Introduction to Price Discrimination

Today we begin a section on price discrimination. Price discrimination means selling the same product to different groups of customers at different prices. We'll be looking at the effects of price discrimination on monopoly profits as well as on social welfare. So let's get started.

Interpol, the International Police Organization, busted a drug smuggling operation that was smuggling drugs from Africa to Europe. What was it? Cocaine, pot, heroine? No, it was none of these. It was the pharmaceutical drug, Combivir, Why? Combivir, the AIDS drug, was priced at about $12.50 per pill in Europe, about the same as in the United States. But GSK was also selling Combivir to people to Africa at a much lower price. How come? Well, for two reasons. First, for humanitarian reasons, and second to get to the subject of this talk, to maximize profits. The smugglers were buying the pills in Africa at the lower price, sending them to Europe, and then reselling them in Europe at the higher price.

Why is it that price discrimination in the first place can increase profits? We actually can show this using a diagram we've already seen. We know that if the demand curve is more inelastic, that suggests the monopolist should set a higher price, put on a higher mark up, while if the demand curve is more elastic, that means a lower price. Suppose that the monopolist can segment its market into two parts, say Europe and Africa, and that the demand curve in Europe is much more inelastic than the demand curve in Africa where consumers are poorer and more sensitive to price.

The conclusion is that the way to maximize profits is to set a high price in the market with the inelastic demand, Europe, and a lower price in the market with the elastic demand, namely Africa. Let's imagine that instead, there was a single enforced world price for the drug. This price would be neither the profit maximizing price for Europe nor would it be the profit maximizing price for Africa. For the supplier, profits would be lower with this single price than with two prices under price discrimination. Of course, price discrimination works only if it's in fact possible to segment and separate the two markets. If smugglers can buy in Africa and sell in Europe and if most of the buyers of the drug end up buying the smuggled product from Africa, that really is going to mean the drug supplier is mostly selling at the low African price and that will not maximize their profits.

So let's briefly review. Price discrimination is selling the same product to different groups of buyers at different prices. And here are some basic principles of price discrimination. First, if the demand curves across two markets are different, it's more profitable to segment those two markets and set different prices. We know the prices you should set. The price should be higher in the market with the more inelastic demand. Second, arbitrage across markets makes it more difficult to price discriminate.

Let's say a little more about arbitrage. Most simply, arbitrage means buying low and then selling high. Buying low in one market, quickly moving those goods to a second market and then reselling them at a higher price. The effect of that arbitrage is to bring the prices in those two markets closer together -- increasing the price in the market with the lower price and decreasing the price in the market which had had the higher price. It's clear that to practice price discrimination successfully, the monopolist has to prevent that kind of arbitrage.

Now smuggling -- that's just an illegal form of this kind of arbitrage. It's a type of arbitrage which breaks down price discrimination. Now markets can be segmented in more ways than just geographically. For instance, Rohm and Haas -- they are a producer of materials, and they had a plastic. I'll call it MM, a plastic that had uses in industry and also uses in dentistry, as in dentures. MM in industry had a lot of substitutes but as dentures there were very few substitutes for using MM.

So the firm price discriminated. It sold MM to industry at about $0.85 a pound and it sold a slightly different version of MM for dentures for dentistry at $22 a pound. Of course, with a price difference like that, entrepreneurs started to buy up industrial MM, convert it to MM for dentures, and then resell that MM at the higher price. How could the company prevent this kind of arbitrage? Amazingly, Rohm and Haas considered poisoning industrial MM so no one would want to use it for dentures. Eventually they decided it was safer to simply spread a rumor that industrial MM had been laced with arsenic.

If that sounds crazy, notice that the government actually does require some goods to be poisoned in order to prevent arbitrage. Ethanol for instance can be use in cars as a fuel and also for alcoholic beverages. The government subsidizes fuel ethanol but doesn't want that ethanol be converted into alcohol so it requires that fuel ethanol be poisoned. The lesson is that it's easier to prevent arbitrage in some goods than in others. It's easier to prevent arbitrage in services, for instance, than in goods. If you get a massage for $20 but that same masseuse wants to charge me $50, it's hard for you to buy the massage at $20 and then somehow resell it to me for $50. I need the masseuse to be the one giving me that massage.

Price discrimination is very common in our world. Think about movie theaters setting one price for children and a second price for seniors, and then yet another price for adults. The cheaper price for seniors -- do movie theater owners love old people or love children? No, it's because those groups are more sensitive to changes in price. Take young adults going out on a date. They want to see the latest movie and they don't want to look cheap. They'll probably pay full price. But retired seniors, if you charge them too high a price, they'll just stay at home and watch it on Netflix streaming. Or take computer software -- businesses and students are often charged different prices. Microsoft offers a significant discount to students who purchase Office.

Airlines -- another classic example of price discrimination. Airlines want to set higher prices for business travelers who are more likely to have inelastic demands than for vacationers who are more likely to have elastic demands. Price discrimination is typically imperfect. The airlines ideally would like to ask someone when they call up for a flight, "Air you a business traveler? Well that will be $1200. But are you a vacationer? Well then it will only be $700." But of course that scheme isn't going to work because people will just lie.

So what businesses try to do is to look for characteristics which are correlated with buyer willingness to pay. What are some characteristics that might be correlated with having an inelastic demand -- with being a business traveler -- as opposed to having an elastic demand, being a vacation traveler? How can an airline distinguish business travelers from vacationers? There are several methods, but business travelers often have less flexibility. They might need to make an important meeting on short notice, so the airlines typically charge more if you want to fly that day or the next day, than if you're able to book several weeks or months in advance. The airlines reason that people who really need to have a ticket for tomorrow on short notice -- they're probably flying somewhere to settle a big business deal. They won't be deterred from flying by a higher price.

On the other hand, people who are booking weeks or months in advance, they have more substitutes. If the price of an airline ticket to California is too high, maybe those people will take a local vacation instead, or fly another airline to Florida. Similarly, vacationers are more willing to stay over a Saturday night than are business travelers. So sometimes it's cheaper to fly by staying over a Saturday than by traveling during the week.

Finally, first class, business class and economy, they all get you to the same place at the same time but first and business class are much more expensive. The airlines figured that anyone willing to pay extra for just a little more space and better food, well, probably those people have a lot more money or maybe their business is paying for their ticket. Those customers won't be so sensitive to the price. What you find when you put these and a whole bunch of other methods of price discrimination together is that the airlines are remarkably adept at charging different people different prices for the same good.

So that's just an introduction to price discrimination. Next time we'll look at the question, is price discrimination good? We've shown that it can increase profits, but what's the effect of price discrimination on social welfare?