Price Discrimination is Good, Part 2

Josh Wright —  1 December 2008

Yesterday I started a new TOTM feature on why price discrimination is good in light of the bad rap that the practice gets in public policy circles and with the public generally. Lest one believe that the examples of regulatory scrutiny of price discrimination in antitrust and regulated industries are special cases, a reader points me to this perfectly timed column from NY Times “Ethicist” Randy Cohen arguing that price discrimination is unethical.

Long time followers of the blog will recognize that TOTM and the “Ethicist” have a bit of a history. Here’s Geoff taking on the Ethicist’s misguided proclamation that an entrepreneurial teenager selling pizza at $2 a slice to kids at the end of a long line waiting for $1 slices was perhaps not unethical, but definitely “poor social policy.” And here’s Thom correcting the Ethicist’s foray into insider trading law. Of course, if the Ethicist views the entrepreneurial teenager’s activities as ethically questionable, its fairly safe to predict what he’s got to say about price discrimination. A reader writes in with the following question about evading an airline ticketing restriction:

I bought a plane ticket to take my young son, Nathaniel, to a family gathering. Near the departure date, I decided to take his older sister instead. The airline prohibited name changes on a ticket, and a replacement cost $700, but someone in customer service told me: “There’s no requirement for children under 18 to present photo identification. Do you understand what I’m saying?” I did. My daughter used her brother’s ticket without incident. Your take? …

The Ethicist’s answer?

You acted deceptively; you violated the airline’s rule; you behaved reasonably. The first two assertions seldom lead to the third, but here they do. This rule is outlandishly unjust. An airline may recoup the bookkeeping cost incurred by a ticket change, but that is nowhere near $700. Nor did you genuinely agree to this rule; it was imposed upon you. You could not choose a carrier that lacked it; such policies tend to apply industrywide. In a narrow sense, air travel — all travel — is voluntary, but by that austere standard, leaving your house is voluntary. Even the airline’s own employee recognized this $700 injustice: he advised you how to avoid it. People are apt to adhere to a business arrangement only if they feel that it is fair. It is this, as much as individual rectitude or mere docility, that encourages virtuous conduct.

I’m less interested in Cohen’s analysis of the purchasers’s conduct than I am in his analysis of the airline’s conduct. The airline’s ticket restriction and setting the replacement cost is “outlandishly unjust,” it seems, because the price exceeds the cost of entering the bookkeeping change? Does he think that it “costs” (in the production sense) a movie theater more to allow a 25 year old to watch a movie than a senior or child? Or cost a supermarket less to sell groceries to a coupon holder? I assume not and that each of these forms of price discrimination is also unjust in his view. Of course, this view is rubbish and fails to take account of the role of price discrimination as a part of the normal competitive process. First, all methods of price discrimination involve attempts to increase revenue by selling additional marginal units of output while minimizing the offsetting negative effect on revenue of the price reduction across all units by targeting the price reduction. But if all methods of targeting such rebates are designed to expand sales and satisfy the demand of marginal consumers that would not be served otherwise, surely any ethical or moral calculation of the ethics of price discrimination must take into account the newly satisfied demand.  In other words, uniform pricing precludes the social benefits of additional sales to more price-sensitive consumers.

Second, as Baumol demonstrates, we also know that price discrimination is not just a part of the competitive process but is also the result of it.  Failure to separate out consumer groups by demand where it is possible to devise a mechanism for doing so is likely to result in the death of the competitive firm.  And again, because the firm investments to devise these mechanisms generally increase output, these are socially useful investments.  When an airline restricts the use of its discounted fares from business travelers and imposes a Saturday stay requirement in an attempt to segment business travelers with higher demand to come home than the leisure travelers, it does so as a result of the competitive process where actual or threatened entry dissipates supra-competitive profits.  It is true that price discrimination increases supplier profits, but it makes no more sense to declare unethical optimal pricing by market segmentation than it does to condemn decreasing prices in the face of a decline in supply.

Measures to enforce price discrimination mechanisms, like the airline restrictions, are designed to expand output and satisfy more consumer demand than would occur under uniform pricing.  There is a “be careful what you wish for” aspect to all of this.  Discussions of the policy implications of price discrimination should avoid the Nirvana fallacy of assuming the uniform pricing does not have its own set of costs.

Keep the examples of price discrimination mechanisms in markets coming.