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Introduction to Price Discrimination - YouTube
Channel: Marginal Revolution University
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- [Prof. Tyler Cowen]
Today we begin a section
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on price discrimination.
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Price discrimination means
selling the same product
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to different groups of customers
at different prices.
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We'll be looking at the effects
of price discrimination
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on monopoly profits
as well as on social welfare.
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So let's get started.
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Interpol, the International
Police Organization,
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busted a drug smuggling operation
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that was smuggling drugs
from Africa to Europe.
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What was it?
Cocaine, pot, heroine?
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No, it was none of these.
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It was the pharmaceutical drug,
Combivir,
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Why? Combivir, the AIDS drug,
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was priced at about
$12.50 per pill in Europe,
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about the same
as in the United States.
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But GSK was also selling Combivir
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to people to Africa
at a much lower price.
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How come?
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Well, for two reasons.
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First, for humanitarian reasons,
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and second to get
to the subject of this talk,
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to maximize profits.
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The smugglers were buying the pills
in Africa at the lower price,
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sending them to Europe,
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and then reselling them
in Europe at the higher price.
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Why is it that price discrimination
in the first place
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can increase profits?
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We actually can show this
using a diagram we've already seen.
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We know that
if the demand curve is more inelastic,
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that suggests the monopolist
should set a higher price,
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put on a higher mark up,
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while if the demand curve
is more elastic,
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that means a lower price.
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Suppose that the monopolist
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can segment
its market into two parts,
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say Europe and Africa,
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and that the demand curve
in Europe is much more inelastic
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than the demand curve in Africa
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where consumers are poorer
and more sensitive to price.
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The conclusion is that
the way to maximize profits
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is to set a high price in the market
with the inelastic demand, Europe,
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and a lower price in the market
with the elastic demand,
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namely Africa.
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Let's imagine that instead,
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there was a single enforced
world price for the drug.
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This price would be neither the profit
maximizing price for Europe
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nor would it be the profit
maximizing price for Africa.
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For the supplier, profits
would be lower with this single price
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than with two prices
under price discrimination.
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Of course,
price discrimination works
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only if it's in fact possible
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to segment and separate
the two markets.
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If smugglers can buy
in Africa and sell in Europe
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and if most of the buyers
of the drug
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end up buying
the smuggled product from Africa,
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that really is going
to mean the drug supplier
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is mostly selling
at the low African price
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and that will not
maximize their profits.
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So let's briefly review.
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Price discrimination
is selling the same product
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to different groups of buyers
at different prices.
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And here are some basic principles
of price discrimination.
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First, if the demand curves
across two markets are different,
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it's more profitable
to segment those two markets
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and set different prices.
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We know the prices
you should set.
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The price should be higher
in the market
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with the more inelastic demand.
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Second, arbitrage across markets
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makes it more difficult
to price discriminate.
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Let's say a little more
about arbitrage.
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Most simply,
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arbitrage means buying low
and then selling high.
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Buying low in one market,
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quickly moving those goods
to a second market
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and then reselling them
at a higher price.
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The effect of that arbitrage
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is to bring the prices in those
two markets closer together --
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increasing the price in the market
with the lower price
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and decreasing
the price in the market
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which had had the higher price.
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It's clear that to practice
price discrimination successfully,
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the monopolist has to prevent
that kind of arbitrage.
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Now smuggling --
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that's just an illegal form
of this kind of arbitrage.
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It's a type of arbitrage
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which breaks down
price discrimination.
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Now markets can be segmented
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in more ways
than just geographically.
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For instance, Rohm and Haas --
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they are a producer of materials,
and they had a plastic.
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I'll call it MM,
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a plastic that had uses in industry
and also uses in dentistry,
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as in dentures.
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MM in industry
had a lot of substitutes
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but as dentures there were
very few substitutes for using MM.
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So the firm price discriminated.
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It sold MM to industry
at about $0.85 a pound
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and it sold a slightly
different version of MM
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for dentures for dentistry
at $22 a pound.
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Of course,
with a price difference like that,
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entrepreneurs
started to buy up industrial MM,
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convert it to MM for dentures,
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and then resell that MM
at the higher price.
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How could the company
prevent this kind of arbitrage?
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Amazingly, Rohm and Haas
considered poisoning industrial MM
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so no one would want
to use it for dentures.
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Eventually they decided it was safer
to simply spread a rumor
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that industrial MM
had been laced with arsenic.
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If that sounds crazy,
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notice that the government
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actually does require
some goods to be poisoned
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in order to prevent arbitrage.
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Ethanol for instance
can be use in cars as a fuel
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and also for alcoholic beverages.
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The government
subsidizes fuel ethanol
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but doesn't want that ethanol
be converted into alcohol
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so it requires that fuel
ethanol be poisoned.
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The lesson is that it's easier
to prevent arbitrage in some goods
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than in others.
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It's easier to prevent arbitrage
in services, for instance,
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than in goods.
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If you get a massage for $20
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but that same masseuse
wants to charge me $50,
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it's hard for you
to buy the massage at $20
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and then somehow
resell it to me for $50.
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I need the masseuse
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to be the one
giving me that massage.
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Price discrimination
is very common in our world.
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Think about movie theaters
setting one price for children
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and a second price for seniors,
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and then yet
another price for adults.
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The cheaper price for seniors --
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do movie theater owners
love old people or love children?
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No, it's because those groups
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are more sensitive
to changes in price.
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Take young adults
going out on a date.
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They want to see
the latest movie
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and they don't want to look cheap.
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They'll probably pay full price.
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But retired seniors,
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if you charge them
too high a price,
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they'll just stay at home
and watch it on Netflix streaming.
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Or take computer software --
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businesses and students
are often charged different prices.
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Microsoft offers
a significant discount
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to students who purchase Office.
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Airlines -- another classic example
of price discrimination.
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Airlines want to set higher prices
for business travelers
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who are more likely
to have inelastic demands
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than for vacationers
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who are more likely
to have elastic demands.
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Price discrimination
is typically imperfect.
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The airlines ideally
would like to ask someone
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when they call up for a flight,
"Air you a business traveler?
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Well that will be $1200.
But are you a vacationer?
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Well then it will only be $700."
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But of course that scheme
isn't going to work
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because people will just lie.
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So what businesses try to do
is to look for characteristics
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which are correlated
with buyer willingness to pay.
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What are some characteristics
that might be correlated
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with having an inelastic demand --
with being a business traveler --
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as opposed
to having an elastic demand,
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being a vacation traveler?
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How can an airline distinguish
business travelers
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from vacationers?
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There are several methods,
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but business travelers
often have less flexibility.
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They might need to make
an important meeting
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on short notice,
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so the airlines
typically charge more
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if you want to fly
that day or the next day,
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than if you're able to book
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several weeks
or months in advance.
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The airlines reason that people
who really need to have a ticket
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for tomorrow on short notice --
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they're probably flying somewhere
to settle a big business deal.
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They won't be deterred
from flying by a higher price.
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On the other hand,
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people who are booking
weeks or months in advance,
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they have more substitutes.
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If the price of an airline ticket
to California is too high,
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maybe those people will
take a local vacation instead,
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or fly another airline to Florida.
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Similarly, vacationers
are more willing
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to stay over a Saturday night
than are business travelers.
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So sometimes it's cheaper to fly
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by staying over a Saturday
than by traveling during the week.
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Finally, first class,
business class and economy,
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they all get you to the same place
at the same time
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but first and business class
are much more expensive.
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The airlines figured
that anyone willing to pay extra
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for just a little more space
and better food,
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well, probably those people
have a lot more money
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or maybe their business
is paying for their ticket.
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Those customers
won't be so sensitive to the price.
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What you find when you put these
and a whole bunch of other methods
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of price discrimination together
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is that the airlines
are remarkably adept
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at charging different people
different prices
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for the same good.
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So that's just an introduction
to price discrimination.
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Next time
we'll look at the question,
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is price discrimination good?
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We've shown
that it can increase profits,
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but what's the effect
of price discrimination
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on social welfare?
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- [Narrator]
If you want to test yourself,
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click "Practice Questions,"
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or if you're ready to move on,
just click "Next Video."
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