Price discrimination

Price discrimination – are we being exploited?

Heather, Ken

INTRODUCTION

Whenever you travel, because you are interested in economics you are probably conscious that you are being charged a different price for your journey than some other persons travelling with you. A rail journey is cheaper in the middle of the day than it is in rush hour. However, even at the same time of day a range of prices is being charged. For example, some have rail cards entitling them to discounts; others do not. Children often travel at half price. It is cheaper for people who book in advance. If we travel by air the price of the ticket probably varies hugely between types of traveller. These variations occur not just for different airlines and different flight times but people travelling on the same aircraft have bought tickets for very different prices. Some will have paid no money at all if they have collected enough `air miles’.

These price differences are not confined to the transport industry. The rates charged at hotels vary between customers even for the same quality of room on the same night. Doctors in the private sector charge different amounts to different patients for the treatment of the same condition.

Although such behaviour has been around for a long time, people are becoming more aware of it, perhaps most of all as a result of the arrival in recent years of the low cost airlines such as easyjet and Ryanair.

Charging different prices to different customers for the same good is known as price discrimination. However, as we shall see, not all the examples quoted above fall into the category of price discriminatory behaviour.

Most people, including many students of economics, find the behaviour of firms in this respect to be unfair. They instinctively feel that it is only fair that people buying the same product should pay the same price. In this article we will attempt to examine these issues by looking at three questions. First, we consider what price discrimination is. Second we will think through the conditions necessary for firms to be able to behave in this way. Third, we will consider whether price discrimination is in some way against the public interest. Our first task is to be clear about what price discrimination is.

WHAT IS PRICE DISCRIMINATION?

Understanding the meaning of price discrimination is much trickier than it might first appear. A typical textbook definition that provides us with a good starting point might be as follows:

“Price discrimination occurs when a firm charges different individual buyers or groups of buyers different priced for the same product for reasons unrelated to production costs.”

a) Production Costs

The question of production costs is important. Choosing different prices for products because firms have different costs of producing them is not price discrimination Clearly therefore, charging first class passengers more than second class passengers is not price discrimination. Even though the difference in cost may be small it does cost an airline more to provide a first class seat. There is greater leg room and therefore a more comfortable journey. But there is an opportunity cost. The airline can fit in fewer passengers. The higher price is charged because the first class passenger must cover the higher costs.

A less obvious example might be a coastal hotel’s policy of charging more for rooms with a sea view. There are no extra costs of cleaning the room or providing the breakfast that often goes with the room. We might therefore think that this is a price difference unrelated to costs. However, the cost of acquiring the hotel, or land on which it was built, was greater for the hotelier because it was on the coast. The sea view costs the hotel more because it has to pay more interest on the money it borrowed to acquire the site. It therefore charges higher prices to those whose rooms have the sea view.

On the other hand different prices are charged when there are no differences in production costs. Providing one second class seat on a train costs no more or less than providing another but people sitting in those seats are paying different amounts according to who they are. Price discrimination, then, takes place only when the price differences are unrelated to costs of production.

b) ‘The Same Product’ Perfect Substitutes?

Referring back to our textbook definition we can see that price discrimination occurs when different prices are charged for the same product. This is a further reason for saying that paying extra for our room with a sea view is not price discrimination. We are paying for a different product. It may be the same sized room with the same facilities but it is a superior product. If people did not think so, the hotel would be unable to charge a higher price for it.

How do economists decide whether we are talking about the same or a different product? The answer is as follows. If the two goods are the same, they are perfect substitutes. The room without the sea view is not a perfect substitute for one that has such a view. If there are two seats on a train and passengers are indifferent between them they are perfect substitutes.

Once we have grasped this idea we realise that there are fewer examples of price discrimination than we might think. Let’s return to our hotel. If you ring a week beforehand to book a room you will be quoted a particular price. On the other hand, if you turn up at ten o’clock in the evening of the day you wish to sleep there and they have some rooms unoccupied you may well be able to negotiate a lower rate. The hotelier will be keen to fill the room even if you pay only the low variable cost and so will be willing to do a deal. Do these differences in the room price reflect price discrimination? There is a strong case for saying “No”: they are different ‘products’. Although the rooms themselves may be identical, part of what you pay for by booking in advance is the security of knowing a bed is there for you. Turning up at the last minute carries the risk that there will be no bed at all. In a real sense, then, the lower price negotiated at the last minute reflects a different, inferior product.

There are two main ways in which the ‘same’ product can be differentiated to allow different prices to be charged. One of them is by time and the other by place. Let’s think of time first. For short-haul flights, prices tend to be much lower for people staying away on a Saturday night than for those not doing so. Although the aircraft may be the same, the timing is not. Airlines do this as a way of persuading businesses to pay more than leisure passengers. Business people are less likely to be discouraged by high prices as they will want to be back with their families at the weekend. Leisure passengers will be put off flying if prices are high, in that they will probably regard their trips as less essential. They will want to be away at the weekend when not at work.

A similar procedure is adopted by hotels. Many business people travel alone whereas most leisure travellers are in twos. Hotels therefore charge substantial `single room supplements’ in the week as a means of charging businesses more than leisure consumers.

Are these examples of price discrimination? One could argue that they are not. In neither case are they perfect substitutes. Consumers are buying different products — differentiated by time.

One could say the same about off-peak electricity prices. Although prices may be lower at 3 am, I do not regard the electricity at that time as a perfect substitute for that which is supplied at 7 pm. I do not want to cook a meal in the middle of the night. I want to be asleep then.

So, when firms charge different prices for a product at different times this is often wrongly regarded as price discrimination. There is a good case for saying that such price differences reflect differences in the nature of the product.

Now we think of differentiating the ‘same’ product by place. Many firms produce a product in one place but sell it in different geographical markets at different prices. For example, the car industry has been well known for charging higher prices to customers in its own home market and lower prices to customers abroad, that is to say in export markets. These price differences exist for cars with precisely the same features. The behaviour of firms in such markets is commonly regarded as price

discrimination. Again, though, we could ask whether the product is really identical. A Ford Fiesta in the showroom near my home is not a perfect substitute for one in Holland. To have the one in Holland requires an investment of time and effort on my part to bring it to the UK. One could argue that the difference in place means that these vehicles are not perfect substitutes and therefore we should not regard them as price discrimination.

Despite what we have said above, there are unambiguous examples of price discrimination. The most common are those relating to differences in income. One example is rail travel. Those under 24 and over 60 can obtain railcards and discounted fares. Those of us between these ages cannot obtain such railcards and thus pay more for the journey. The higher price that we pay is for the same seat on the same train at the same time of day. The price discrimination is not hard to understand. The young and the retired tend to have lower incomes. Unless they are offered relatively low fares they will probably not travel. Those in the ,middle-aged’ group have, on average, higher incomes. If they are charged rather more they will be mostly be willing and able to pay the extra and will still travel. So this is an example of price discrimination via income on the principle of ‘charge what the market will bear’.

What makes this example different from the ones we considered involving time and place? In those cases they are different products. As a consumer I can chose to buy whichever product I prefer. For example I can buy my new Fiesta from the showroom down the road or from Holland. But I cannot choose a cheaper seat on the train. I must pay the price asked for or not travel. I am obliged to pay the higher price for the seat for which the student would pay less. Similar arguments apply to children travelling on buses and

students receiving discounts from hairdressers.

There are then, examples of price discrimination. However, we must be sure that the good for which different prices are charged is a perfect substitute.

WHAT CONDITIONS MAKE PRICE DISCRIMINATION POSSIBLE?

Although firms would like to price discriminate, they may not be able to do so. In fact, it will only be possible if all three of the following circumstances apply: (a) They must have an element of monopoly power, (b) they must be able to prevent arbitrage, (c) there must be a difference in the elasticity of demand for the product.

(a) Monopoly Power

This is perhaps the most obvious of the three conditions necessary. A firm in perfect competition cannot price discriminate. If it charges any of its customers a higher price than the price set by the market it will sell nothing. Other firms are producing an identical product and are willing to sell at the price determined by supply and demand. Most firms, however, can differentiate their product in some way and so have some degree of monopoly power even if it is very limited.

(b) Preventing Arbitrage

Arbitrage is the process whereby profit motivated traders buy a good in markets where price is low and resell in markets where the price is higher. Their effect is to raise price in the lower priced market since their presence there increases demand. Their effect is to lower price in the higher priced market since their presence there increases supply. If there are no transaction costs (costs of transport, storage etc) arbitrage makes the price of a good the same wherever it is sold. Where a firm practises price discrimination there is the potential for arbitrage. If people can buy where the monopolist is selling the good cheaply and resell where the good is more expensive, the ability of the firm to raise profit by price discrimination is destroyed.

The monopolist must be able to prevent arbitrage. We mention two examples of how this might be possible.

What prevents young people from buying rail tickets at low prices and reselling them to the `middle-aged’? The train

operators insist on the traveller being able to produce identification that they are entitled to the lower fare. This prevents arbitrage. Our other example is from the car industry. If cars are cheaper in Holland than in the UK, what prevents profit motivated traders buying cars there and reselling them to UK consumers? The answer some years ago was the high transaction costs involved. Now the internet has made people more aware of price differences. Companies transport the cars in large quantities, gaining economies of scale, and many people now buy cars in the UK in this way from such companies as Jamjar. So car companies are finding their ability to prevent arbitrage is much less. Differences in car prices between the UK and Europe are becoming less marked.

The prevention of arbitrage, then, is a key condition for successful price discrimination.

(c) Different Elasticities of Demand

The final circumstance necessary for price discrimination is that consumers have different demand elasticities. For example, since business people feel they must travel whereas leisure consumers feel it to be less imperative, those in business will tolerate a higher price. The higher price will discourage few business people from travelling but will discourage many leisure travellers. Demand for travel among business people is price inelastic; demand among leisure travellers is price elastic. Business travellers will therefore be charged more.

We can show the idea diagrammatically in figure 1. We assume a monopolist that has a leisure market with an associated demand curve D^sub 1^ and a business market with its demand curve D^sub b^ and where the business market demand is relatively inelastic. Each market has its associated marginal revenue curve MR. We also assume, for simplicity, constant average cost. Not that there is only one MC and AC curve. This is one product being produced for two markets. A profit maximiser will produce where MC = MR. To find MR for the whole market we need to add the individual MRs from each of the two markets. The horizontal sum of the two MR curves gives SMR. The profit maximising output is therefore

Q^sub pm^ where MC = MR.

The firm now wishes to distribute that output between its two markets in an optimal way. To do this it must make sure that MR in each market is the same. This may seem a tricky idea at first but think about it in the following way. Suppose MR in the two markets were different. By redistributing its output to the market where MR is higher the monopolist’s revenue would increase. But as it sells more in the market where MR is higher, MR will fall. Similarly as it sells less where it is lower, MR will rise. So it keeps redistributing sales between the markets until MR in the two markets is the same. This means selling Q^sub b^ in the business market and Q^sub 1^ in the leisure market. (Q^sub 1^ + Q^sub b^ Q^sub pm^, of course)

Following the standard profit maximising behaviour, Q^sub b^ output is sold at the highest price the market will bear, P^sub b^ Similarly Q^sub 1^ output is sold at the lower price P^sub 1^.

Notice that if elasticity of demand in each of these markets were to be the same, when the firm equated MR in the two markets price would also be the same. Price discrimination would not be possible.

Let us summarise. The firm, in order to price discriminate, needs some monopoly power. Elasticity of demand must be different in the two markets. The resulting differences in price can only be sustained if there are barriers to arbitrage.

PRICE DISCRIMINATION: BAD FOR CONSUMERS?

Finally, we consider briefly whether the kind of price discrimination that we have been considering is bad for consumers.

There is a clear case for saying “Yes”. Monopoly power enables firms to capture consumer surplus. Price discrimination enables a monopolist to capture even more consumer surplus. Indeed this is one way of describing what price discrimination is about. It is a mechanism for capturing more consumer surplus. However, there may be circumstances where such behaviour is in the public interest. We will consider just one idea here.

Suppose a monopolist that did not practise price discrimination had a cost and revenue structure such that the firm could not cover costs in the long run. The firm would not be in the market at all. It would produce nothing. Now suppose that it could price discriminate. If the firm’s ability to make inroads into consumer surplus is sufficient to cover the long run loss, it will stay in the market and produce. The output it produces is socially worthwhile, and it is in the interests of consumers that it be produced. Under these circumstances an attempt by government to ban price discrimination would lower social welfare by driving the firm out of business.

CONCLUSION

Examples of price discrimination appear to be all around us. However, understanding what we mean by this term is not straightforward. Firms that wish to engage in this practice can only do so under specific conditions. Whilst this behaviour may at first seem unacceptable in that it reduces welfare, there are circumstances in which consumers as a whole gain from it even if some consumers in the market find themselves paying higher prices.

Copyright Economics and Business Education Association Autumn 2002

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