Price Discrimination

Abstract

Price discrimination is generally defined as charging different prices for the same product or services and may occur on first-, second- or third-degree levels, which are defined according to knowledge of the market and the goals of the seller. In the minds of the general public, price discrimination often conjures up visions of inherent unfairness, but many economists maintain that price discrimination is necessary to keep the market stable. Price discrimination based on such characteristics as race and gender are generally considered unacceptable.

Overview

Most prices are based on the cost of providing a product or service, plus a profit for the seller. Firms normally establish prices according to reservation prices that are based on what customers/clients are willing to pay and the minimum they, as sellers, are willing to accept. When prices are lower than customers are willing to pay, the result is consumer surplus. When the reservation price of the buyer and seller are too far apart, no sale is made. From a business owner’s perspective, the ideal pricing would always be based on charging each customer what he/she is willing to pay, resulting in higher prices for those willing to pay more and lower prices for those who are unwilling or unable to pay more. Economists have attempted to clarify the meaning of price discrimination by explaining that it occurs only when a firm sells goods at price ratios that are different from the ratios of marginal costs (Edwards, 2014). The classic example of this is when a publisher sells a hardback book for $30 and an e-book version of the same book for $10 at a ratio of 3:1. Other examples include movie tickets sold at discounted prices to students and seniors, airplane tickets sold at different prices to business travelers, coupons, college tuition that is lower for in-state residents than for those from out-of-state, and store loyalty programs that offer discounted prices to regular customers who allow companies to track their purchases.

Economists agree that price discrimination occurs at different levels. First-degree price discrimination is limited to buyers who possess complete knowledge of the willingness of customers to accept a particular price. In such situations, customers are prevented from seeking out the lowest price available because of market monopolies. With second-degree price discrimination, sellers control large segments of the market and offer lower prices to those who buy in bulk. Since small firms cannot afford to store large quantities of merchandise, they are required to pay higher prices for the same good.

Third-degree price discrimination is based on the concept of setting prices according to the high and low demands of particular groups. The classic example of third-degree price discrimination is providing student and senior discounts to segments of the populations with lower demands and incomes. Because the different levels of price discrimination may result in injuries to those paying higher prices, different levels of injuries are accepted by the courts. Primary-line injury occurs when sellers engage in predation, offering goods or services at reduced prices solely for the purpose of shutting out local competitors either through forcing them out of business or preventing new competitors from entering the market. Reduced prices in one area may be financed by charging higher prices in another area where no local competitor is present. Second-line injury is often experienced by disfavored firms who pay higher prices than favored firms for the same product.

Most economists agree that price discrimination is dependent on an accurate segmentation of the market, the ability to prevent the resale of products sold (arbitrage), and control of a particular market (DePasquale, 2015). Business owners may prevent arbitrage through requiring identification for purchase of the product or service, placing maximums on the number of items purchased at a particular price, or prohibiting the transfer of a particular price or service to another customer. Arbitrage is considered beneficial in some instances since buyers are more likely to purchase items from retailers who have some knowledge of a product and its uses. The issue of arbitrage came before the Supreme Court in 2013 in Kirtsaeng v. John Willey and Sons (131 S Ct. 1351). The case involved the actions of Supap Kirtsaeng, a Thai student who purchased textbooks from Asia and resold them on the American market at lower prices than those demanded by the publisher. Wiley was originally awarded $600,000 for copyright infringement, but the Supreme Court overturned the case on the basis of the first-sale doctrine, holding that a buyer had the right to resell a copy of a book brought anywhere in the world without engaging in copyright infringement.

Firms may use predation to force competitors out of business or keep them from entering the market. McGee (1958) was the first to argue that predation was often the result of rational behavior. Building on McGee’s foundation, economists developed reputation, long-purse predation, and signaling models to explain the concept of predation. Some predators use the reputation model to assert their right to dominate the market by appearing so tough that no rival is able to compete. Those who practice long-purse predation use their "deep pockets" to survive a period of reduced profits while undercutting all competition. In the signaling model, an incumbent business depends on market signals such as existing prices and advertising to convince competitors that it is inadvisable to enter a given market. Pires and Jorge (2012) argue that all predation models are based on incomplete information of those who challenge incumbent business owners.

Applications

During the rapid industrialization of the late nineteenth and early twentieth centuries, Americans became disillusioned with monopolies that cut down all competitors large and small. New federal legislation was passed, and antitrust suits flourished. The Interstate Commerce Commission was established in 1887 to protect free trade and enforce fair pricing across state lines. Congress passed the Sherman Antitrust Act in 1890, threatening both individuals and corporations with heavy fines and prison terms for engaging in monopolies. In 1911, both Standard Oil Company v. U.S. (221 US 1) and US v. American Tobacco Company (221 US 106) were used to break up monopolies that had enabled the giant companies to practice widespread price discrimination. Congress passed the Clayton Antitrust Act in 1914 as a means of preventing monopolists from using price discrimination to keep small local companies out of a particular field. The Clayton Act provided for damages of three times injuries suffered for victims who experienced antitrust price discrimination injuries.

By the 1930s, Congress had become concerned with protecting small business owners from being overridden by the large chains that had opened across the country. These chains were able to buy items in bulk for low prices and then resell them at higher prices. Congress amended the Clayton Antitrust Act in 1936 by passing the Robinson-Patman Act, providing a means of protecting victims of primary- and second-line injury (Blair, Piette & Durance, 2015). From the beginning, the Robinson-Patman Act was unpopular with economists who believed that Congress had not left enough leeway for price differences related to costs. In cases brought under Robinson-Patman, the plaintiff bore the burden of proving that an antitrust violation had occurred and was required to prove that liability was likely to hamper competition or threaten monopoly (Blair et al., 2015). For example, in Brunswick Corporation v. Pueblo Bowl-o-Mat, Inc. (429 US 477), in 1977, the Court held that Brunswick, one of several local bowling centers, had created a likelihood of predatory pricing by acquiring Bowl-o-Mat’s failing competitors and thereby preventing healthy competitors from adjusting their prices upward.

Before Brunswick, the Court had tended to focus entirely on the issue of liability, requiring plaintiffs to demonstrate that an actual antitrust injury had been suffered. The most notorious case dealt with on these grounds was Utah Pie Company v. Continental Baking Company (386 US 685, 1967). The case arose out of the entry of Utah Pie into the frozen pie market in Salt Lake City. Before that time, pies had been bought exclusively from Carnation, Continental Baking, and Pet Milk, but the local company sold their pies at lower prices. Within two years, Utah Pie was claiming 67 percent of the frozen pie market, leading to lower prices and increased competition. As other companies increased output and sold pies in Salt Lake City at prices lower than elsewhere, Utah Pie’s share of the market fell to 45 percent, and the company filed suit on the grounds of price discrimination under the Clayton and Robinson-Patman Acts. The Court agreed, holding that sellers were prohibited from selling items at different prices with the intention of interfering with the freedom of the market.

The issue of primary-line-injury was again visited by the Court in 1993 in Brook Group Ltd. v. Brown and Williamson Tobacco Corporation (509 US 209). The case resulted from disputes over prices for generic cigarettes, which were introduced as the demand for cigarettes fell in the early 1980s. As a way to recoup losses, the Brook Group began selling generic cigarettes at prices 30 percent lower than name-brand cigarettes. A price war erupted when Brown and Williamson began selling generic cigarettes at even lower prices. The Brook Group filed suit, claiming that volume discounts granted by Brown and Williamson were a form of price discrimination. The Court established a two-prong test to determine predatory pricing that required plaintiffs to prove that prices were "below an appropriate measure of its rival’s costs" and that a reasonable prospect of recouping investments by selling products below cost prices existed.

Issues

Since there are significant variations in what is considered justifiable price discrimination, the courts have consistently been called upon to settle the legal boundaries between what is acceptable and what is not. Cases decided on the basis of Robinson-Patman have involved both first- and second-degree injury (DePasquale, 2015). In the 1940s the Morton Salt Company began providing five favored grocery store chains with salt that could be bought in bulk for $1.35 a case. Disfavored companies challenged the practice, and FTC v. Morton Salt (334 US 37) was heard by the Supreme Court in 1948. The Court held that the bulk discounts were illegal because the cost of the salt was not based on costs involved in producing the product. Some analysts insisted that the Court had erred in its decision because no injury had been suffered by disfavored companies since the sale of salt made up only a small portion of store profits. Morton Salt was revisited in 2006 in Volvo Trucks North America, Inc. v. Reeder-Simco GMC, Inc. (546 US 164) when the Court held that injury could be proved only when identical products were being sold by favored and disfavored companies.

The standard for judging secondary-line injury was established in J. Truett Payne Company v. Chrysler Motors Corporation (451 US 557), in 1981. Chrysler had been providing bonuses to selected dealers that were based entirely on quotas established by Chrysler. The quota required of J. Truett Payne was higher than those of its rivals, and the company did not receive a bonus because it was unable to meet its quota and was subsequently forced out of business. J. Truett Payne then filed suit under the Clayton and Robinson-Patman Acts. A jury awarded the petitioner $111,247.48 in damages, and that amount was trebled by a federal district court. However, the decision was reversed by the Court of Appeals, which argued that the petitioner had failed to produce sufficient evidence of antitrust injury. The Supreme Court also rejected the claim of "automatic damages."

The number of courts challenging price discrimination under Robinson-Patman began a steady decline in the mid-1970s, and the last time the Department of Justice filed a Robinson-Patman case was in 1972. Since 1990, the Federal Trade Commission has filed only one Robinson-Patman case (Blair et al., 2015). However, private suits continue to be filed. Robinson-Patman was the basis for Texaco, Inc. v. Hasbruck (496 US 543, 1990), which concerned a Spokane gas retailer who had offered discounts to Gull and Dompier distributors in the early 1970s during the Oil Crisis. Other retailers who were charged higher prices were forced out of business. Ultimately, Texaco was convicted of discriminating against small competitors.

In October 2014, Woodman’s Food Market, a fifteen-store supermarket chain based in Janesville, Wisconsin, brought suit against Clorox, charging them with price discrimination for selling bulk packages of products such as Clorox, Glad, Hidden Valley, and Bert’s Bees only to large retailers such as Sam’s Club and Costco. In February 2015, a federal district court dismissed Clorox’s claim that the challenge was based on "outdated" FTC rulings and allowed the case to proceed.

In some cases, the unfairness of price discrimination is so obvious that the public is able to win a resolution without resorting to the courts. Such a case occurred in late 2000 when it became known that Amazon, the Internet giant, was selling DVDs to customers at different prices. When customers alleged price discrimination, Amazon CEO Jeff Bezos apologized, explaining that price differences were simply a response to a random price test that had been conducted to determine if more items would be purchased when they were sold at a lower price. Some 6,896 customers were refunded $3.10 each.

Beginning in 1991, Ian Ayers, an economics and law professor at Yale University, has done significant work on the issue of gender and racial price discrimination. In a landmark study (1991), Ayers found that when purchasing automobiles, white women were charged a 40 percent mark-up. African American males were charged twice as much for the same car as a white male, and African American women were charged three times as much. An updated study in 1995 revealed that African Americans and white females were still being charged higher prices than white males. Some price discrimination based on gender is considered acceptable as in the case of haircuts, deodorants, and face creams.

Some price discrimination has occurred at the global level. In the summer of 2015, the European Commission and French authorities learned that Disneyland Paris was charging different prices to citizens of different countries. The same package was being sold to French residents for $1,486, to British residents for $2,065, and to German residents for $2,702 in direct violation of single-market rules established by the European Union. Disneyland claimed that the price differences were a response to promotional packages designed for particular markets.

Terms & Concepts

Arbitrage: The process of reselling goods bought at a low-price for a higher price. The practice is often associated with the reselling of goods bought on foreign markets.

Clayton Antitrust Act: Federal legislation passed in 1914 for the purpose of preventing American firms from using price discrimination to force local competitors out of the market.

First-Degree Price Discrimination: Type of price discrimination that occurs when sellers have perfect knowledge of what each customer is willing to pay and charge customers accordingly.

Predatory Pricing: Practice by which firms establish low prices on a product or service for the sole purpose of driving a competitor out of the market or preventing entry of a competitor into the market.

Price Discrimination: Also known as differential pricing, tiered pricing, and smart pricing, price discrimination exists when the same or similar goods or services are sold to consumers at different prices.

Reservation Price: Maximum price that a buyer is willing to pay and the minimum price that a seller is willing to accept for goods or services.

Robinson-Patman Act: Legislation passed by Congress in 1936 as an amendment to the Clayton Antitrust Act as a way to prevent monopolists from practicing predatory pricing.

Second-Degree Price Discrimination: Type of price discrimination that allows bulk buyers to buy items or services at lower prices than those who have small inventories. It also occurs when sellers set different prices for products by varying them in some way.

Sherman Antitrust Act: Federal legislation passed in Congress in 1890 that banned all interference with open trade, including price discrimination and monopolist practices. Corporations faced fines of $100,000,000 for violating the act.

Third-Degree Price Discrimination: Type of price discrimination that is responsive to the self-sorting of individuals into particular groups such as those based on age or geography.

Uniform Pricing: Practice of charging all customers the same price for an item or service. While it is considered easier for both buyers and sellers, it is not considered beneficial by most economists.

Bibliography

Ayers, I. (1991). Fair driving: Gender and race discrimination in retail car negotiations. Faculty Scholarship Series. Paper 1540. Retrieved November 29, 2015 from http://digitalcommons.law.yale.edu/fss‗papers/1540/

Blair, R., Piette, D., & Durrance, C. (2015). Private damage actions under the Robinson-Patman act. Antitrust Bulletin, 60(4), 384–401. Retrieved November 21, 2015 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=a9h&AN=110970184&site=ehost-live

Cabral, L. (2000). Principles of pricing: An analytical approach. Cambridge, MA: MIT Press.

DePasquale, C. (2015). The Robinson-Patman act and the consumer effects of price discrimination. Antitrust Bulletin, 60(4), 402–413. Retrieved November 21, 2015 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=110970185&site=ehost-live

Edwards, M. A. (2014). Teaching consumer price discrimination: An interdisciplinary case study for business law students. Journal of Legal Studies Education, 31(1), 291–324. Retrieved January 3, 2016 from EBSCO Online Database Education Research Complete. http://search.ebscohost.com/login.aspx?direct=true&db=ehh&AN=97177207&site=ehost-live

Elegido, J. M. (2011). The ethics of price discrimination. Business Ethics Quarterly, 21(4), 633–660. Retrieved November 21, 2015 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=66804218&site=ehost-live

McGee, J. (1958). Predatory price cutting: The Standard Oil (NJ) case. Journal of Law and Economics, 1, 137–169.

Pires, C., & Jorge, S. (2012). Limit pricing under third-degree price discrimination. International Journal of Game Theory, 41(3), 671. 698. Retrieved November 21, 2015 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=77656540&site=ehost-live

Vohra, R. V., & Krishnamurthi, L. (2012). Principles of Pricing: An Analytical Approach. New York, NY: Cambridge University Press.

Suggested Reading

Chao, Y., & Nahata, B. (2015). The degree of distortions under second-degree price discrimination. Economics Letters, 137, 208–213. Retrieved January 3, 2016 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=111486081&site=ehost-live

Kain, J. F. (2004). A pioneer’s perspective on the spatial mismatch literature. Urban Studies, 41(1), 7–32.

Marcoux, A. M. (2006). Much ado about price discrimination. Journal of Markets and Morality, 9(1), 57–69.

Motta, M. (2004). Competition policy–Theory and practice. Cambridge, UK: Cambridge University Press.

Okada, T. (2014). Third-degree price discrimination with fairness-concerned consumers. Manchester School (14636786), 82(6), 701–715. Retrieved January 3, 2016 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=99008355&site=ehost-live

Waldfogel, J. (2015). First Degree Price Discrimination Goes to School. Journal Of Industrial Economics, 63(4), 569-597. Retrieved January 3, 2016 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=112000280&site=ehost-live

White, J. B. (2014). Price Discrimination: A Classroom Exercise. Business Education Innovation Journal, 6(2), 100-103. Retrieved January 3, 2016 from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=101197677&site=ehost-live