The Handbook of Competition Economics 2009 A Global Competition Review special report published in association with: Compass Lexecon www.globalcompetitionreview.com PRICE DISCRIMINATION Should Competition Policy Prohibit Price Discrimination? Dennis W Carlton and Mark Israel Compass Lexecon Price discrimination – which can be defined simply Clearly some degree of (at least short-lived) as a firm charging different prices to different market power, some ability to segment consumers, consumers for the identical item – is a pervasive and some limitations on resale characterise feature of economic transactions. Rather than most markets, making the prevalence of price charge a single price to all consumers, firms discrimination a predictable outcome. often choose to segment consumers based on Given its prevalence, it is critical that their willingness to pay and to price discriminate competition policy has a clear view of whether accordingly. This is obviously true for many price discrimination should be permitted. “business to business” transactions in which prices Unfortunately, this is not always the case, as price – including rebates, incentives, discounts, and discrimination, while generally permitted (at least so on – are individually negotiated, but it is also in the US), is often viewed with suspicion. In true of many retail prices that vary by customer addition, while price discrimination on its own is group (eg, some cinema tickets), loyalty or other not a violation of US antitrust law, practices whose discount programmes, coupons, prices on bundled sole purpose is to enable price discrimination products, and many other forms of pricing. Indeed, – such as tying products together to meter usage even in situations where prices vary for what may – can be antitrust violations. In other jurisdictions be seen as cost-based reasons, such as volume (including Europe) price discrimination on its discounts and risk-based pricing for credit cards own can be an antitrust violation. And some or insurance, the price distinctions may reflect recent academic work argues that due to its short- differential demand sensitivities in addition to run and long-run effects on consumer and total differential marginal costs. welfare, price discrimination (specifically, tying A complication arises in defining price for the purpose of price discriminating) should be discrimination when different customers impose considered an antitrust violation. different costs on the firm. Should we say that In this chapter, we explain our view that, as a price discrimination exists if the price difference matter of competition policy, price discrimination between two customers is not equal to the (and other practices whose sole purpose can difference in marginal costs imposed by the two be shown to be price discrimination) should be customers, or should we instead require that the permitted. Given the change in administration price mark up (price minus marginal cost divided in the US and the continued development of by price) differs between the two customers? For competition policies in other countries such as simplicity, we adopt the first definition in our China, we believe this is an important time to discussion in this chapter. firmly establish that efforts to prohibit price The prevalence of price discrimination is not discrimination are misguided. surprising to an economist. It is well known that an We proceed in two steps. First, in the second individual firm with any degree of market power section we compare price discrimination with – even lasting only for a short time, perhaps due the simpler practice by a firm with market power to product differentiation, search costs, switching of setting price above marginal cost (henceforth costs, or other factors – will generally have an “simple monopoly pricing”). We note that both incentive to price discriminate as long as: are attempts by a firm to capture a greater share • it can find some way to segment consumers of total surplus in the form of profits, and thus based on willingness to pay; and the well-accepted view (under US antitrust law) • consumers cannot completely “arbitrage” that it is not an antitrust violation for a firm to away the price differences via resale from low possess market power or to set the monopoly to high price buyers. price should also guide policy with respect to price discrimination. Next, in the third section we consider possible distinctions between price 10 The Handbook of Competition Economics 2009 PRICE DISCRIMINATION discrimination and simple monopoly pricing that to earn very large profits. It is the possibility one might use to support differential antitrust of these profits that provides the incentives for treatment of price discrimination and explain innovation. Indeed, this is the reason for granting why these distinctions do not, in fact, support patents, through which government officials create restrictions on price discrimination as a matter of market power and associated profits to stimulate competition policy. investment and innovation. Second, while there may be cases in which the Simple monopoly pricing v price discrimination static welfare costs of simple monopoly pricing Under United States antitrust policy it is neither outweigh the dynamic gains, the cost of attempting unlawful to possess market power, nor to use such to identify these cases and then implement a rule market power to raise prices above marginal cost. to restrict prices in only those cases is likely to This is true despite the fact that, as a matter of be extremely high. Beyond just the monetary basic economics, setting a price above marginal costs associated with study and enforcement, cost implies that some consumers who value a the costs in terms of lost innovation are likely product more than the cost of producing that to be substantial. In evaluating the return on product do not obtain it, and thus that static investment, potential innovators would have to welfare is reduced. consider the possibility that their prices would be In a simple case, if all of the buyers from a single restricted, as well as the associated legal costs of firm exhibited the same, low price sensitivity, that the associated antitrust processes, and the induced firm would be permitted to charge them all the risk and uncertainty with regard to future cash associated profit-maximising price, which may be flows. Avoidance of the potential dampening effect substantially above marginal cost. So the obvious on investment and innovation requires a clear question is, if another firm faces buyers with policy to permit firms to set profit-maximising heterogeneous price sensitivities, why shouldn’t prices above marginal cost. it be allowed to implement policies that charge Given these rationales for allowing a firm to each of them the associated profit-maximising set the simple monopoly price, we see no basis price? As another example, suppose two different to disallow price discrimination. As noted above, firms with market power sell to two distinct sets individual firms with market power generally of consumers with different price sensitivities. have an incentive to price discriminate in order Each of these firms would be permitted to set to maximise profits. So the logic of prohibiting or the (different) profit-maximising prices to each restricting price discrimination would have to be set of consumers. Why should antitrust policy that – in order to create incentives to invest and distinguish this from the case where a single firm innovate – firms should be permitted to maximise sells to both those sets of consumers and sets the profits, but only subject to the constraint of no (different) profit-maximising price to each? We see price discrimination. We see no economic basis no basis for the distinction. for imposing this constraint. In addition, the cost Consider why antitrust policy permits simple of implementing and enforcing such a constraint monopoly pricing, despite its detrimental effect on would be quite high. In this case, there would not static welfare. We see two primary explanations. only be the costs associated with determining when First, antitrust policy appropriately does not limit to optimally permit or prohibit price discrimination, its attention to static welfare, but rather recognises along with the dampening effect on innovation, the critical role of dynamic incentives to invest but also the cost associated with determining and innovate. Indeed, economic research has whether the observed price differences are due demonstrated that the extent of investment and to demand differences rather than marginal cost innovation is the most important determinant of differences. There could also be substantial costs an economy’s growth rate. In order to create the associated with firms attempting to find alternative, proper incentives to invest and innovate, firms permissible business practices to achieve the same should be able to profit from their success. For goals and with regulators attempting to identify this reason, it is sound policy to allow firms that and police these alternatives. have legitimately obtained market power to set This logic does not indicate that all behaviour prices above marginal cost and in some cases that increases profits should be permitted. Rather, www.globalcompetitionreview.com 11 PRICE DISCRIMINATION in our view, the relevant distinction is whether willingness to pay – and whether the industry is permitting a practice by a given firm or set of firms a monopoly or oligopoly. To provide a complete increases or decreases the incentive and ability of picture, we briefly consider each possibility. other existing firms and new entrants to compete. If price discrimination is perfect, the result is Allowing a firm to set the simple monopoly well known. Under some mild assumptions, for price or to price discriminate to maximise its any given number of firms competing in the market profits increases the “prize” associated with – whether it be a monopoly or oligopoly – perfect successful competition in the marketplace and price discrimination increases total static welfare thus increases the incentives for competitors to relative to simple monopoly pricing.