For an economist, price discrimination describes a practice of charging different buyers different net prices for the same product. In other words, price discrimination happens if differences in prices paid by buyers cannot be justified only by cost differences but also reflect differences in buyers’ willingness or ability to pay. So the definition of price discrimination also describes the situation, in which two buyers pay the same price for a good or service even though the cost of serving them differs, for example, where all customers pay the same price regardless of their location.107 In contrast, if the same good is sold at different prices to different consumers, but the price differences fully reflect the differences in costs (e.g., transportation costs), then for an economist there is no price discrimination.108
106 Furthermore, net neutrality regulation might impact the CDN market in many different ways. In particular, net neutrality regulation in an extreme could also imply that CDNs have to be dissolved as they facilitate the prioritization of traffic. For more detail on this, see Ovum (2010).
107 One can argue that this describes pricing on the Internet to a large extent today: prices are usually identical, but the cost of serving different customers can differ substantially.
108 See Phlips (1983).
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Differentiated products (see principle 2) can also be sold at discriminatory prices.
If two varieties of a differentiated product are sold at prices which do not fully account for the differences in costs due to product differentiation, then price discrimination takes place. For a multiproduct firm, price discrimination often results from a joint profit maximization problem. Rather than optimizing the profits in each market segment separately, the firm takes into account several product models (or several time periods or regional markets) simultaneously and charges different (net) prices for each of them. For example, uniform delivery prices with transportation costs imply discrimination that favors more distant customers at the expense of customers located closer to the seller’s plant.
Although price discrimination may invoke negative reactions and connotations among the public, it is a practice that is widespread in a variety of market settings.
Price discrimination “might be as common in the marketplace as it is rare in the economic textbooks.”109 There is also a common understanding among the economic profession that it is generally welfare-enhancing. As a common practice in both concentrated and competitive settings, price discrimination only occasionally raises competition concerns and justifies per se prohibition.110
Price discrimination typically occurs in markets with differentiated products (see principle 2), but it is also possible in settings with homogeneous goods. In a market with perfectly competitive firms the law of one price prevails and price discrimination is impossible. Hence, it is often claimed that any firm that is able to engage in price discrimination must have market power, if only because some of the prices it charges are above the marginal costs. However, more recent research has shown that discriminatory pricing can also be prevalent in competitive industries and does not necessarily imply existence of market power. For example, it has been recently recognized that price discrimination may be a necessary feature in competitive industries in which there are high reoccurring fixed costs and barriers to entry are low.111 If firms were to charge prices at marginal costs they would not be able to recover the high fixed costs and would end up consistently losing money. If they were to charge a high uniform price they would attract entry. So even sellers constrained by competitive conditions may find it necessary to engage in price discrimination as a way to recover fixed costs and
109 Phlips (1983), 7.
110 One notable exception is to input price discrimination between vertically integrated and independent downstream producers which may lead to margin squeeze and foreclosure.
111 See Baumol and Swanson (2003).
break even. Similar conclusions are reached in industries with large joint and common costs, which give rise to economies of scale and scope.112
Price discrimination is a common feature of more competitive, oligopolistic markets. The welfare implications of the monopolistic setting, however, do not necessarily apply. On the one hand, it is still the case that price discrimination tends to increase total industry output which increases efficiency. On the other hand, while monopolistic price discrimination benefited the producers and extracted consumer surplus, the opposite can be true in more competitive settings.
Price discrimination in competitive settings can benefit consumers by intensifying competition among sellers. It is still generally true that – holding other things constant (including the behavior of its rivals) – an individual firm typically has incentives to discriminate.113 However, if all firms were to switch from uniform to differentiated pricing, it is possible that overall profits in the industry would decrease. This often takes place as losses from intensified price competition due to price differentiation often exceed gains from additional surplus extraction allowed by price differentiation. The result is an increase in total and consumer welfare, but a reduction in firms’ profits. If the firms could commit to uniform pricing, they would prefer to do so.
The output expansion effect of price discrimination (which is generally a feature of both monopolistic and oligopolistic settings) has an important additional implication in network industries and two-sided platforms such as the Internet (see also principle 4 and 6). In such settings, the output expansion due to price discrimination not only reduces the deadweight loss on one side of the market, but generates an additional positive effect because increased participation on one side is beneficial by increasing the value of the market or a platform to the other side.
So the beneficial effects of price discrimination in two-sided markets are likely to be even greater than in standard one-sided markets.114 The economic intuition behind this observation is very similar to the “waterbed effect” (discussed later as economic principle 4): If price discrimination increases participation on one side of the market, it generates a positive externality on the other side of the platform.
Extending this intuition further, the greatest benefits can be achieved if price discrimination is possible not just on one, but on both sides of the market, as
112 See Levine (2002).
113 Ignoring potential strategic response from its rivals, a firm faces a standard optimization (profit maximization) problem. Allowing it to differentiate its pricing expands the set of feasible strategies which in turn might enable it to (possibly) reach a higher maximum.
114 See Weyl (2010).
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increased participation on each side due to price discrimination increases demand on the other side and creates a virtuous feedback loop of enhanced benefits.
Price discrimination, through its output expansion effect, may also significantly impact incentives to invest and innovate. In a highly stylized setting, the return on innovation (such as a reduction in the marginal cost of production) is proportional to the level of output.115 For example, consider a firm which sells 100 units at a mark-up of €10 at uniform price or 120 units at a mark-up of six with discriminatory pricing.116 Suppose also that the firm may undertake an investment which would reduce its costs (and hence increase its mark-up) by one euro per unit. For any given cost of such an investment, it becomes more profitable and thus more likely, the more units the firm sells. Because we generally expect a higher level of output with price discrimination than with uniform pricing, incentives to invest and innovate should also be correspondingly higher with price discrimination than with uniform pricing. There are formal economic models which extend this highly stylized example. Taking the investment incentives explicitly into account they show that in some circumstances the welfare benefits associated with price discrimination may be sufficiently high so that even the consumers who are discriminated against can be better off. The intuition behind these results is that with price discrimination investment incentives are higher and so marginal costs of production are low, which may lead to a situation in which prices for both groups (in case of a third-degree price discrimination) of consumers are lower than a uniform price (with lower innovation and thus higher marginal cost) would be.117 To summarize, the overall effect of price discrimination on total welfare can be characterized as generally positive. The aggregate effect on consumers’ welfare is less clear and some groups of consumers may be better off while others may be worse off. For example, consumers with a low valuation of the good usually are better off, since they are no longer priced out of the market, while consumers with a high valuation are typically worse off, since they may need to pay higher price.
The more competitive the environment, however, the more likely consumers are better off.
115 Profit is a product of quantity sold and (average) mark-up. Mark-up is the difference between the (average) price and cost.
116 We are assuming here that, consistent with our earlier analysis of price discrimination in a competitive environment, mark-up and profitability is lower with price differentiation.
However, the example would still be valid in the monopoly setting, where both mark-up and profits with price differentiation were higher because the calculation does not depend on the level of mark-up but rather on the increase in mark-up due to investment in cost reduction, which is the same regardless of the market structure.
117 See Alexandrov and Deb (2010).
Principle 4: A price increase to content providers reduces the price to end