Why Price Discrimination is More Promising than It Sounds

By Sarah Ouyang

There are two meanings to the phrase, “We want the same thing.” The first, that we should work together since we aim to achieve the same goal. The second, that you want what I want. The problem is, only one of us can have it. But which one?

In a field where scarcity is the underlying issue of all discussion, the latter meaning of the phrase is much more prevalent than the diplomatic, politics-heavy former. Economics deals with many factors that come in pairs: production and consumption, private and public, regulation and laissez-faire. One of the dilemmas is that of efficient allocation versus profit maximization. Essentially, the distribution of goods and services among the demand population — or of limited resources among suppliers — poses a question to firms (specifically, various levels of monopolies) who favor producing at a different output level than would be optimal.

To be allocatively efficient, a market should ensure that production reaches the output point where the last unit offers the consumer a marginal benefit that equals its marginal cost. In conceptual terms, this means that everyone who values each unit of output as much as it costs to produce that unit should receive their goods and services.

When prices are ubiquitous, which is nearer to reality the more competitive an industry is, this point is easy to pinpoint on the graph yet leaves many unhappy because it becomes extremely difficult to provide goods and services to those consumers who value the products less than the equilibrium price. Considering a monopolistically competitive industry, however, the scenario becomes easier to manipulate and hypothesize with one understandably controversial tool: price discrimination.

To determine the effectiveness of price discrimination, it is necessary to differentiate between three genres of the practice. Third-degree price discrimination is the most intuitive of the three, the type that everyone would imagine when picturing price discrimination. In simple words, different groups of people are charged different prices. The most common example is the movie theater, where tickets for seniors and children are frequently far lower than those for teenagers and adults.

When you cash in a coupon at the local Starbucks that activates a discount as soon as you reach a minimum purchase total, you are experiencing second-degree price discrimination. This type centers around the quantity of goods or services that the customer purchases, which would determine (often rather indirectly) the prices they pay.

First-degree price discrimination is the boldest, a clear discrepancy between prices charged to each individual customer. Such distinguishment often removes the greatest amount of consumer surplus and is usually possible when the firm has access to enormous amounts of consumer data. Airlines, for example, practice what has become known as inter-temporal pricing, a feat made possible by their salience in regards to clientele information. They can easily determine the urgency of ticket buyers based on the proximity of their purchase date to the flight date. (In other words, the later you buy the ticket, the more desperate you seem, and thus more willing — in the airline’s eyes — to pay higher prices.)

Price discrimination is risky. We have given firms the power to charge different consumers different prices, and exploitation is almost inevitable in a system where consumer surplus has been eradicated — hence the apprehensive reference to first-degree price discrimination. However, according to economist Michael Spence in The American Economic Review, firms’ profits should naturally become synonymous with marginal contribution to overall social welfare. In these cases, where private and public benefits coincide, socially optimal production is far more obtainable because selfish incentives lead to publicly beneficial outcomes.

Various factors weigh in on the success of this practice. Problems arise when data on consumer characteristics become unevenly distributed among producers, reducing their ability to make sound economic decisions. Oligopolies are inefficient for this reason; game theory and collusion are damaging for more reasons than one. Barriers to entry and exit of the market are also less sturdy than economic models would theoretically suggest. Regulation from a politically divided government could affect the impacts as well.

In theory, economic models are intrinsically inaccurate and difficult to apply to the real economy. If we are content to ponder the surface before diving in, however, price discrimination has great potential in an economy as profit-driven and (currently) allocatively inefficient as the one in this country. All we need to do is look past the apparent immorality of charging different prices and realize that a universal price tag could very well be just as economically unfair as demanding $450 for a plane ticket that was sold for $300 a week ago.