Why I Love “Price Discrimination”

by
Joseph T. Salerno
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Last week, I went to a vision center to get my new eyeglass prescription filled. Because I wear progressive lenses with antireflective coating and do not have vision insurance, I anticipated that the out-of-pocket cost of the glasses would be quite high. When I entered the shop and stated my business, the manager immediately asked if I had vision insurance, and I responded that I did not. The manager consulted with a saleswoman and sent her to assist me in choosing frames to try on. I noticed that she was selecting mainly Ray-Bans and other designer frames.

When I questioned her about the price of the frames, she informed me and then hastily added that because I did not have vision insurance, I was eligible for a 20 percent discount on the total price of the eyeglasses, including lenses and coating. I ended up choosing designer frames and received a discount of $132.60 on my purchase. In other words, a different customer who had vison insurance would have paid a different price for an identical pair of glasses, $132.60 higher than the price I paid.

In mainstream economics, this practice of selling the same product to different buyers at different prices is called “price discrimination.” This failure to charge a uniform price to all customers is alleged to be due to “monopoly power.” After all, in the fictitious model of perfect competition, which mainstream economists use as a standard of efficiency and welfare to evaluate the real markets’ performance, it is supposed that every industry is composed of perfectly informed buyers confronting a multitude of tiny competitors selling an identical product. Under these conditions, no seller can charge any buyer a higher price than the uniform market price without losing customers and profits. In contrast, a seller possessing monopoly power, under certain conditions, may be able to segment the market into different groups of buyers according to whether the buyers are more or are less sensitive to a price reduction.

Buyers who would purchase little or none of the product at the so-called monopoly price but would significantly expand their purchases at a lower price are offered a discount, while those buyers whose demand is less responsive to a price reduction pay the higher price. This explains why, for example, movie theaters discount tickets for preteens, students, and seniors. A more opaque form of price discrimination occurs when colleges and universities offer scholarships based on “need.” In both cases, the two preconditions for price discrimination are present.

First, the goods once purchased cannot be resold to the “supramarginal” buyers; i.e., those that would not have received the lower price, because this would cause the monopolist to lose his high-price customers and render the discriminatory pricing scheme less profitable than a uniform monopoly price. This condition obviously holds for theater showings and college education. Second, the “marginal” buyers, whose demand is more “elastic,” or responsive, to a price reduction, are easily distinguished from the buyers relatively insensitive to price variations and whose demand is “inelastic.”

In practice, this means that low-income buyers, who are more resistant to high prices, must be readily differentiated from high-income buyers. Movie theaters may inspect picture IDs of those requesting or displaying discounted tickets, and colleges and universities regularly require income data to discern who “needs” a scholarship. In the case of prescription eyeglasses, discriminatory pricing occurs because it is difficult if not impossible to find a potential buyer for the eyeglasses with the same visual impairment as the initial purchaser and because vison insurance renders the demand of the insured less responsive to price changes than the demand of the uninsured.

Now the AMC theater chain is hardly acting altruistically when it charges lower-income groups lower prices. In fact, it increases its profits by selling almost the same quantity of the product at the monopoly (or even higher) price while selling additional units at a smaller, but positive, profit margin to buyers with a more elastic demand. The same is true of nonprofit colleges and universities, which reap a higher total revenue from charging discriminatory tuition fees.

Mainstream economists concede that price discrimination may increase “social welfare” if it results in the production and sale of a greater quantity of the good than a monopoly charging a uniform price. Nonetheless, they condemn both kinds of monopoly because neither meets the absurd standards of perfect competition, in which no seller can charge even one penny above the perfectly competitive price without losing all his customers to the multitude of competitors selling an identical product.

Let’s get back to the real world and my story to evaluate the actual effects of multiform pricing—a more precise and less value-loaded term than price discrimination—on buyers and sellers. By voluntarily paying the discounted price for my designer eyeglasses, I clearly demonstrated that I improved my well-being by giving up something I valued less in exchange for an item I valued more. The same is true of the owners of the vison center, who demonstrably valued the sum of money they voluntarily accepted from me more highly than the eyeglasses, which they happily handed over in exchange. Because both parties to the exchange enhanced their welfare without demonstrably injuring a third party, we can say that the exchange increased social welfare. But suppose another customer, who possessed vision insurance, came along a little later and purchased an identical pair of glasses from the vison center, paying $132.60 more than I paid. And suppose further that his insurance covered only half of the price difference, so that his out-of-pocket expense was $66.30 more than mine.

Since the values an individual attaches to different goods can only be subjectively ranked and never objectively measured, our analysis of the welfare effect of this hypothetical later transaction is the same: both parties valued the item they received in the exchange more highly than the item they gave away. In the second exchange, social welfare was not reduced because the same item was sold for a different price than in the first exchange.

What about the effects of price discrimination on economic forecasting, calculation, and efficiency? In fact, entrepreneurs can anticipate whether the conditions for price discrimination will exist for the good or service they are planning to produce. Furthermore, they can calculate costs and revenues, profits, and capital values just as well with multiform prices as they can with a uniform price. And profits will indicate the highest-valued use for resources in markets in which consumer demand can be segmented just as well as in markets with a uniform price. Finally, we might note that despite the existence of instances of price discrimination, there is a powerful tendency toward charging a uniform price in all markets. New and venturesome entrepreneurs will always be trying to siphon off the supramarginal buyers from the price-discriminating firm by offering lower prices, more effective advertising, more attractive brands, or a superior-quality product.

In the meantime, I’ll bask in my status as a marginal buyer in the prescription eyeglass market.