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Price Discrimination

24 April, 2015 - 15:48

Throughout the text up to this point, we have assumed that firms sold all units of output at the same price. In some cases, however, firms can charge different prices to different consumers. If such an opportunity exists, the firm can increase profits further.

When a firm charges different prices for the same good or service to different consumers, even though there is no difference in the cost to the firm of supplying these consumers, the firm is engaging in price discrimination. Except for a few situations of price discrimination that have been declared illegal, such as manufacturers selling their goods to distributors at different prices when there are no differences in cost, price discrimination is generally legal.

The potential for price discrimination exists in all market structures except perfect competition. As long as a firm faces a downward-sloping demand curve and thus has some degree of monopoly power, it may be able to engage in price discrimination. But monopoly power alone is not enough to allow a firm to price discriminate. Monopoly power is one of three conditions that must be met:

  1. A Price-Setting Firm The firm must have some degree of monopoly power—it must be a price setter. A price-taking firm can only take the market price as given—it is not in a position to make price choices of any kind. Thus, firms in perfectly competitive markets will not engage in price discrimination. Firms in monopoly, monopolistically competitive, or oligopolistic markets may engage in price discrimination.
  2. Distinguishable Customers The market must be capable of being fairly easily segmented— separated so that customers with different elasticities of demand can be identified and treated differently.
  3. Prevention of Resale The various market segments must be isolated in some way from one another to prevent customers who are offered a lower price from selling to customers who are charged a higher price. If consumers can easily resell a product, then discrimination is unlikely to be successful. Resale may be particularly difficult for certain services, such as dental checkups.

Examples of price discrimination abound. Senior citizens and students are often offered discount fares on city buses. Children receive discount prices for movie theater tickets and entrance fees at zoos and theme parks. Faculty and staff at colleges and universities might receive discounts at the campus bookstore. Airlines give discount prices to customers who are willing to stay over a Saturday night. Physicians might charge wealthy patients more than poor ones. People who save coupons are able to get discounts on many items. In all these cases a firm charges different prices to different customers for what is essentially the same product.

Not every instance of firms charging different prices to different customers constitutes price discrimination. Differences in prices may reflect different costs associated with providing the product. One buyer might require special billing practices, another might require delivery on a particular day of the week, and yet another might require special packaging. Price differentials based on differences in production costs are not examples of price discrimination.

Why would a firm charge different prices to different consumers? The answer can be found in the marginal decision rule and in the relationship between marginal revenue and elasticity.

Suppose an airline has found that its long-run profit-maximizing solution for a round-trip flight between Minneapolis and Cleveland, when it charges the same price to all passengers, is to carry 300 passengers at $200 per ticket. The airline has a degree of monopoly power, so it faces a downward-sloping demand curve. The airline has noticed that there are essentially two groups of customers on each flight: people who are traveling for business reasons and people who are traveling for personal reasons (visiting family or friends or taking a vacation). We will call this latter group “tourists.” Of the 300 passengers, 200 are business travelers and 100 are tourists. The airline’s revenue from business travelers is therefore currently $40,000 ($200 times 200 business travelers) and from tourists is currently $20,000 ($200 times 100 tourists).

It seems likely that the price elasticities of demand of these two groups for a particular flight will differ. Tourists may have a wide range of substitutes: They could take their trips at a different time, they could vacation in a different area, or they could easily choose not to go at all. Business travelers, however, might be attending meetings or conferences at a particular time and in a particular city. They have options, of course, but the range of options is likely to be more limited than the range of options facing tourists. Given all this, tourists are likely to have relatively more price elastic demand than business travelers for a particular flight.

The difference in price elasticities suggests the airline could increase its profit by adjusting its pricing. To simplify, suppose that at a price of about $200 per ticket, demand by tourists is relatively price elastic and by business travelers is relatively less price elastic. It is plausible that the marginal cost of additional passengers is likely to be quite low, since the number of crewmembers will not vary and no food is served on short flights. Thus, if the airline can increase its revenue, its profits will increase. Suppose the airline lowers the price for tourists to $190. Suppose that the lower price encourages 10 more tourists to take the flight. Of course, the airline cannot charge different prices to different tourists; rather it charges $190 to all, now 110, tourists. Still, the airline’s revenue from tourist passengers increases from $20,000 to $20,900 ($190 times 110 tourists). Suppose it charges $250 to its business travelers. As a result, only 195 business travelers take the flight. The airline’s revenue from business travelers still rises from $40,000 to $48,750 ($250 times 195 business travelers). The airline will continue to change the mix of passengers, and increase the number of passengers, so long as doing so increases its profit. Because tourist demand is relatively price elastic, relatively small reductions in price will attract relatively large numbers of additional tourists. Because business demand is relatively less elastic, relatively large increases in price will discourage relatively small numbers of business travelers from making the trip. The airline will continue to reduce its price to tourists and raise its price to business travelers as long as it gains profit from doing so.

Of course, the airline can impose a discriminatory fare structure only if it can distinguish tourists from business travelers. Airlines typically do this by looking at the travel plans of their customers. Trips that involve a stay over a weekend, for example, are more likely to be tourist related, whereas trips that begin and end during the workweek are likely to be business trips. Thus, airlines charge much lower fares for trips that extend through a weekend than for trips that begin and end on weekdays.

In general, price-discrimination strategies are based on differences in price elasticity of demand among groups of customers and the differences in marginal revenue that result. A firm will seek a price structure that offers customers with more elastic demand a lower price and offers customers with relatively less elastic demand a higher price.

It is always in the interest of a firm to discriminate. Yet most of the goods and services that we buy are not offered on a discriminatory basis. A grocery store does not charge a higher price for vegetables to vegetarians, whose demand is likely to be less elastic than that of its omnivorous customers. An audio store does not charge a different price for Pearl Jam’s compact disks to collectors seeking a complete collection than it charges to casual fans who could easily substitute a disk from another performer. In these cases, firms lack a mechanism for knowing the different demands of their customers and for preventing resale.

KEY TAKEAWAYS

  • If advertising reduces competition, it tends to raise prices and reduce quantities produced. If it enhances competition, it tends to lower prices and increase quantities produced.
  • In order to engage in price discrimination, a firm must be a price setter, must be able to identify consumers whose elasticities differ, and must be able to prevent resale of the good or service among consumers.
  • The price-discriminating firm will adjust its prices so that customers with more elastic demand pay lower prices than customers with less elastic demand.

TRY IT!

Explain why price discrimination is often found in each of the following settings. Does it make sense in terms of price elasticity of demand?

  1. Senior citizen discounts for travel
  2. Food sold cheaper if the customer has a coupon for the item
  3. College scholarships to students with the best academic records or to students with special athletic, musical, or other skills

Case in Point: Pricing Costa Rica’s National Parks

Costa Rica boasts some of the most beautiful national parks in the world. An analysis by Francisco Alpizar, an economist with Gothenburg University in Sweden and CATIE, a tropical research institute in Costa Rica, suggests that Costa Rica should increase the degree to which it engages in price discrimination in pricing its national parks.

The country has experimented with a wide range of prices for its national parks, with the price varying between $.80 and $15 for a daily visit. With data on the resultant number of visitors at each price, Professor Alpizar was able to estimate the demand curve, compute the price elasticity of demand, and develop a recommendation for pricing the country’s national parks.

Presumably, foreign visitors have a relatively less elastic demand for visiting the parks than do local citizens. Local citizens have better knowledge of substitutes for the parks—namely other areas in Costa Rica. And, of course, once foreign travelers are in the country, they have already committed the expense of getting there, and are less likely to be willing to pass up a visit to national parks based on pricing considerations.

Costa Rica already discriminates to a large degree. Foreigners are charged $7 per day to visit the parks; locals are charged $2. Professor Alpizar proposes increasing the degree of discrimination.

He estimates that the price elasticity of foreign demand for visits to Costa Rica’s national parks is −0.68. That, of course, suggests inelastic demand. Costa Rica could increase its revenue from foreign visitors by increasing the fee. Professor Alpizar proposes increasing the fee for foreigners to $10. He proposes that the price charged to Costa Ricans remain at $2—a price that he calculates equals the marginal cost of an additional visit.

Professor Alpizar calculates a fee of $10 per visit by a foreigner would more than pay the country’s fixed cost of maintaining its extensive park system, which utilizes 24% of the country’s land. The higher price would thus allow the government to meet the major costs of operating the national parks. Charging a $2 fee to locals would satisfy the efficiency requirement that price equal marginal cost for local visitors; the $10 fee to foreigners would permit the country to exploit its monopoly power in permitting people to visit the parks. The Costa Rican government has asked Professor Alpizar to design three pilot projects aimed at incorporating his proposal to raise park fees to foreign visitors.

Source: Francisco Alpizar, “The Pricing of Protected Areas in Nature-Based Tourism: A Local Prospective,” Ecological Economics, 56(2) (February 2006): 294–307 and personal correspondence with Professor Alpizar.

ANSWER TO TRY IT! PROBLEMS

  1. Senior citizens are (usually!) easy to identify, and for travel, preventing resale is usually quite easy as well. For example, a picture ID is required to board an airplane. Airlines might be expected to oppose implementing the rule since it is costly for them. The fact that they support the rule can be explained by how it aids them in practicing price discrimination, by preventing the resale of discount tickets, which now can easily be matched to the purchasing customers. The demand for air travel by senior citizens is likely to be more elastic than it is for other passengers, especially business travelers, since the purpose of their travel is largely discretionary (often touristic in nature) and since their time is likely to be less costly, making them more willing to seek out information on travel alternatives than the rest of the population.
  2. Since the customer must present the coupon at the point of sale, identification is easy. Willingness to search for and cut out coupons suggests a high degree of price consciousness and thus a greater price elasticity of demand.
  3. Such students are likely to have more choices of where to attend college. As we learned in an earlier chapter on elasticity, demand is likely to be more elastic when substitutes are available for it. Enrollment procedures make identification and prevention of resale very easy.