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Thursday, July 06, 2006

Price Discrimination

Robert Frank uses travel and computer market examples to explain how price discrimination can be beneficial, though I've only included the computer market example here. This issue is also the topic of a recent post about price discrimination in the market for orthopedics, and the previous post has a link to further discusion of differential pricing and efficiency by Hal Varian:

How Much Is That Laptop? It Depends on the Color of the Case. And That's Fair, by Robert Frank, Economic Scene, NY Times: If I ... order Apple's new MacBook laptop, the company will charge me $1,499 for a machine in black, but only $1,349 for an identically configured one in white.

As economists use the term, price discrimination means charging some buyers more than others for essentially the same product or service. Is it a bad thing? Buyers paying the higher prices understandably resent the practice. They might thus be surprised to learn that it often enables them to enjoy both lower prices and higher quality than would be possible if sellers charged the same price to everyone. Even more surprising, price discrimination often metes out rough justice among buyers, requiring those who are responsible for a greater share of sellers' costs to shoulder a greater share of the burden.

For these claims to hold, sellers' costs per unit must decline with the number of units sold. This test is met in many markets. ..., for example, ... the average cost of laptop computers declines sharply with the number produced — largely because research and development costs are essentially fixed. ... The upshot is that pricing schemes that enable companies to attract more buyers reduce the average cost per buyer served. And that frees resources that can be used to support higher quality — more frequent flights for travelers and more sophisticated laptops for computer buyers.

Among the ingenious tactics that sellers have developed for getting some buyers to pay more than others, many share a common feature: sellers offer discounts, but only to buyers who are first willing to jump a hurdle of some sort, like taking the trouble to mail in a rebate coupon. From the seller's perspective, the perfect hurdle is one that price-sensitive buyers can jump without difficulty but that other buyers find impossible to jump. ...

Although some people care a great deal about cutting-edge hardware and software, others would happily settle for simpler machines if that meant lower prices. Offering discounts to buyers of traditional white machines enables Apple to expand its market. And this reduces its cost per unit sold, freeing resources to develop even more sophisticated machines.

Apple's research program benefits all its buyers, but disproportionately those who care most about the new features it makes possible. In a just world, those buyers would pay a greater share of Apple's research costs. The premium price for new-look black machines is a crude device for identifying those buyers. People who are willing to pay it are largely the same ones who are willing to pay the most for the new machine's cutting-edge features.

Of course, discount hurdles do not apportion costs among buyers with precision. Some ... buyers who do not care much about a computer's technical abilities may have an overriding preference for machines in black, while others for whom those abilities are important may be equally happy with machines in white.

On balance, however, there appears to be at least rough justice in these and other hurdle schemes. The buyers who care most about quality tend also to be those who are least willing to jump over discount hurdles. To the extent these hurdles work, ... buyers of black laptops have little grounds for complaint.

    Posted by on Thursday, July 6, 2006 at 12:12 AM in Economics, Market Failure, Technology | Permalink  TrackBack (0)  Comments (13)


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