November 21, 2014 Show Notes: Playing with Fire: Price Discrimination in Practice

. . . [N]ot only is price discrimination pervasive in society, it is an important way in which society covertly and unintendedly redistributes consumption, much of it from rich to poor. . . . [I]ts effects on output and welfare relative to single-price firms with monopoly power are likely to be positive. . . . [I]t tends to make consumption more equal across income classes.

—Mark Skousen and Kenna C. Taylor – Puzzles and Paradoxes in Economics

Consumer Surplus

I can remember finding a rare first edition of Stanley Marcus’ book Quest for the Best in a used bookstore in San Diego. I had been searching for this book for a couple of years, since this was before the Internet, and was elated when I stumbled across it by chance. As soon as I skimmed through it and learned it was in good condition, and autographed by Stanley himself, I would have been willing to pay $100 for it. Of course, the bookstore owner had no idea, nor does he even know me or of my desire to own this rare book. He priced it at $10. I can assure you I did not offer to split the difference between my value price and his asking price. I left the store, as an economist would say, $90 wealthier, keeping the entire consumer surplus to myself.

This raises an interesting moral and ethical question: If it is unethical for businesses to charge high prices, is it also unethical for customers to seek out low prices? Is my keeping 100% of the consumer surplus any more or less unethical than the bookstore owner capturing any portion of it above $10?

This is why Alfred Marshall thought the consumer surplus was a measure of customer well-being and satisfaction, because as prices become lower, and more and more consumers can buy a greater quantity of products at the same price, the equivalent of having more income.

On the other hand, there is also a producer surplus, the difference between the price for which a producer would be willing to provide a good or service and the actual price at which the good or service is sold. The consumer’s and producer’s surplus provides a measure of the gain to both parties, and the sum being the social gain, or welfare gain, due to the existence of the market.

While the consumer surplus is the gain the buyer receives from trade, the producer surplus is sometimes referred to as economic rent—the amount received by sellers of an item over and above what they would have accepted.

Michael Jordan and Tiger Woods receive an enormous amount of economic rent above what would be needed to induce them to play their favorite sport. There is also a consumer detriment, representing the customers who are willing to pay more than cost but less than the market price. While consumer surplus makes customers happy, it is economic rent that makes companies—and individuals—rich.

Charging different prices to different customers is the definition of price discrimination, a term coined in 1920 by Arthur Cecil Pigou in The Economics of Welfare. Price discrimination occurs when a good or service is sold at different prices that do not reflect differences in production costs. Companies engage in this practice in order to extract the consumer surplus from various customers.

It is worth reiterating that price discrimination does not imply discriminating against people based on race, gender, religion, ethnicity, and so forth, but only on their willingness and ability to pay, which is based on the value they are receiving.

Price Discrimination Principles

In a perfect market (from the seller’s perspective anyway), customers would each pay their reservation price for each product or service, defined as the maximum amount they are willing and able to pay for a product. This would be the ultimate expression of pure price discrimination.

Unfortunately for producers, the marketplace is not perfect and other methods must be devised to ascertain how much different buyers value their offerings, such as popcorn lovers valuing the movie experience more than non-eaters. Successful pricing strategies are designed to induce customers to better reveal their reservation price, thereby capturing a larger percentage of the consumer surplus. To achieve price discrimination, four requirements must be met:

  1. The firm must have market power—Not monopoly power, but a downward-sloping demand curve, so a firm can raise prices without losing all of its customers—as would happen with a completely horizontal demand curve—imperfect, as opposed to perfect, competition.
  2. Buyers with different demand elasticities must be separable into submarkets—Differences arise from income disparities, preferences, locations, etc.
  3. The transaction cost is less than the potential profit—Costs associated with separating buyers with differential demands must be lower than the differential gain in profit expected from the multiple-price as compared with the one-price strategy.
  4. The seller must separate buyers to avoid arbitrage—Otherwise, products sold more cheaply in one location can be purchased there and transported to a higher-price location.

These four requirements present barriers to engaging in price discrimination, but they are surmountable, and as we shall see, many companies have developed very imaginative and creative ways to overcome these challenges. Let us explore each of the four requirements.

First, companies must have market power, meaning a downward-sloping demand curve. Even the most elastic products meet this requirement, which means the company has some ability to control the price they charge rather than merely being a price taker.

Second, separating buyers with different demand elasticities requires that a company understand its customers’ motivations, how they benefit from its product, and how it will be used in order to judge the marginal value. If you sell in business-to-business markets, understanding your customer’s business model, how they make money, and how you can help them be more successful is essential in separating them into various value segments. This is obviously easier with long-term customers, with whom a deep relationship has been established.

The third requirement is that the potential profit must be greater than the costs of separating buyers for price discrimination purposes. A case in point where this requirement became a barrier to charging different customers different prices was Disneyland’s A–E ticket system (E stood for exciting), used to price its attractions. On October 11, 1955 (the year Disneyland opened) A, B, and C tickets cost from 10 cents to 50 cents each, depending on the attraction. D tickets were added in 1956 and E tickets in 1959, priced at 50 cents each.

From a pricing perspective, the A–E ticket system was a pure price discrimination strategy. However, over time the problems with the A-E system began to outweigh the benefits.

Disney had to print the tickets, its guests had to wait in long lines to purchase them (thus diminishing the fun and experience of the park visit), and the cast members at each ride had to handle and the police the tickets, sometimes turning guests away carrying the wrong ticket. The total costs of engaging in this type of customer segregation began to exceed the marginal profits derived from it, and in 1982 Disneyland changed to the Disneyland Passport, a fixed-price, unlimited use of attractions, all-day pass.

The fourth, and final, requirement, avoiding arbitrage, is much easier for service providers to meet than product sellers. If a bakery were to sell pies in two nearby towns, and price them $10 in one town and $5 in the other, eventually customers would buy in the lower-price location. Some customers would even buy pies in the lower-price location and transport them back to the higher-price location and sell them, thus keeping some of the consumer surplus for themselves, a process known as arbitrage.

We witness this with drugs being purchased in Canada by American citizens due to lower prices. Some high-priced U.S. drugs, such as for AIDS or Norplant, sell for much lower prices in less-developed countries, due to a more elastic demand curve. Sometimes drug companies will package products differently in different markets, varying the sizes and quantities in order to make arbitrage more difficult.

But one cannot arbitrage services. You cannot send your butler, who may be charged on a sliding scale based on his income, to get your kidney transplant. A customer cannot sell their tax return or legal services to someone else. Services consumed on location, such as movie theater popcorn or medical and dental care, are not susceptible to arbitrage, making it easier for companies in these industries to engage in price discrimination.

We have studied the four requirements necessary to price discriminate, let us now examine the three degrees of price discrimination:

  1. First-degree price discrimination—Charging each customer the most that he would be willing to pay for each item that he buys, thereby transferring all of the consumer surplus to the seller.
  2. Second-degree price discrimination—Charging the same customer different prices for identical items.
  3. Third-degree price discrimination—Charging different prices in different markets.

Due to the high transaction costs of determining what each and every buyer is willing to pay, auctions and negotiable price markets are the closest approximation to first-degree price discrimination. Whether it is the late Princess Diana’s dresses or articles from the Kennedy estate, buyers line up and identify the maximum amount they are willing to pay, and thus the item is sold to the individual who values it the most.

Second-degree price discrimination exists when businesses charge the same customer different prices for identical items, such as Proctor & Gamble giving Wal-Mart a discount on Pampers for large-quantity orders. Another example is utility companies and cellular phone companies charging different rates for “peak” and “off-peak” use, the theory being that a phone call placed during peak hours is more valuable (say, for a salesman to make an appointment with a prospect) than a call during off-peak hours (say, to order a pizza on the way home from work).

An example of third-degree price discrimination—charging different prices in different markets—is coupons. If Proctor & Gamble can make a profit selling a box of Tide soap with a 50-cents-off coupon, what are they making when a customer buys a box without a coupon?

Other Resources

Pricing on Purpose: Creating and Capturing Value, by Ronald J. Baker

Implementing Value Pricing: A Radical Business Model for Professional Firms, by Ronald J. Baker