Arnold Kling  

Price Discrimination Explains Everything

PRINT
Why Don't More Therapists Use ... What I've Been Reading...

In my high school economics class, my students asked me to explain why there are sales on "Black Friday." The class period was over, so I only had time to blurt out "price discrimination" without getting into an explanation of what it is and why it explains sales.

I think that price discrimination really deserves a lot more attention than it gets in the economics curriculum. A lot of "economic naturalist" sorts of questions are correctly answered by appealing to the concept of price discrimination. I think it explains airline pricing, credit card pricing, cable TV pricing, cell phone pricing, movie popcorn pricing, etc.

Suppose that a new video game console comes out. BZ likes video games, but he is only willing to pay about $200 for the console. JS lives for video games, and he would pay $400 for the console. The manufacturer would like to charge $400 to JS and $200 to BZ. However, to do so blatantly would be illegal. It might also be impractical--what is to stop BZ from buying two consoles for $200 and selling one of them to JS for much less than $400?

The console maker looks for ways to price discriminate. There might be a "standard" version of the console that sells for $200 and a "deluxe" version that sells for $400. If the features in the deluxe version appeal to JS but not to BZ, this will work. Or the maker might release the console initially at a price of $400, wait three months, and cut the price to $200. If BZ is willing to wait but JS is not, then this will work.

Back to the original question, temporary sales are often a tool for price discrimination. If you need something now, you have to buy it whether or not it is "on sale." But if the purchase is discretionary, you may only buy it "on sale." The store keeps its prices high ordinarily, in order to pick up profits from the price-insensitive shoppers. The store puts items "on sale" on rare occasions, hoping to pick up profits from price-sensitive shoppers. Unfortunately, they lose profits from price-insensitive shoppers who happen to come in the day of the sale.

The beauty of holding sales on "Black Friday" is that stores know that many price-insensitive shoppers will stay away in order to "avoid the crowds." So you can get revenue from price-sensitive shoppers without sacrificing profits from price-insensitive shoppers.


Comments and Sharing





COMMENTS (15 to date)
Eli writes:

Do you really think most stores that hold Black Friday sales have significant market power?

Justin Martyr writes:

As a "weekend warrior" in economics I've come across the concept of price discrimination many times in the discussions of monopoly pricing. I've also thought that it isn't invoked enough to explain rising college tuition rates. But I think this post makes a good point that price discrimination is ubiquitous.

Does that mean that stores with "everyday low prices" cater to the non-price discriminators? Does that mean if you are a coupon clipper you should shop at stores that don't have everyday low prices?

Mike Hammock writes:

Your video game console example is interesting because it seems that producers in that market are not pricing optimally: They may have repeatedly underpriced their consoles when they are initially released:

Blog Entry 1

Blog Entry 2

The price discrimination argument works for different SKUs of the same console, but then this question remains: Why don't console makers do a better job price discriminating between early adopters and low-demand consumers, by charging a really high price for the first month or so? There are some possible answers (none of which I find totally satisfying) at the links above.

kebko writes:

I agree. I also think this issue is a very important counterpoint to measured income inequality. I am always amazed at how pro-rated the prices are at grocery stores. Take something like canned vegetables. Items of practically the same quality are available right next to each other, frequently with very large price differences. After adding in the effects of clipping coupons, etc., it is really quite amazing how it all plays out in the budgets of different consumers.

Rich writes:

"The manufacturer would like to charge $400 to JS and $200 to BZ. However, to do so blatantly would be illegal."

Really? Unless JS and/or BZ belongs to a specifically protected group, I don't think this is illegal at all.

wilco writes:

Rich,

"Really? Unless JS and/or BZ belongs to a specifically protected group, I don't think this is illegal at all."

It is. See the Robinson-Patman Act

blink writes:

If you're right, we should see quite a few "in store only" deals that are not available on the internet, etc. If, however, the crowd-fearing price-insensitive shoppers can get the same prices from their living rooms, then the story breaks down. Do you have any data one way or the other?

ac writes:

I very much agree with kebko, and further wonder if the prevalence of price discrimination throws off our ability to track the damage from recession. If overall spending drops X%, for example, can we not assume that welfare has dropped by something significantly less than X%, as the mix of price-sensitive vs insensitive consumers shifts? i.e., folks are consuming as much as before, just paying less for it.

Jacob writes:

Good straightforward post. I never thought that one through before. Thanks.

I've been seeing quite a few retailers this year preparing to drive traffic with a low price on a fewer number of SKUs compared to previous years. I wonder if this is a permanent shift (new Nash equilibrium where companies try to take advantage of the high number of shoppers) or a temporary one (it's a bad economy so quite a few retailers are willing to take the chance of not discounting as much as previous years).

I guess we'll know the answer to that in about 370 days. :)

agnostic writes:

I think there may have been some baby thrown out with the bathwater, but this casual reader thinks that the "price discrimination is everywhere" view lost out because they overdid it.

Probably the most important reason is that they weren't imaginative enough to see how the two supposedly identical products were not in fact identical. Not only on a functional level -- then they just missed some detail of how it was put together.

But more importantly on the subjective value dimension, which Virginia Postrel talks about at length in The Substance of Style. It's also what bedevils attempts to compare GDP from 100 or 200 years ago to today -- hey, we both have shirts, don't we? Well, no real change then. But of course our shirts today come in a much wider variety, providing greater customer satisfaction.

I don't know about the more "serious" attempts to document price discrimination, but as far as a lot of the "naturalist" attempts go, most seem to me to lack imagination. You have to first establish that they're identical products. "Hey, they're both shirts, aren't they?"

For me, documenting when price discrimination does and does not work would be better if done with commodities -- real commodities, not fake ones like shirts. Show that in a monopoly arena, sellers price discriminated, and how they did it. Then show how once that monopoly was broken up, or in some other time and place where entry was open and the market competitive, price discrimination was no longer possible.

But as the Freakonomics franchise shows, people are eager to rush to sexy theories rather than use their imagination and pose reality checks on their ideas.

Lord writes:

I think it is more product than price discrimination. The sales are usually on the cheapest products with limited functionality or quality, more dated or otherwise inferior product where price is not the main thing but the only thing.

Dave Tufte writes:

It tends to be just watered down intermediate microeconomics, but one of the things that makes managerial economics as taught in business schools is the extra emphasis on price discrimination.

Ivin writes:

There is another element involved in Black Friday sales - Information Economics (ala Stigler). Stores normally have to advertise their short-term sales in order to draw in shoppers who would normally find the price just outside their willingness to pay (WTP). The Black Friday phenomenon makes it possible to reduce the amount of advertising necessary to bring in a crowd (reduce, not eliminate) while still allowing for the store to reach the price sensitive shopper.

Great post.

Ivin

Ryan Vann writes:

I think price discrimination explains about 80% of the motivations behind sales (though food is a completely different story), with inventory liquidation explaining the remaining 20%. There is probably some excess inventory as a result of price discrimination as well, so price discrimination might explain even more than the arbitrary 80% I threw out.

Great post by the way; it was intuitive and clearly written.

Jedermann writes:

Choice magazine Australia recently published a study in which service providers were asked to quote for a wedding and a 40th birthday, for the same number of people in both cases. It seems that venues, photographers, djs etc routinely charge higher prices if it is for a wedding. Presumably the mere fact of having a wedding sends a price insensitive signal.

I think this is gated, but this is the link:

http://www.choice.com.au/Reviews-and-Tests/Money/Shopping-and-Legal/Shopping/Wedding-investigation/page/What%20we%20found.aspx

Comments for this entry have been closed
Return to top