Discriminatory pricing
Discriminatory pricing, also known as price discrimination, is a pricing strategy where sellers charge different prices to different customers for identical or similar products. The practice exploits variations in customers' willingness to pay and price elasticity of demand[1]. Arthur Cecil Pigou formalized the theoretical framework in his 1920 work "The Economics of Welfare," distinguishing three degrees of price discrimination.
Airlines, cinemas, and software companies commonly employ this strategy. Student discounts and senior citizen rates represent familiar examples.
Historical development
Economists recognized discriminatory pricing practices long before formal theoretical treatment. Railroad companies in the nineteenth century charged different rates for similar shipments based on commodity type and route competition. This practice prompted regulatory intervention through the Interstate Commerce Act of 1887.
Arthur Cecil Pigou (1877-1959), a Cambridge economist and student of Alfred Marshall, systematically analyzed price discrimination in "The Economics of Welfare" (1920)[2]. His three-degree classification remains the standard framework. Pigou succeeded Marshall as Professor of Political Economy at Cambridge in 1908 and held the position until 1943.
Joan Robinson expanded the analysis in "The Economics of Imperfect Competition" (1933). Her work examined how monopolistic firms could segment markets and extract consumer surplus through differential pricing.
The Robinson-Patman Act of 1936 addressed discriminatory pricing in the United States. Congress passed this legislation to protect small retailers from large chain stores that could negotiate preferential wholesale prices. The act prohibits price differences that substantially lessen competition.
Degrees of price discrimination
First-degree (perfect) discrimination
The seller charges each customer the maximum amount that customer will pay. This extracts the entire consumer surplus. Perfect price discrimination is largely theoretical since sellers rarely possess complete information about individual reservation prices.
Automobile dealerships approximate first-degree discrimination through negotiated pricing. Skilled salespeople attempt to identify each buyer's maximum willingness to pay. Custom software development and consulting services also involve individually negotiated prices.
Second-degree discrimination
Prices vary according to quantity purchased or product version selected. Bulk discounts represent the most common form. Costco offers lower per-unit prices for larger packages. Electric utilities charge lower rates as consumption increases beyond certain thresholds.
Versioning creates artificial product tiers. Microsoft Office sells in Home, Business, and Enterprise editions with different feature sets and prices. Airlines offer economy, business, and first-class seats that differ primarily in comfort rather than transportation value.
Third-degree discrimination
Different customer groups pay different prices based on observable characteristics. This is the most prevalent form. Market segmentation requires identifiable groups with different demand elasticities.
Common examples:
- Student discounts - AMC Theatres offers $6 student tickets versus $12-15 regular admission
- Senior rates - National parks provide $20 lifetime passes for visitors 62 and older
- Geographic pricing - Spotify Premium costs $10.99 monthly in the United States but equivalent to $1.58 in India
- Time-based pricing - Uber surge pricing increases fares during peak demand periods
Conditions for successful discrimination
Several requirements must be met for discriminatory pricing to succeed:
- Market power - the seller must have some control over price
- Market segmentation - distinguishable customer groups must exist
- Prevention of resale - arbitrage between groups must be impossible or costly
- Different elasticities - segments must have varying price sensitivities
Services naturally prevent resale. A haircut cannot be transferred. Warranties tied to original purchasers limit secondary markets for products. Geographic restrictions and regional encoding serve similar purposes for media content.
Economic effects
Discriminatory pricing can increase or decrease total welfare depending on circumstances. When price discrimination allows a firm to serve customers who would otherwise be priced out of the market, output increases and welfare may improve. A movie theater that offers student discounts might fill seats that would otherwise remain empty.
Conversely, price discrimination can transfer wealth from consumers to producers without efficiency gains. If all customers would have purchased at a uniform price, discrimination merely increases producer surplus at consumer expense.
Amazon's dynamic pricing algorithm adjusts prices based on browsing history, time of day, and competitive factors. Research by Northeastern University in 2014 found that Amazon changed prices on popular items up to 2.5 million times daily[3]. The company denies discriminating based on individual customer characteristics.
Legal framework
United States
The Robinson-Patman Act prohibits sellers from charging different prices to competing buyers for commodities of like grade and quality where the effect may substantially lessen competition. The law contains exemptions for cost-justified differences, meeting competition, and functional discounts.
The Federal Trade Commission enforces Robinson-Patman violations. Recent enforcement has been limited. The Supreme Court's decision in Brooke Group Ltd. v. Brown & Williamson Tobacco Corp. (1993) established high standards for proving competitive harm.
European Union
EU competition law addresses discriminatory pricing through Article 102 of the Treaty on the Functioning of the European Union. Dominant firms cannot apply dissimilar conditions to equivalent transactions, thereby placing trading partners at a competitive disadvantage.
The European Commission fined Intel $1.4 billion in 2009 for offering loyalty rebates that discriminated against computer manufacturers who sourced processors from AMD[4].
Industry applications
The airline industry pioneered sophisticated yield management systems. American Airlines developed SABRE in the 1960s to optimize seat pricing. Modern systems adjust prices continuously based on booking patterns, competitor fares, and remaining capacity. Business travelers who book late pay significantly more than leisure travelers who plan ahead.
Pharmaceutical companies practice international price discrimination based on national income levels. Gilead Sciences priced its hepatitis C drug Sovaldi at $84,000 for a 12-week course in the United States but licensed generic versions for $900 in India[5]. The pricing reflected both willingness to pay and public health considerations.
References
- Pigou, A.C. (1920). The Economics of Welfare. Macmillan
- Robinson, J. (1933). The Economics of Imperfect Competition. Macmillan
- Tirole, J. (1988). The Theory of Industrial Organization. MIT Press
- Varian, H.R. (1989). Price Discrimination in Handbook of Industrial Organization, Volume 1
Footnotes
- Price discrimination relies on market segmentation and prevention of resale between customer groups.
- Pigou, A.C. (1920). The Economics of Welfare established the three-degree classification system still used in economic analysis.
- Chen, L., Mislove, A., & Wilson, C. (2016). "An Empirical Analysis of Algorithmic Pricing on Amazon Marketplace." WWW '16 Proceedings.
- European Commission Decision of 13 May 2009, Case COMP/C-3/37.990 - Intel.
- Gilead Sciences Form 10-K Annual Report 2014; Médecins Sans Frontières pricing documentation.