reasons, such as tastes for certain kinds of buyers, and this is considered unfair and worth acting against. The confusion/conflation could happen in many ways:

  • Confusing something that isn't price discrimination for price discrimination, because of the end result that prices are different for different customers.
  • Not appreciating the conceptual distinction between profit-based price discrimination and price discrimination for other reasons.
  • Confusing price discrimination that is, in a specific instance, profit-based, with price discrimination practiced for taste-based reasons.

Alternatively, even without confusing these many issues, it may be argued that even if price discrimination is not discriminatory in intent and is purely profit-based, it is still immoral because of its greater impact (in terms of prices) on some individuals/groups compared to others, and hence must be forbidden or critiqued.

Legal regulation of this strategy

In the United States

Price discrimination in sales to retailers, when intended to reduce competition among retailers, is regulated under the Robinson-Patman Act in the United States. Direct-to-consumer price discrimination is not illegal.

References

Online encyclopedia/dictionary references

Weblog entries/articles

Journal references

General-purpose economics textbook references

These are texts intended for use in undergraduate/graduate economics teaching.

Book Pages Chapter/section More comments Link
Price theory and applications by Steven E. Landsburg, 10-digit ISBN 0324579934, 13-digit ISBN 978-0324579932More info 329-334 Section 9.3 (Price discrimination) Google Books (330 onward; 329 unavailable for viewing)
Principles of Economics by N. Gregory Mankiw, 10-digit ISBN 0324589972, 13-digit ISBN 978-0324589979More info 326-332 Google Books
Economics by Paul Krugman and Robin Wells, 10-digit ISBN 0716771586, 13-digit ISBN 978-0716771586More info 376-382 Chapter 14 (Monopoly) Google Books
Price theory and applications: decisions, markets, and information by Jack Hirshleifer, Amihai Glazer, David HirshleiferMore info 238-243 Section 8.4 (Monopolistic price discrimination) Google Books

Other textbook references

Book Pages Chapter/section More comments Link
The Economics of Price Discrimination by Louis Phlips, 10-digit ISBN 0521283949, 13-digit ISBN 978-0521283946More info whole book
Theory of Price by George J. StiglerMore info 72-?, 210
The Economics of Welfare by Alfred C. PigouMore info 275-289 Chapter 17 (Discrimination Monopoly) Google Books
Book:HandbookofIndustrialOrganizationMore info Chapter 10 (Price discrimination) by Hal Varian
Man, Economy and State by Murray Rothbard, 10-digit ISBN 0945466307, 13-digit ISBN 978-0945466307, Full view at Google BooksMore info 739-745 Multiform prices and monopoly The term price discrimination only appears on Page 745 Google Books

Expository book references

Book Pages Chapter/section More comments Link
The Armchair Economist by Steven E. Landsburg, 13-digit ISBN 9780029177761, 10-digit ISBN 0029177766 (paperback)More info 157-167 Chapter 16 (Why popcorn costs more at the movies and why the obvious answer is wrong) Google Books
The Undercover Economist by Tim Harford, 10-digit ISBN 0345494016, 13-digit ISBN 978-0345494016 (paperback)More info 29-55 Chapter 2 (What supermarkets don't want you to know) Google Books
Freedomnomics: why the free market works and other half-baked theories don't by John R. Lott, 10-digit ISBN 1596985062More info 22-32 Google Books
Naked Economics: Undressing the Dismal Science by Charles Wheelan, 10-digit ISBN 0393324869, 13-digit ISBN 978-0393324860More info 19-20 Chapter 1 (The Power of Markets: Who Feeds Paris?) Google Books
The Economic Naturalist: In Search of Explanations for Everyday Enigmas (paperback) by Robert H. Frank, 10-digit ISBN 0465003575, 13-digit ISBN 978-0465003570More info 41, 84, 153 Google Books