Price Discrimination

Written By: Yogin Vora on February 18, 2009 No Comment

1 Introduction

In broad terms, one can say that price discrimination exists when two “similar” products which have the same marginal cost to produce are sold by a firm at different prices.1 This practice is often highly controversial in terms of its impact on both consumers and rivals. This chapter aims to explain some of the main economic motives for price discrimination, and to outline when this practice will have an adverse or beneficial effect on consumers, rivals and on total welfare. Broadly speaking, there are three main reasons why competition policy may be concerned with price discrimination. First, a dominant firm may “exploit” final consumers by means of price discrimination, with the result that total and/or consumer welfare are reduced. Here, the question that needs to be addressed is: in what circumstances does price discrimination by a dominant firm have an adverse effect on welfare? The answer to this, as will be clear in this survey, often depends on the welfare standard that guides the application of competition law. However, in practice competition authorities hardly ever concern themselves with price discrimination as an exploitative device. Second, and especially in Europe, it is sometimes a policy objective to attain a “single market” across the region. Arguably, one manifestation of a single market is that a firm does not set different prices in different regions, or at least it does not prevent arbitrageurs reselling goods sourced in the low-price region to the high-price region. That is to say, firms are often prevented from segmenting markets with a view to engaging in price discrimination.
In Europe, this concern has lead to a very hostile attitude by the authorities to attempts by firms to prevent “parallel imports”, for instance. Third, and perhaps most importantly from a competition authority’s point of view, we may be concerned that price discrimination can be used by a dominant firm to “exclude” (or weaken) actual or potential rivals. The question is in which cases price discrimination can be an effective way to put the buyer’s rivals (primary line injury) or the seller’s rivals (secondary line injury) at disadvantage so as to force them to exit the market, or induce them to compete less aggressively. The appropriate antitrust treatment of price discrimination may require consideration of more than one of these concerns. For instance, a form of price discrimination may potentially be an efficient way to supply services to final consumers, and yet it may also possess exclusionary effects. In such cases, competition law and policy needs to balance the risk of preventing firms from pricing their products efficiently with the risk of permitting conduct that leads to a less competitive market structure. This chapter aims to explain some of the main economic motives for price discrimination, and to outline when this practice will have an adverse or beneficial effect on consumers, rivals and total welfare. The plan of the chapter is as follows. Section 2 outlines some of the principal methods of price discrimination. Section 3 shows how the ability to engage in price discrimination can sometimes lead to efficient (e.g., marginal cost) prices, which clearly leads to welfare gains. Section 4 discusses how price discrimination can open up new markets or shut down existing markets. Section 5 examines when price discrimination causes total output to rise or fall. Section 6 discusses when the introduction of price discrimination will cause some prices to rise and other to fall, while sections 7 and 8 focus on less familiar situations in which price discrimination causes all prices to fall or all prices to rise. Section 9 examines the impact of price discrimination on entry incentives. Section 10 introduces dynamic price discrimination, while section 11 outlines the impact of price discrimination in vertically-related markets. The discussion throughout focusses on the underlying economics of price discrimination and its impact on profits, entry, consumer surplus, and welfare. Where relevant, though,particularly prominent anti-trust cases are mentioned as we go along

2 Forms of price discrimination

There are numerous business practices which fall under the heading of price discrimination. First, consider static situations in which consumers buy all relevant products in a single period. In most markets, firms set the charge for purchase of their products by means of a simple price per unit for each product, where these prices do not depend on who makes the purchase. Such tariffs (i) are anonymous (they do not depend on the identity of the consumer), (ii) do not involve quantity discounts for a specific product (i.e., there are no “intra-product” discounts), and (iii) do not involve discounts for buying a range of products (i.e., there are no “inter-product” discounts). Various forms of price discrimination are found by relaxing restrictions (i)—(iii). Non-anonymous price discrimination: This occurs when a firm offers a different tariff to identifiably different consumers or consumer groups. When the tariff also involves simple per-unit pricing (rather than nonlinear pricing or bundling), this is the familiar case of third degree price discrimination. Examples of this practice include selling the same train ticket at a discount to senior citizens, selling the same car at different prices in two countries, or selling the same drug at difference prices for human and animal use. Unless arbitrage between consumer groups is very easy or competition between firms is almost perfect, we expect that any firm, if permitted to do so, would wish to set different tariffs to different groups. In antitrust cases this type of price discrimination can occur when the alleged abuse consists in “selective price cuts” or “geographic price discrimination”.
Another example of this form of price discrimination is first-degree price discrimination, where each consumer is charged exactly her willingness-to-pay for the product(s). In its purest form, the information needed for first-degree price discrimination makes it more of a theoretical benchmark than a realistic business strategy. However, it provides a transparent limit framework in which to discuss the possible efficiency gains from price discrimination, as well as its distributional impact on consumers.
Quantity discounts: This occurs when the per-unit price for a specific product decreases as the number of purchased units increases. A simple–and easy implemented–instance of this is a two-part tariff, whereby a buyer must pay a fixed charge in return for the right to purchase any quantity at a constant marginal price. There are two distinct motives to use nonlinear tariffs. First, nonlinear tariffs provide a more efficient means by which to generate consumer surplus. With linear pricing, the only way to make profit is to set prices above costs, which entails dead weight losses. With a two-part tariff, however, a firm can extract profit using the fixed charge, while leaving marginal prices close to marginal costs (which then maximizes the size of the “pie” to be shared between consumer and firm). This role for nonlinear pricing exists even if all consumers are similar. A second role emerges if consumers have heterogeneous tastes for a firm’s products. In this case, a nonlinear tariff can be used to sort different types of consumers endogenously (so-called second-degree price

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