Teaching price discrimination: some clarification.

• Author: Carroll, Kathleen

1. Introduction

   Economics is useful and important as a tool for the study of policy. Indeed, what interests students most are those topics with direct policy relevance. We think it important that these topics be covered with as little opportunity for confusion as possible, especially in the Principles course, which may be the only exposure students get to many of these issues. Treatment of price discrimination in both Principles and Intermediate texts are often laden with misleading and even incorrect information.

   We have reviewed the discussions of price discrimination in several Principles and Intermediate textbooks. Principles texts we have reviewed include: Mansfield (1992), Baumol and Blinder (1994), Miller (1994), Tresch (1994), Gwartney and Stroup (1995), Samuelson and Nordhans (1995), Taylor (1995), Lipsey and Courant (1996), McConnell and Brue (1996), and Parkin (1996). Intermediate texts we have reviewed include Ekelund and Ault (1995), Mansfield (1997), Nicholson (1997), Hirshleifer and Hirshleifer (1998), Landsberg (1998), Pindyck and Rubinfeld (1998), Browning and Zupan (1999), and Perloff (1999). Across these texts, we have found a wide variance in the approach and the issues raised.

   In general, the discussions in Principles texts focus on either theory or antitrust policy, but rarely link the two. Those that focus on theory scarcely mention the regulatory issues and legislation. These discussions usually are part of the chapter on monopoly. Most of these texts indicate that a downward sloping demand curve and market segmentation are required. Some mention that prohibition of resale is a requirement. Most texts in this group define price discrimination as a situation in which the same good is sold at different prices unrelated to cost differences, but there are exceptions. Almost exclusively, the graphical exposition demonstrates first-degree price discrimination, but the examples of real-world price discrimination are of the third-degree variety.

   One major problem with these treatments is that the theoretical presentation and the examples are inconsistent. A second problem is that it is very hard to justify the examples as coming from monopolized industries. For example, common textbook cases of price discrimination are senior citizen discounts offered by restaurants, child prices for movie theaters, and differential pricing for business and vacation travelers on airlines. Few people would argue that restaurants, theaters, or airlines are monopolies. Hence, texts suggest that price discrimination is a pure monopoly phenomenon, then proceed to provide examples in which monopoly is dubious at best and ludicrous at worst.

   Those texts that focus on the antitrust issues summarize legislation pertaining to regulation of anticompetitive behaviors and defenses that business can use if charged with illegal price discrimination. Students reading from this group of texts get little information on the conditions under which price discrimination may occur, that there are several varieties of price discrimination, or the likely effects of these pricing schemes on economic efficiency and income distribution. In other words, students get little indication that economic theory has anything to contribute in this policy area.

   Similar problems with the treatment of price discrimination arise in some Intermediate microeconomics texts. For example, Landsburg (1998, p. 361) defines price discrimination as "the act of charging different prices for identical items"; Nicholson (1997, p. 305) defines price discrimination as "selling identical units of output at different prices"; and both suggest that price discrimination is exclusively a monopoly phenomenon. Pindyck and Rubinfeld (1998) make no mention of cost differences in their treatment of price discrimination, but Ekelund and Ault (1995) do. Mansfield (1997) notes that differences in prices are not sufficient to show price discrimination but makes no mention of efficiency effects. He also indicates that price discrimination can occur whenever a firm has some market power, as do Pindyck and Rubinfeld (1998), Browning and Zupan (1999), and Perloff (1999). Hirshleifer and Hirshleifer (1998) discuss the importance of market segmentation, using the example of differences in the prices of Japanese cars sold in the United States and those sold in Japan. In the context of a chapter on monopoly, as it is presented, the discussion is likely to confuse students who are well aware of the existence of multiple car manufacturers from both the United States and Japan.

   This article provides some suggestions for teaching price discrimination and for providing examples that should avoid confusion and give students a better understanding of the important issues. Our discussion of price discrimination focuses on three areas: (i) the definition of price discrimination, (ii) situations or conditions in which price discrimination occurs, and (iii) the effects of price discrimination.

2. Definition of Price Discrimination

   Popular textbooks on industrial organization define price discrimination as differences in the ratio of price to marginal cost across buyers or units of a good.(1) One form of price discrimination is the practice of a firm charging multiple prices for the same good where the difference in price is not attributable to a corresponding difference in cost. This definition implies that different observed prices for apparently identical goods need not be discriminatory. Another form of price discrimination is the practice of a firm charging the same price for all units of the same good when there are cost variations in supply. This implies that observed identical prices for apparently identical goods may be discriminatory. Cost differences, not simply price differences, must be considered.

   Lott and Roberts (1991) make this point forcefully by carefully examining four commonly used "examples" of price discrimination: the spreads in retail gasoline prices, the prices of dinners at restaurants, the price of popcorn at movie theaters, and the variation of airline ticket prices with time between ticket purchase and flight date. They show that cost differences, particularly opportunity cost differences, may explain the price differences. Their examples may not necessarily be convincing, however, because one can reasonably dispute whether the "goods,' sold at different prices are really the same thing. For example, Lott and Roberts (1991) explain why the price of dinner in a restaurant may be higher than the lunch time price of the same food; the time spent at the table is longer for dinner than for lunch, so the higher dinner price represents the greater opportunity cost of tying up the table. Yet eating lunch, with its particular set of accompanying services, is probably not a close substitute for eating dinner, which may have a very different set of accompanying services. The possibility that these two meals may be very differently bundled presents a more complicated pricing situation, along the lines of second-degree price discrimination. In this type of situation, where marginal cost is difficult to determine, the usual definitions of price-marginal cost ratios or differentials may be insufficient to rule out the possibility of price discrimination.(2)

   The more standard example of price discrimination at a restaurant is that of senior citizen discounts. In this case, two diners at the same table ordering exactly the same meal will face different prices if one carries an American Association of Retired Persons card but the other does not. Lott and Roberts' opportunity cost explanation for different prices does not work for this example. Nonetheless, Lott and Roberts (1991) have succeeded in showing that there may be subtle cost differences that justify price differences in situations where one may be tempted to claim the existence of price discrimination.

   Even though price discrimination occurs when price-marginal cost ratios differ across either units or buyers of a good, not all price discrimination is the same. Different types of price discrimination have been identified, each with different implications and distinct characteristics. In fact, two distinct, but related, taxonomies of price discrimination exist.(3) The most common taxonomy of price discrimination identifies first-, second-, and third-degree price discrimination.

   First-degree price discrimination occurs when a different price is charged for each and every unit offered for sale. The seller is able to set price on each unit at the maximum that some buyer is willing and able to pay.(4) The seller is in a position to make a "take-it-or-leave-it" offer to the buyers of the good or to bargain the buyer to his or her reservation price. Sellers are unlikely to have this level of information in many situations. One famous, if controversial, example of first-degree price discrimination is William Niskanen's (1971) model of the relationship between bureaus and Congress. Niskanen gives bureaucrats the ability and the desire to make "take-it-or-leave-it" offers to Congress. Niskanen's bureaucrats then capture all of the surplus in the form of budget allocation associated with provision of public services.(5) Another example of individual unit pricing would be a situation where the seller deals individually with each buyer and can "size" him up and price accordingly, such as in auto or insurance sales.

   Second-degree price discrimination encompasses a variety of pricing schemes through which the firm is able to induce consumers with high valuations to pay higher prices than consumers with low valuations. Second-degree price discrimination schemes induce consumers to self-select into groups based on their willingness to pay. Firms do not have the consumers' valuation information in this case, as they do under first-degree discrimination, nor do they have information that would enable them to identify high- versus...