Wednesday, February 22, 2006

Price Discrimination

In yesterday's blog entry I stated that the hotels and museums in Russia were practicing price discrimination when they charged foreign tourists different rates than local Russian tourists. This is not the same as racial or other types of discrimination whereby people are denied rights due to their race or some other identifying characteristic. Instead, it describes a situation where seller's can take advantage of the fact that not only are certain groups of consumers willing to pay more for a good or service than another but it is possible to charge each group what it is willing to pay AND prevent the higher paying group from paying the lower prices offered to the other group.

All of you should understand that the price of a good or service in the market by the intersection of the demand and supply curves. However, there are some people who fall along the portion of the demand curve that is above the equilibrium point. These people are willing and able to pay a higher price for the good or service but, seeing they can get it for the lower market equilibrium price, end up paying the equilibrium price. The difference between the price an individual is willing to pay and the equilibrium price that that individual actually pays is known as consumer surplus. Now, if I, as a consumer, drive into a gas station with my tank on empty and am willing and able to pay $2.90 per gallon but see that the gas is offered for $2.30 I am not going to insist that the attendant accept $2.90 per gallon for the gas I purchase. In fact, I will be angry if the attendant, somehow knowing that I am willing to pay $2.90, attempts to charge me that price after charging the customer ahead of me $2.30 for the same grade of gasoline. Given the opportunity, the consumer will always elect to pay a lower rather than a higher price, ceteris paribus, even though he is willing and able to pay the higher price.

The opportunity for price discrimination arises when a seller is able to first identify two or more different segments of consumers with each segment having a different price they are willing to pay. Second, the seller must have some control over price. Monopoly, monopolist competition and oligopoly all allow sellers to exercise some control over the price they charge as the products these sellers offer are to some degree unique. Price discrimination is not possible under pure competition since the good or service offered by each seller is identical to that of all other sellers of the good or service enabling consumers to get the lower price simply by going to a competing seller. Finally, and most importantly, it must be impossible or too costly for a buyer to purchase the good or service at the lower price and resell it to buyers in the higher price category at a price between what she paid and what the seller is charging that group. If such arbitrage opportunities exist any price discrimination will soon disappear.

The conditions described above existed in the hotel and museum industry in Russia and that is how they were able to practice price discrimination. Another example of price discrimination closer to home is the sale of seats on airplanes. Think of two passengers sitting next to each other in tourist class on a flight from Tucson to Chicago. One passenger paid $1,200 and the other paid $300 for the same service. How is the airline able to get away with this? Well, the first passenger is a businesswoman whose employer paid the $1,200 to get her to Chicago to close a multi-million dollar deal while the second passenger is a retired grandfather on a budget who had to purchase his own ticket. Being retired, the grandfather's time is flexible so he was able to purchase a ticket twenty-one or more days before and able to schedule his departure and return such that he will be spending a Saturday night in Chicago. The businesswoman's employer would have liked to pay $300 for her ticket but when the client called the day before and said they were ready to sign they had to send her immediately – they were not about to lose a multi-million dollar deal by trying to save $900. Further, they are probably paying this woman a high salary and cannot afford to have her sitting around Chicago after the deal waiting until Sunday morning in order to qualify for the $900 savings. Business needs to respond quickly and usually does not have the luxury of 21 day advance reservations. Also, it is usually less expensive to pay the extra cost of the tickets than lose the employee's services for a few days (to say nothing of the fact that the employees prefer to be home with their families on weekends rather than sitting alone in a hotel room in a distant city). Tourists have the luxury of planning ahead and don't mind spending Saturday at their destination but they are also more price sensitive to price. The 21 day advance reservation and Saturday night layover requirements are effective ways to segregate the two groups of consumers. There is also no easy or inexpensive way for tourists to purchase extra tickets and make a profit selling them to business so the price discrimination works in this case.

The Anderson book also gives the example of monopolies charging more for the first unit of the good or service than for succeeding units. This works when the majority of the consumers have a compelling need for first unit of the good or service but not for additional units. Electricity is a good example here. It is almost impossible for a modern home to be without electricity. A certain minimal amount is needed each month for lights, alarm clocks, cooking, heating (or starting the heating unit if it is not electric) and, in Arizona in the summer, cooling. But after the basic electrical needs are met other uses are nice but not a necessary. It is necessary to use the air conditioner in summer to cool the house down while we are in it. It is nice, but not as necessary, to keep the house cool all day so you can walk into a cool home after work and not have to wait for it to cool down. Similarly, a twenty minute hot shower on a cold winter morning is great but two are three minutes are all that is necessary to clean yourself. Thus, people will purchase the first necessary units but are reluctant to spend the same amount for additional units. Recognizing this, the monopolist offers the additional units at lower prices to induce individuals to keep consuming past the first required purchase. (NOTE: this second example is also a good example of diminishing marginal utility where the satisfaction gained from consumption of the good or service declines with each additional unit consumed. In this case in order to keep the cost of the satisfaction or utility the same for each unit purchased, the price paid for each additional unit must be reduced proportionally.)

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