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.)

How a Free Market Works

In both the ECN 201 Microeconomics class and the ECN 200 Basic Economic Principles courses I assigned the same article by Murray Rothbard entitled What is the Free Market? and one of the questions asked in both courses was:

Explain why the socialist planners in the former Soviet Union were unable to take a bumper (i.e., very large) harvest of wheat and convert it to bread and other baked goods for consumption by consumers in cities throughout the former Soviet Union.

To date the few assignments I have received have all paraphrased Rothbard to the effect that the Soviet planners lacked a free market and prices to guide them. Some have also added that the absence of prices and profits also resulted in a lack of incentives to produce. While I have accepted these answers so far, it is clear that those answering the question didn’t really grasp why the free market and price system is important and how they work.

A real life story from my wife’s experience may help clarify the problem. My new wife is from Ryazan, a city in western Russia with about the same size population as Tucson. Ryazan is located about three hours by train or car south of Moscow. According to my wife, there were no stores with food for sale in the city in the period prior to the fall of communism in the early 1990s. Despite the fact that among the city’s industries was a large meat processing plant (the total output of which was sent to Moscow for sale) people had to travel by car (if they had one) or by train to Moscow to do their grocery shopping. My wife and her former husband had to travel by car with his parents (who owned the car) once a month to do their grocery shopping. The trip took three hours each way to get to Moscow and back and the rest of the day was spent in lines in stores trying to get food. Back in Ryazan they had a small apartment (for themselves and their two children) with a small kitchen and a refrigerator about half the size of contemporary American refrigerators.

I had previously visited Moscow and St. Petersburg (then known as Leningrad) in my senior year of college 1969 as a part of a Russian history course that included a 2 week field trip to the Soviet Union. I observed that life was drab but the people I saw and met had sufficient food, clothing and shelter. There was not much variety in the food – mostly fresh potatoes and vegetables. Meat was very scarce and people’s main source of animal fat for energy was the lard that food was frequently used for cooking. Obtaining food required going from store to store and standing in long lines hoping they still had food in stock when you reached the counter. The clothing was dull and ill fitting. The colors were mostly dark blues, grays, browns and blacks and even these dark colors were dull compared to the same colors in clothes manufactured in the west. The quality of western clothing was so superior that a westerner could not walk down a street without having a dozen or more people approach them with offers to purchase the extra clothes they had back at the hotel. The ruble prices offered for the used clothing were usually in excess of the original price paid in the west. This despite the fact that the buying or selling of items outside regular stores was illegal. The housing was mostly small apartments.
This was the situation in Russia for most of its citizens under communist rule. Practically everyone was poor by western standards but it was not the absolute poverty of the third world. Things were bad but not desperate.

In a market economy prices for food in a city, like Ryazan, would be high. This would signal producers that there was an opportunity for profit and they would begin moving food to Ryazan to sell. But, without a market driven price system, this signal did not exist so the city’s plight did not come to the attention of the planners in Moscow. The other, non-market, signal that would have alerted the planners would have been large numbers of people dieing of starvation or masses of hungry people taking to the streets and rioting. But, there was no shortage of food in the sense that people were going hungry. Food was not plentiful and it was inconvenient to obtain it but, with effort, sufficient food could be obtained. Like a person with a long illness who has learned to live with his or her pain, the people of the former Soviet Union endured. Thus, in the absence of signals, the planners, occupied with trying to make all the economic decisions for a nation that stretched from the Baltic to the Pacific, easily overlooked Ryazan.

As my first described it to me when I first visited her in Ryazan in 2002, “…there was a fellow named Gorbachev in charge and things got really bad. Then one day things suddenly changed. Gorbachev was gone and food appeared in the stores in Ryazan”. The change was literally overnight as Russia went from communist central planning to a free market. The first thing that changed was money became important. Under the communists prices were set by the planners with some attempt to ration scarce goods. But, both the lack of good information and political meddling made most prices meaningless and rationing was done by having people wait in long lines or use political influence to obtain needed goods. Further, incomes did not vary much so everyone tended to suffer equally. Acquiring money through saving was not allowed. The government owned all the businesses so there was no place to invest one’s money. Starting one’s own business was illegal. Finally, it was illegal to take money abroad, but that didn’t matter because, the currency was basically worthless outside of the Soviet Union.

With the communists no longer in control entrepreneurs were free to begin making money by providing products to consumers. Farmers dug into their limited supplies of food that they had hidden for emergencies and began selling it in the cities. Making a profit, they returned home and began growing and scrounging anything edible to take to the cites to sell. Others, not in farming began noticing arbitrage opportunities where food in large cities, like Moscow, was more plentiful and therefore less expensive while in places like Ryazan it was scarce and expensive. They went to the places with less expensive food, purchased it and returned home to sell it at a profit. (The fall of communism meant that people were no longer paid when they took off from work, it also meant that gasoline prices were allowed to rise and trains, which were still run by the state but needed money to keep operating, were now making everyone pay the regular fare. In the past paying was more of an honor system which most people chose not to honor.) It was thus profitable for people out of work to specialize in traveling long distances to obtain food and other goods for re-sale in their home cities but costly for people with jobs. In a market system goods that are in great demand and short supply command high prices while those which are in large supply and/or not in great demand have lower prices. While planners had to try to figure everything out in order to make the economy run (and when they did not know everything, which was all the time, goods became scarce), entrepreneurs in a market economy don’t have to know everything. They just have to be able to identify which goods command a high price and can be produced or obtained at a lower price somewhere else.

The Russia I visited in 2002 was vastly different from the Soviet Union of 1969. Food was plentiful and in greater variety. Clothing was also plentiful and of comparable quality to western clothing. In 1969 you could literally spot a foreign tourist a mile away by their clothing. In 2002 the only way to identify a western tourist was if they spoke in a language other than Russian or, in the case of Americans, if they wore a wedding band on their left hand (Europeans generally wear wedding bands on their right hands). I even took a three day bus tour with my then fiancée using a Russian name and not speaking (I don’t speak Russian) and easily passed myself off as one of the locals.

Prior to the fall of communism people, including economists, were wondering if it was possible to convert from the communist economic model to a market economy peacefully given the huge distortions created by the communist central planning. In the 1999 book The Commanding Heights. The Battle Between Government and the Marketplace that is Remaking the Modern World. authors Daniel Yergin and. Joseph Stanislaw describe the situation in Poland when the communist economy collapsed. The communist generals who had staged a coup earlier and replaced the civilian communist rulers in a last ditch attempt to save the system gave up and turned the government over to Solidarity. American economists, trained in free market economics under the tutelage of Milton Friedman and the University of Chicago, and fresh from their success in turning the Chilean economy around after its short bout of communism under Salvador Allende were called in to perform the same miracle in Poland. But Poland was a complete disaster. With food supplies expected to run out in the cities in a matter of days and mass starvation imminent, the American advisors advised going cold turkey by instantly abolishing all forms of government control over the economy and letting it move to a free market instantly rather than the gradual transition the many were urging. The government declared that effective at midnight a couple of days later the transition would occur. The American economists crossed their fingers and made reservations to leave on the first plan out after midnight just in case the experiment didn’t work and chaos ensued. The transition to a market economy took place at midnight as planned and by 5 a.m. there were lines of farmers making their way to the cities with food. Within days the food shortage had ended.

Seeing Ryazan in 2002 I could easily believe my then fiancée when she described the change as no food one day and food suddenly appearing within days of the unreported (in Russia) coup that moved the country from communist central planning to a market economy literally over night.

Brown Lung DiseaseDiscussed in Lesson 1 of ECN 200

Brown Lung Disease, also called Byssinosis, is a lung disease that results from prolonged (often ten years or more) exposure to breathing of cotton fibers present in the air during the production of cloth from raw cotton (in the U.S. most textile mills process cotton fiber so the most common cause of Byssinosis in the U.S. is cotton fiber, in other countries it is caused by flax, hemp or other material fibers as well as cotton).

It is believed that byssinosis is the result of constant irritation and/or release of toxic substances by the fiber on the lungs over a long period of time. Byssinosis is characterized by shortness of breath, feelings of tightness in the chest and constant coughing. Continued exposure after onset of disease results in a reduced ability to breathe, especially exhale, which is very similar to the symptoms experienced by people with chronic bronchitis. There is some indication that smoking or occurrence of other lung ailments aggravates byssinosis. While "brown lung" is the term used to describe the condition, patients' lungs do not turn brown as a result of the disease.

According to the video and statistics cited by OSHA at the time of the implementation of safety standards to prevent the disease in 1978, about 100,000 or about 20% of the workers in textile mills in the U.S. were AT RISK of contracting the disease. After implementation of the new rules, OSHA statistics showed that between 1979 and 1996 an estimated 35,000 current and former textile workers (due to long period needed to develop the disease, most of these probably contracted the disease in the years prior to the implementation of the safety standards) actually had the disease and, of these, between 120 and 188 died from it in the period 1979-1996.

While it was unfortunate that some workers contracted the disease and a few died of byssinosis, the cost of the cure according to your book was the loss of 300,000 jobs in the textile industry in the U.S. Additional jobs were probably lost in service industries that provided goods and services to the workers (stores, restaurants, bars, banks, etc. all of which would have seen business decline and would have laid off workers due to loss of business from the unemployed textile workers) and services to the companies themselves (delivery people, suppliers of raw materials, machinery, etc.). In many cases the impact of the closing of textile factories could be tremendous in cases where the textile company was the major employer in the area. Also, for many of the workers jobs in the textile mills were probably both one of the few jobs for which they had skills and the textile jobs probably paid more than the few other low skill jobs.

Why was the actual rate of disease and death so low? There are a number of possible reasons. First, the disease generally occurs only after long exposure to breathing the cotton fibers. Many people got a start in the textile mills and then moved on to work in another industry. Second, many of those who spent their careers in the textile mills only spent part of their career or part of their working time in those parts of the factory floor where the fibers were concentrated. Finally, contracting the disease and the severity of it once contracted can be related to one's overall health. People with weak lungs are probably at greater risk than those with healthy lungs. Secondly, smoking and other activities that harm or weaken the lungs will increase the risk of byssinosis and this risk will be even greater in people whose lungs are weak to begin with.

While we cannot dismiss the deaths of 188 or so workers or the debilitating illness of 35,000 workers as an acceptable cost for the saving of over 300,000 jobs. But, at the same time, it is difficult to justify drastic actions that severely harm many to save a few especially when there are other alternatives. As your text and video pointed out, in the case of byssinosis, a mask that cost $1.49 per worker would have been a low cost interim solution. True, the masks were uncomfortable but that was better than losing one's job in a job market with few other possibilities. As companies renovated factories and built new ones they would have installed the new equipment in an effort to keep their existing labor force and attract new workers from the firms that had older factories. But incorporating new technology into the building of a new factory is considerably less expensive than attempting to retrofit new equipment into an existing structure.

The study of economics should show you that there is no such thing as a free lunch. Everything has costs and all economic activity involves tradeoffs between costs and benefits. The goal should be to find production processes that yield the most benefits with the least cost. But more importantly, activists and policy makers should consider the implications of the policies they are pushing. The workers in the textile mills were free to choose between keeping their jobs and risking the possibility of contracting byssinosis or seeking a different job. While their options may have been limited, they were still in the best position to analyze their personal situation and make a decision. Instead, union officials, Congressmen, bureaucrats, Supreme Court Justices, etc. in Washington and other places far from the textile mills and with jobs that would be unaffected by their decisions, made the decisions that cost over 300,000 textile workers their jobs.

For more information on lung diseases and occupational dangers affecting lung health see the
American Lung Association web page.

Videos for ECN 200 Telecourse

All students in the ECN 200 Telecourse should have received a Telecourse broadcast scheedule with the syllabus that was mailed to you by the Community Campus. In there it shows the ECN 200 course videos being broadcast on Comcast Channel 96 on Wednesdays from 6 - 8 pm and on Cox Channel 96 at the same time (Wednesdays from 6 - 8). It is very important that you make a point to watch these broadcasts as these constitute the lectures that you would be attending if this were a regular classroom class. If you schedule does not permit viewing at this time here are your additional options:

1 Set the timmer on your VCR and record the program for later viewing.

2 Go to the LRC desk at the Community Campus (located at 401 N. Bonita Ave.) and check out the three tapes that contain the entire series. This will require a Pima Community College ID card (which can be purchased at this or any PCC campus for about $2 upon showing proof of registration). You will be required to return the tapes at the end of the semester in the same condition as when checked out or a fine will be levied and a hold placed upon your records.

3 You can go to the Library at any PCC campus and check out a video FOR VIEWING AT THE LIBRARY.

4 Go to www.learner.org on the internet and view the videos on your PC over the Internet. See below for more on viewing the videos over the Internet.

A student in last Fall's class discovered the Learner.Org site which contains numerous resources for students and teachers. The best way to access the videos used for the ECN 200 course is to click on the blue Telecourses button along the top of the page and then scroll down to the Economics U$A link. Each of the videos is listed and can be viewed by clicking the video button next to the one you wish to view.

This site does require you to register in order to view a video. But it is a one time free registration. I did a quick check of it and they are the same videos that are broadcast for the class. The only limitation is that, being video, you need broadband access for good viewing. If you have a dial-up connection, as I have, it is slow and difficult. If you do not have broadband at home I suggest that you go to any PCC computer lab or library to view them or visit a Tucson Pima Public library and use their computers (U of A students can also use U of A facilities).

Those of you in my ECN 201 and ECN 202 independent study courses may also want to check out this site as the videos are an excellent resource and do a very good job of presenting the material in an interesting and understandable manner.

Opportunity Cost Explained

Usually when we think about the term costs we think of money. However, in economics we use the word opportunity costs to consider costs in a larger sense.

Normally when we purchase something we give up money in exchange for a good or service we want. But the true cost, or opportunity cost, is usually more than this. If my wife and I decide to go to a movie and pay $20 for tickets we are giving up not only something else that we could purchase with the $20 but also something else that we could have done with the time spent in the theater viewing the movie. It is the other thing that we could have brought with the money as well as the other thing that we could have done with the time that is the true, or opportunity cost. Everything we do involves a choice and when we make a choice the cost of that choice is the other things we could have had or done if we had not made this particular choice.

Now, as rational economic beings we choose that which will give us the greatest satisfaction at that particular moment. The opportunity cost of a particular choice is the next best alternative that you would have chosen. This is the thing you give up in order to obtain the thing you choose.

I may not agree with your choice and, later today or tomorrow you may regret having chosen option 'A' over option 'B'. But this does not invalidate the concept of opportunity cost. You choose what was most important to you at the time based upon the best information available and your desires at that moment. Part of growing up and acquiring knowledge is to enable us to make better decisions and look at choices from a broader perspective.

Advances in technology have done much to reduce opportunity costs but, in a world of unlimited wants and limited resources, opportunity cost still exists. As recently as two hundred years ago shoes (actually boots) were so expensive that most people, if they could afford boots at all, could afford no more than one pair and that pair had to last for years. In England at that time stealing a man's boots was such a serious crime that the penalty was death (since walking was the main mode of transportation and most work was done outdoors, stealing a man's boots was the equivalent of taking away his ability to support himself and his family). Thanks to advances in technology, shoes today are so inexpensive that even the poorest people can usually afford more than one pair. But while an average person may be able to afford as many pairs of shoes as they want and still have plenty of money left over for other things, opportunity cost is still present. While money may not be the major constraint, space is. Where do you store the shoes? Despite the relative affluence of the average contemporary American, most of us can't afford mansions with unlimited rooms. So the more shoes one acquires and stores by stacking them from floor to ceiling in the closet the less space there is for clothes. With closet space as the scarce resource the opportunity cost of more shoes would be fewer clothes.

Supply and Demand

Demand Curve – shows quantities of a good demanded (that will be sold) at various prices. The higher the price the lower the quantity demanded and vice versa.

Think of it this way, if you have $10 in your pocket and an item costs $10 you can afford to purchase one unit of the item. But if the price is $5 you can afford to buy 2, and if price is $2.50 you can purchase 4, etc.

Further, since there are more middle and lower income people than rich people, the lower the price the greater the number of people who will be able to afford to buy the product and the more people able to afford the product the greater the quantity that will be demanded.

Supply Curve – shows quantities of a good supplied at various prices. The higher the price the greater the quantity supplied.

No business (supplier of a product or service) can afford to sell at a price lower than cost and remain in business. BUT all suppliers of a good do not face the same set of costs. A farmer with fertile soil, a good climate and sufficient rain can produce a larger crop, at a lower cost than a farmer growing the same crop in poor soil in the desert. The desert farmer incurs the same costs for seed, labor, etc. as the other farmer. But the desert farmer must also purchase fertilizer, install irrigation and pay for water. As a result, the desert farmer will have higher costs per bushel of product than the farmer in the ideal location. In order to make a profit on his crop, the desert farmer has to receive a higher price per bushel than the other farmer. The point is that producers of a good or service face different circumstances and some are able to produce at a lower cost (require fewer resources) than others. As the price of a good rises more producers are able to offer the good or service.

As a second example, consider yourself and the sale of your labor services. If you had tickets to a concert for tonight and your supervisor asked for a volunteer to work overtime at the regular hourly rate you probably would not volunteer. If double time was offered, you might be tempted but the desire to see the concert would probably be greater. But, if your supervisor offered a $1,000 bonus to put in an additional four hours this evening, doing your regular work, you would probably take the offer. As the price goes up you, as the seller of your labor services, are more inclined to increase the quantity of labor you are willing to provide. In this example the cost is your opportunity cost. If you earn $10 per hour and your concert ticket cost $50 the decision to volunteer or not is a no brainer since you will lose the $50 spent on the ticket and only gain $40 from working the four hours. If your supervisor offered you double time (i.e., $20 per hour) for the extra four hours you would earn $80 and lose $50 for a net gain of $30. More than likely the desire to see the concert would be greater than the $30 of additional net income so you would probably still turn down the extra work. But $1,000 or $250 per hour, for four hours of work would probably change the equation as the opportunity cost of giving up the extra pay ($1,000) dwarfs the $50 plus satisfaction of attending the concert.

In summary, the demand curve shows the various quantities of a good that will be demanded (i.e., consumers are willing and able to buy) at various prices, while the supply curve shows the various quantities of a good that will be supplied (offered for sale by producers) at various prices. The point where the two intersect is the point where the quantity demanded equals the quantity supplied and this is the equilibrium or market price.