PriceDisc

How do you feel about discrimination? Is it a good or a bad thing? Is it justifiable, or is it simply wrong? Should a person be denied a job because he or she happens to be the wrong gender? Should a person be fired because of age? Should children pay lower prices for movies? Should girls have lower insurance rates than boys, or should women's pensions be lower than men's?

You probably have some strong feelings on some of these questions, but you probably did not know they are all related in that at the core they are about discrimination - the treatment of identifiable groups differently. At this time we will not involve ourselves in a broad debate over discrimination, but we will come back to look at the issues of age and racial discrimination later. Now we will look at only one type of discrimination, price discrimination, and then compare the price discrimination with the mark-up pricing model. We will also briefly discuss alternative pricing strategies.

To understand the concept, consider two pricing options for Mary who is working in a Newport T-shirt shop where she wants to sell 100 T-shirts that cost her $5.00. One option would be to put up a sign announcing that all T-shirts would be sold at a set price of $5.00. A second option would be to put up a sign that said something to the effect "make me an offer I cannot refuse." Which option do you think would generate more revenue?

It is likely the second option would be the winner even if the approach had no impact on the number of potential customers who walked in the door. Why? Because you are likely to have some potential customers like Karl who really wants a Newport T-shirt, and some like Kristen who would probably pay the $5.00. In fact Karl wants one badly enough that he would be willing to pay $7.00. If we adopted the first strategy, both T-shirts would have been sold at $5.00 giving Mary $10 in revenue, but under the second option Mary could have earned revenues of $12. She was able to earn the extra revenue because she could charge different prices.

This practice of charging different prices for the same product is an example of one type of price discrimination. There are actually two forms of price discrimination which can be employed.

But what is the key to successful price discrimination? Why don't all sellers discriminate? First, to discriminate you must be able to keep the markets separate which is one of the reasons why age, rage, and gender were so popular as the bases for discrimination. The pervasiveness of this type of discrimination can be seen in the following headlines taken from national newspapers in the early 1960s before passage of the federal Civil Rights Act of 1964. I am old enough to remember 'ladies' night at the local movie theaters and watering holes.

Chicago Tribune January 3, 1960	New York Times January 3, 1960	Washington Post January 3, 1960
LABORATORY TECHNICIAN Experienced, Modern southside medical center. White Salary open. Call Vincennes 6-3401	COOK, housekeeper, Negro preferred, experience essential, prominent family, permanent position, high salary, MA 7-5369	AMBITIOUS MEN (WHITE) National concern requires services of 3 neat-appearing young men, 18-35, to work in the library dept. for executive person... For appointment call MR ALBRIGHT, ME, 8-1484, 9 a.m. 'til 2 p.m.

Second, there must be restrictions on transactions between markets - no resales. If someone buying at a low price can resell it to the person willing to pay the higher price, your ability to set different prices will be eliminated. This would not be too difficult to do if we were talking about a movie, but it would be difficult if we were talking about a textbook which could be purchased at the lower price and quickly sold to the group that faces the higher sticker price. The process of buying where the price is low and selling it is high is called arbitrage. Firms have come up with a number of strategies to reduce / eliminate resale. Warranties are one such strategy as are adulteration of the product. An example of the latter would be drinking and rubbing alcohol. Also included here would be versioning, creating different versions for different markets. There could be some contractural arrangements such as the University's agreement not to resell computers that it purchases at discounted academic rates.

Third, demand in the sub markets must be different otherwise the optimal price to charge would be the same in both markets.

If demand is different and discrimination is possible, the seller then faces the decision of setting the appropriate prices in the sub markets. What should guide the pricing decision? As long as the seller is concerned with maximizing profit the rule is the same - set the price such that MC = MR. The new wrinkle here is that MR will be different in different markets. If you work your way through the algebra or the graphs, you will end up with the following result: prices will tend to be higher where elasticity of demand is lower which should make sense. You will tend to raise prices in those sub markets where demand is less responsive to price changes - where any price increase will be met with smaller reductions in demand.

Who gets charged the higher price? Below you will find a graph of the situation facing a producer selling the same product in two sub markets. In the diagram the demand in each sub market is represented by a demand (D) and marginal revenue (MR) curve. The two sub markets differ in terms of the elasticity of demand, where demand is more responsive (flatter demand curve) in the market designated by the Di curve. Because the firm is selling the same product, the MC curve is the same in the two markets and to make life easy, we are assuming that the MC curve is horizontal

To maximize profit the firm will follow the MR = MC rule and establish the output levels for the two markets at Qe and Qi. Once these output levels are set, the demand curves will be used to set the prices at Pe and Pi. What we see here is a graphical 'proof' of the result that a seller would charge different prices in different markets.

What is not obvious from this graph is the relationship between price and elasticity of demand, although once you think about it you should find it rather intuitive. The secret to increased profits through price discrimination is charge the higher price where the market will bear it. Translated into elasticity, this means the price should be higher where demand is less responsive to price changes. You will tend to raise the price higher if there is less of a decline in demand when you raise the price. If you want any convincing, you might want to check out the algebra that "proves" price and elasticity of demand are inversely related - higher elasticity, lower price.

The MC/MR pricing model is only one of a set of possible pricing strategies that a firm can employ and at this time we will discuss a few alternatives - the mark-up pricing model, limit pricing, and predatory pricing. Limit pricing and predatory pricing are both pricing strategies designed to reduce competition. Predatory pricing is generally considered to exist when a firm charges a very low price, below short run marginal cost, in the hopes of driving out any competitors. Once out, the firm will then be free to raise price. A second strategy would be limit pricing. Here the firm sets a price above cost, but below the level that another firm would find it profitable to enter the market.

A third possibility would be mark-up pricing. Very often you run into the mark-up pricing model where the price is set as some multiple of the cost. One example would be where you would simply set the sales price of your product at double the price you paid for it. Its advantage as a pricing strategy is its easy. It can also be set in such a way as to equal the profit maximizing price. If you assume that you are marking up price on the initial cost, then you would have the following relationship. The mark-up (MU) equals the percentage differential between sales price (P) and input cost (C). If, for example, you bought an item for 410 and sold it for $20, then the mark-up would be 100% [($20-$10)/$10 = $10/$10 = 1 = 100%]

We also know from our analysis of optimal pricing that the following relationship between the price and elasticity exists.

Allowing for the cost of the product to also be the marginal cost, the situation in a competitive market, we can now combine these as follows:

The bottom line, mark-up pricing can be viewed as optimal if the mark-up is based on elasticity of demand - the higher the elasticity of demand, the lower the mark-up.