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- [Prof. Tyler Cowen] Today we begin a section
on price discrimination.
Price discrimination means selling the same product
to different groups of customers at different prices.
We'll be looking at the effects of price discrimination
on monopoly profits as well as on social welfare.
So let's get started.
Interpol, the International Police Organization,
busted a drug smuggling operation
that was smuggling drugs from Africa to Europe.
What was it? Cocaine, pot, heroine?
No, it was none of these.
It was the pharmaceutical drug, Combivir,
Why? Combivir, the AIDS drug,
was priced at about $12.50 per pill in Europe,
about the same as in the United States.
But GSK was also selling Combivir
to people to Africa at a much lower price.
How come?
Well, for two reasons.
First, for humanitarian reasons,
and second to get to the subject of this talk,
to maximize profits.
The smugglers were buying the pills in Africa at the lower price,
sending them to Europe,
and then reselling them in Europe at the higher price.
Why is it that price discrimination in the first place
can increase profits?
We actually can show this using a diagram we've already seen.
We know that if the demand curve is more inelastic,
that suggests the monopolist should set a higher price,
put on a higher mark up,
while if the demand curve is more elastic,
that means a lower price.
Suppose that the monopolist
can segment its market into two parts,
say Europe and Africa,
and that the demand curve in Europe is much more inelastic
than the demand curve in Africa
where consumers are poorer and more sensitive to price.
The conclusion is that the way to maximize profits
is to set a high price in the market with the inelastic demand, Europe,
and a lower price in the market with the elastic demand,
namely Africa.
Let's imagine that instead,
there was a single enforced world price for the drug.
This price would be neither the profit maximizing price for Europe
nor would it be the profit maximizing price for Africa.
For the supplier, profits would be lower with this single price
than with two prices under price discrimination.
Of course, price discrimination works
only if it's in fact possible
to segment and separate the two markets.
If smugglers can buy in Africa and sell in Europe
and if most of the buyers of the drug
end up buying the smuggled product from Africa,
that really is going to mean the drug supplier
is mostly selling at the low African price
and that will not maximize their profits.
So let's briefly review.
Price discrimination is selling the same product
to different groups of buyers at different prices.
And here are some basic principles of price discrimination.
First, if the demand curves across two markets are different,
it's more profitable to segment those two markets
and set different prices.
We know the prices you should set.
The price should be higher in the market
with the more inelastic demand.
Second, arbitrage across markets
makes it more difficult to price discriminate.
Let's say a little more about arbitrage.
Most simply,
arbitrage means buying low and then selling high.
Buying low in one market,
quickly moving those goods to a second market
and then reselling them at a higher price.
The effect of that arbitrage
is to bring the prices in those two markets closer together --
increasing the price in the market with the lower price
and decreasing the price in the market
which had had the higher price.
It's clear that to practice price discrimination successfully,
the monopolist has to prevent that kind of arbitrage.
Now smuggling --
that's just an illegal form of this kind of arbitrage.
It's a type of arbitrage
which breaks down price discrimination.
Now markets can be segmented
in more ways than just geographically.
For instance, Rohm and Haas --
they are a producer of materials, and they had a plastic.
I'll call it MM,
a plastic that had uses in industry and also uses in dentistry,
as in dentures.
MM in industry had a lot of substitutes
but as dentures there were very few substitutes for using MM.
So the firm price discriminated.
It sold MM to industry at about $0.85 a pound
and it sold a slightly different version of MM
for dentures for dentistry at $22 a pound.
Of course, with a price difference like that,
entrepreneurs started to buy up industrial MM,
convert it to MM for dentures,
and then resell that MM at the higher price.
How could the company prevent this kind of arbitrage?
Amazingly, Rohm and Haas considered poisoning industrial MM
so no one would want to use it for dentures.
Eventually they decided it was safer to simply spread a rumor
that industrial MM had been laced with arsenic.
If that sounds crazy,
notice that the government
actually does require some goods to be poisoned
in order to prevent arbitrage.
Ethanol for instance can be use in cars as a fuel
and also for alcoholic beverages.
The government subsidizes fuel ethanol
but doesn't want that ethanol be converted into alcohol
so it requires that fuel ethanol be poisoned.
The lesson is that it's easier to prevent arbitrage in some goods
than in others.
It's easier to prevent arbitrage in services, for instance,
than in goods.
If you get a massage for $20
but that same masseuse wants to charge me $50,
it's hard for you to buy the massage at $20
and then somehow resell it to me for $50.
I need the masseuse
to be the one giving me that massage.
Price discrimination is very common in our world.
Think about movie theaters setting one price for children
and a second price for seniors,
and then yet another price for adults.
The cheaper price for seniors --
do movie theater owners love old people or love children?
No, it's because those groups
are more sensitive to changes in price.
Take young adults going out on a date.
They want to see the latest movie
and they don't want to look cheap.
They'll probably pay full price.
But retired seniors,
if you charge them too high a price,
they'll just stay at home and watch it on Netflix streaming.
Or take computer software --
businesses and students are often charged different prices.
Microsoft offers a significant discount
to students who purchase Office.
Airlines -- another classic example of price discrimination.
Airlines want to set higher prices for business travelers
who are more likely to have inelastic demands
than for vacationers
who are more likely to have elastic demands.
Price discrimination is typically imperfect.
The airlines ideally would like to ask someone
when they call up for a flight, "Air you a business traveler?
Well that will be $1200. But are you a vacationer?
Well then it will only be $700."
But of course that scheme isn't going to work
because people will just lie.
So what businesses try to do is to look for characteristics
which are correlated with buyer willingness to pay.
What are some characteristics that might be correlated
with having an inelastic demand -- with being a business traveler --
as opposed to having an elastic demand,
being a vacation traveler?
How can an airline distinguish business travelers
from vacationers?
There are several methods,
but business travelers often have less flexibility.
They might need to make an important meeting
on short notice,
so the airlines typically charge more
if you want to fly that day or the next day,
than if you're able to book
several weeks or months in advance.
The airlines reason that people who really need to have a ticket
for tomorrow on short notice --
they're probably flying somewhere to settle a big business deal.
They won't be deterred from flying by a higher price.
On the other hand,
people who are booking weeks or months in advance,
they have more substitutes.
If the price of an airline ticket to California is too high,
maybe those people will take a local vacation instead,
or fly another airline to Florida.
Similarly, vacationers are more willing
to stay over a Saturday night than are business travelers.
So sometimes it's cheaper to fly
by staying over a Saturday than by traveling during the week.
Finally, first class, business class and economy,
they all get you to the same place at the same time
but first and business class are much more expensive.
The airlines figured that anyone willing to pay extra
for just a little more space and better food,
well, probably those people have a lot more money
or maybe their business is paying for their ticket.
Those customers won't be so sensitive to the price.
What you find when you put these and a whole bunch of other methods
of price discrimination together
is that the airlines are remarkably adept
at charging different people different prices
for the same good.
So that's just an introduction to price discrimination.
Next time we'll look at the question,
is price discrimination good?
We've shown that it can increase profits,
but what's the effect of price discrimination
on social welfare?
- [Narrator] If you want to test yourself,
click "Practice Questions,"
or if you're ready to move on, just click "Next Video."
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