Price Discrimination

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R. Preston McAfee, Price Discrimination, in 1 ISSUES IN COMPETITION LAW AND POLICY 465 (ABA Section of Antitrust Law 2008)

Chapter 20 _________________________

PRICE DISCRIMINATION
R. Preston McAfee*
This chapter sets out the rationale for price discrimination and discusses the two major forms of price discrimination. It then considers the welfare effects and antitrust implications of price discrimination.

1. Introduction
The Web site of computer manufacturer Dell asks prospective buyers to declare whether they are a home user, small business, large business or government entity. Two years ago, the price of a 512 MB memory module, part number A0193405, depended on which business segment one declared. At that time, Dell quoted $289.99 for a large business, $266.21 for a government agency, $275.49 for a home, and $246.49 for a small business. What explains these price differences? How does Dell benefit from it? Different segments have different willingness to pay. Dell optimizes its prices, offering lower prices to relatively price-sensitive segments. An interesting aspect of Dell’s attempt to charge different prices to different customers is that the customers aid Dell in its effort. According to a Dell spokesperson, each segment independently sets prices and the customer is free to buy from whichever is cheapest. Thus, the customers paying more are choosing to pay more, probably because they do not expect the prices to vary so significantly. This chapter explores the economic rationale for price discrimination. Section 2 presents the basic theory of price discrimination and describes the conditions necessary for price discrimination to exist. Section 3 then discusses direct price discrimination, while indirect price discrimination is discussed in Section 4. Section 5 provides a discussion of the welfare effects associated with price discrimination, while Section 6 concludes this chapter with a discussion of the antitrust implications of price discrimination.

2. Basic theory of price discrimination
Price discrimination can exist when three conditions are met: consumers differ in their demands for a given good or service, a firm has market power,1 and the firm can prevent or limit arbitrage. If consumers had identical demands for a good, then all consumers would demand the same amount of the good for each price, and the price and * 1. California Institute of Technology. “Market power” as used in this chapter refers to the economic definition of the term, which is the ability to price above marginal cost. See STEVEN E. LANDSBURG, PRICE THEORY AND APPLICATIONS 329 (6th ed. 2005); Franklin M. Fisher, Detecting Market Power, which appears as Chapter 14 in this book.

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ISSUES IN COMPETITION LAW AND POLICY

quantity of the good would depend only on the number of consumers in the market and the ability of firms to supply the good (the supply curve). If firms have no market power, that is, no ability to affect the price of the goods they sell, the theory of perfect competition implies that all goods would be sold at one price (the law of one price). Finally, if consumers can arbitrage price differences, any attempt to charge higher prices to some group would be defeated by resale. The basic theory of price discrimination is the theory of monopoly, applied to more than one market or group. What is a monopolist’s profit-maximizing price? Consider a firm that can sell q(p) units when it charges price p. The firm’s profits are S ( p)

pq ( p )  c ( q ( p ))

(1)

where c is the cost function. The function q is the demand facing the firm, that is, it gives the quantity the firm can sell. In the case of monopoly, the demand facing the firm and the market demand are the same. Assume that q is a downward-sloping demand curve. This means that the firm has some pricing power—a price increase does not send the quantity demanded from the firm to zero. This pricing power is known as monopoly power or market...
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