Price Discrimination Explains Everything

Two years ago, the Executive Office of the President wrote,

Ultimately, whether differential pricing helps or harms the average consumer depends on how and where it is used. In a competitive market with transparent pricing, the benefits are likely to outweigh the costs. For example, while there is lots of differential pricing in airline ticket sales, the Internet has made it relatively easy for many travelers to compare prices and itineraries across airlines and to select the best deal for any given trip. Some studies even suggest that differential pricing can intensify competition relative to uniform pricing, by allowing high-margin sellers to compete more aggressively for price-sensitive customers who might otherwise buy from a lower-priced rival.

differential pricing seems most likely to be harmful when implemented through complex or opaque pricing schemes designed to screen out unsophisticated buyers. For example, companies may obfuscate by bundling a low product price with costly warranties or shipping fees, using “bait and switch” techniques to attract unwary customers with low advertised prices and then upselling them on different merchandise, or burying important details in the small print of complex contracts.

Pointer from Timothy Taylor.

The report’s reference to “a competitive market with transparent pricing” is disingenuous. There is little scope for price discrimination in a truly competitive market. If there are only one or two airlines flying a particular route, you can price discriminate. Not so if there were a hundred.

So get the highly competitive model out of your mind. The real world in which most businesses live is one with high fixed costs and low marginal costs. Then marginal-cost pricing is too low, while average-cost pricing is too high.

A numerical example will help. Suppose that the fixed cost is $1 million and each unit costs you $1 at the margin to produce. Think of selling a hundred thousand units, which means a total cost of $1.1 million, or an average cost of $11. If you price at marginal cost, of only $1, you fail to recover fixed cost, and you go out of business. If you price at average cost, $11, you drive away a lot of customers who are willing to pay more than your marginal cost of $1 but less than a price of $11.

If you can price discriminate, then you might charge $2 to the price-sensitive customers and $20 to the price-insensitive customers. That way, both sets of customers contribute to covering your fixed costs.

6 thoughts on “Price Discrimination Explains Everything

  1. Arnold;
    As a biologist, I think you are ignoring the lessons of your own book. Yes, in a sense, price discrimination is impossible in a transparent market. But in another sense, price discrimination creates two (or 1000) different products.

    The person who can drive to the parking space is buying something different than the person who asks a valet to put the same car in the same space. The person who orders a la carte is getting something different than the person who orders ‘chef’s choice’ (omakase). The traveler who must leave on a specific flight is getting a different service than the traveler who will take the lowest cost ticket in a time window, even if they end up on the same flight, or indistinguishable seats.

    Restricting the dimensionality with which the product can be described is not favorable to anyone.

    A coworker has a sign: ‘Life is hard. It’s harder if you are stupid.’

    In this context, perhaps people pay to reduce the cognitive load of the decision. We don’t want to protect them from that.

    Alternatively, people may simply make poor decisions, paying for features they don’t really need (could be the tow package on the car, could be flexibility in rebooking that airline ticket) or by not doing due diligence during the process of choice. We can’t protect them from that.

    Restrictions on differential pricing/price discrimination don’t really make sense, although I am loathe to defend illegible contracts, false advertising, and some other classic schemes.

  2. Without the airline market, where would 25% of upperclass Economic majors get there semester paper on pricing discrimination? I loved back in 1990, you prove pricing discrimination of airline that is cheaper from LA to Atlanta with layoff in St. Louis than a ticket from LA to St. Louis. (Still true probably in a lot of cases.)

    1) The internet has solved a lot of these issues for consumers and it is better than 25 years ago. I hope healthcare test might go down a similar route.
    2) It is impossible for airlines to ever get fully competitive. Their marginal and average cost curves and flight options are too extreme to get there.
    3) As a Democrat, we should celebrate the airline deregulation as a significant Jimmy Carter success. It is an example of Ds being pro-market.

  3. “There is little scope for price discrimination in a truly competitive market. ”

    Really? I thought there were a number of ways to price discriminate in a competitive market. Coupons for example and brief discount windows, for example. Or slight product differentiation (to get more money out of the status conscious). The methods the airlines use (advance booking requirements, Saturday night stays) to discriminate between price-sensitive leisure travelers and price-insensitive business travelers seem to work in competitive markets also. None of this is any kind of secret, but business people often can’t plan a trip 30 days ahead of time, and they want to be home for the weekend, so they pay more.

  4. “The real world in which most businesses live is one with high fixed costs and low marginal costs.”

    Is not two-thirds of the US economy services? I do not see services having the above characteristics, so are you really characterizing all sectors?

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