Price Discrimination

Optometrist: “The glasses will be fifty dollars.”

Looks at the customer, who says nothing

“for the frames. The lenses are another twenty.”

Looks at the customer, still no protest.

“Each.”

It is the classic account of price discrimination, a seller trying to charge the highest price the buyer will be willing to pay.¹ In the course of about a week recently I twice encountered real world versions of the same approach, first with the Washington Post then the Mercury News. I subscribed to each at a very attractive price, possibly as low as a dollar a year for the News. A year later they raised it — to $120/year for the Post, $13.07 for four weeks (169.09/year) for the News. The Post told me in advance that they were doing it, the News thanked me for the first payment at the new price.

I cancelled my subscription with the Post online, was promptly offered a much better price, accepted. I tried to cancel with the News online but for some reason, probably a bug in their software — but they are the newspaper of Silicon Valley so the bug may be synthetic — was unable to. I called their number, said I wanted to cancel, was offered a subscription at a dollar a week. It’s possible I could have gotten them down further but, having already spent several minutes being told at length in a badly accented English of the virtues of the paper and not wanting to sit through a repeat, I agreed.

The tactic collects the high price from people who did not notice the price change, people who value their subscription at the higher price and do not realize that they can get it at a lower price by trying to unsubscribe, perhaps a few rich enough not to think getting the lower price worth the trouble. They can still sell subscriptions to people willing to pay the low price but not the high. Since providing an additional on-line subscription costs them almost nothing, less than nothing if it increases their revenue from advertising by more than any additional cost, it is worth doing even at a low price.

This is one solution to the problem faced by a seller who wants to increase revenue by selling the same product at different prices to different buyers. It is not a very good solution because it depends on customers willing to pay a high price not realizing that they can get a better offer by trying to cancel. If only one newspaper was doing it the tactic might work. As it is, with many trying the same tactic, the first time a subscriber is faced with an increase to a price at which he wants to cancel he discovers the trick and it never works on him again.

An approach that avoids that problem is to price discriminate by some observable characteristic that correlates with willingness to pay. A familiar example is the policy of charging less for children than for adults at movie theaters. A child takes up just as much space as an adult, one seat, and may well impose higher costs in noise and mess on the theater and the other patrons. Why then do theaters often charge lower prices for children? The obvious answer is that children are (usually) poorer than adults; a price the theater can get adults to pay is likely to discourage children from coming or parents with several children from bringing them.

A similar example is the youth fare that airlines used to offer. It was a low fare for a standby ticket, offered only to those under a certain age. The lower fare reflected in part the advantage to the airlines of using standby passengers to fill empty seats but that does not explain the age limit. The obvious answer is that making the fare available to everyone might have resulted in a substantial number of customers buying a cheap standby ticket instead of an expensive regular one. Presumably the airlines thought that making it available to youths would result in their buying a cheap standby ticket on an airplane instead of taking the bus, driving or hitchhiking.

A second tactic is to sell two versions of the product, the more attractive at a higher price. Richer customers or ones who particularly value the product will be willing to pay the higher price for the superior version. Youth fares are gone, but the division between economy and business class tickets is a version of that tactic still with us, as is the price difference between hardcover and paperback.

In those cases the alternative versions of the product differ both in value to the customer and in cost of production to the seller. What makes the difference in part price discrimination is that the price difference is more than the cost difference. If that was not the case for youth fares they would not have been limited to youth. If it was not the case for differing fares at present a nonstop flight from San Francisco to DC would not cost about five time more in business class than in economy.²

A firm engaged in this sort of discriminatory pricing faces two practical problems. The first is the problem of distinguishing customers who will buy the good at a high price from those who will not. In the examples I have given that is done indirectly by characteristics of the buyer or the product. The second problem is preventing resale. It does no good to offer your product at a low price to poor customers if they then turn around and resell it to rich ones, thus depriving you of high price sales. This is why discriminatory pricing is so often observed with regard to goods that are consumed on the premises, transportation, movies, speeches, and the like. If GM sells cars at a high price to rich customers and at a low price to poor ones, Rockefeller can send his chauffeur to buy a car for him. There is little point in having the chauffeur take a trip for Rockefeller or see a movie for him.

The ability of a firm to engage in successful discriminatory pricing also depends on its being a price searcher, having some degree of what is sometimes called monopoly power. In a market with many firms producing virtually identical products, price discrimination is impractical; if one firm tries to sell the product at an especially high price to rich customers or customers who very much want the product, another firm will find it in its interest to lure those customers away with a lower price. That makes airline price differences by class a puzzle since lots of airlines fly from San Francisco to DC. My best guess is that it reflects the fact that the sort of people willing to pay business class fares are also the sort of people who want to fly at a particular time; there are lots of flights from SFO to DCA but only one nonstop flight that leaves after noon. Readers, especially ones who know more about the airline industry than I do, are invited to suggest alternative explanations.

The other cases I have described involve some element of monopoly. Youth fares existed at a time when airline fares were controlled by the Civil Aeronautics Board, a regulatory agency that provided government enforcement for a private cartel, keeping rates up and new firms out; they have since disappeared along with airline regulation. Copyright laws give each publisher a monopoly, not of books but of a particular book. The result is that publishers are price searchers; each knows that some customers are willing, if necessary, to pay a high price, while others will only buy the book if they can get it at a low price. Movie theaters have an element of monopoly, at least in areas where they are scarce enough that a customer cannot conveniently pick among several showing the same film.

Should I Be Angry?

It is tempting to treat price discrimination as cheating me, to believe that if the seller could cover his cost for ten dollars it is unfair for him to charge me twenty. It is tempting but I think wrong. If the product costs him ten dollars and is worth twenty to me, as demonstrated by his willingness to sell to other customers at the lower price and mine to pay the higher, that means that the transaction produces a net gain of at least ten dollars, perhaps more. There is no more reason why I should get it than why he should.

Is Price Discrimination a Bad Thing?

If we think, as economists sometime do, in terms of the summed effect on everyone affected, is price discrimination good or bad?

The answer is both.

To see one reason it may be a good thing, consider a firm with large fixed cost and low marginal cost. Producing a newspaper costs quite a lot, adding one more subscriber costs very little. Writing a book is a lot of work, providing it in the form of a Kindle to one more reader costs almost nothing. If the product is sold at the same price to everyone that price will have to be at least average cost, so potential customers who value it at less than that but more than marginal cost don’t buy it. That may mean that the product does not get produced; there may be no price at which total revenue covers total cost. Successful price discrimination lets the producer provide the product to more people and still at least cover the cost of doing so.

For an explanation of why price discrimination may be a bad thing, see Chapter 16 of my Price Theory, especially the passage starting with the subhead “Discriminatory Monopoly: The Solution?” or, better but a little less convenient, Chapter 16 of my Hidden Order after the same subhead.³

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1. The subject of Part II of Chapter 10 of my Price Theory.

2. From Travelocity for October 24^th.

3. The latter book is the former rewritten to convert a textbook into a book for people who want to teach themselves economics for the fun of it.