Free trade and price discrimination

Should a free trader be in favour of allowing firms to charge different prices to different customers?

The Globalisation Institute thinks not, in the context of pharmaceuticals. Drug companies in the United States are trying to find ways to prevent pharamaceuticals from being imported from markets outside the US where they are sold more cheaply. Is that vested interests trying to protect rigged markets, or is it markets operating at their most efficiently? In the case of pharmaceuticals, I think that price discrimination may be the optimal, free market outcome.

For those who have not heard the term, price discrimination is when a producer charges different prices to different customers. A classic example of price discrimination is Easyjet, which uses sophisticated technology to adjust the price of seats on the plane to ensure that every flight is full. On other airlines, cheap seats for people who stay a Saturday night help to distinguish business travellers from people paying for their own fare. This works because airline tickets are non-transferable – you can’t travel on a ticket that I have booked, so I can’t buy up seats and then sell them on; and because the airline has some way to distinguish different customers’ willingness to pay (by observing when they book the flight.) Price discrimination is also used by other travel industries (Young Person’s railcard, off-peak fares, first class tickets etc).

Hardback books are a form of price discrimination: the price difference from a paperback is much bigger than the difference in cost; publishers use the publication of hardbacks before paperbacks to get revenue from institutional buyers (libraries etc) and from those who will buy the latest book at any price; before allowing the book on to the market at a lower price in paperback for high volume, lower price sales.

Here in the United States, coupons and mail-in rebates are used to enable firms to charge different prices to different customers. Low-income purchasers will clip coupons from newspapers and magazines, and so they observe a different product price than better off consumers who do not bother. (More than 40% of mail in rebates are never claimed.)

Other examples of price discrimination include the operation of multiple tariffs for mobile phones; low use pricing rebates for utilities; brand name outlet stores; end-of-season sales; packaging of branded products as supermarket own-brands, and student discounts for software.

Now in a perfectly competitive market, there is generally a single price, which should equal marginal cost. Firms would not want to sell below marginal cost, as they would lose money; and they can’t sell above marginal cost because another firm will undercut them. In that case the market clears at marginal cost. This is socially optimal, as it ensures that people will consume something only if they value it as much or more than it costs society to make it.

But in many markets – including those for pharmaceuticals and software – firms have to be able to sell goods at above marginal cost, because they need to recoup large fixed costs such as R&D. Patents and other Government interventions exist to make it possible for firms to charge above marginal cost without being undercut by a competitor. So in these cases, it does make financial sense for firms to sell to some consumers below the market clearing price but above marginal cost, if the firms can do so without losing revenue from consumers who are willing to pay more. Should we be in favour of allowing firms to do this?

For convenience, let’s call the consumers who would be willing to pay the market clearing price "rich", and those with a lower willingness to pay, "poor", though in practice that might not be an accurate generalisation. Suppose that a firm is able to price discriminate perfectly (sometimes called pricing down the demand curve) so that each consumer pays exactly what he or she would be willing to pay, right down to the consumer who is only willing to pay the marginal cost. How does that compare in economic efficiency to a market in which everyone pays the same price, set above marginal cost?

First, rich consumers will pay more than they would have paid otherwise. This is not an overall loss of welfare to society, as firms receive a correspondingly larger revenue from these consumers – this is a zero-sum transfer from rich consumers to firms.

Second, poor consumers who would have been willing to pay above marginal cost, but less than the single market clearing price, are better off, as they can now consume a product which they would otherwise have been denied. This is a net gain to society, as it prevents the welfare loss that would occur if some consumers were priced out of using something that costs less to produce than it is worth to them. (In the case of pharmaceuticals, the welfare loss from pricing somebody out of access to a medicine could be very significant indeed; and this exclusion is a pure social welfare loss if the drug costs less to make than the buyer is willing and able to pay.)

Finally, firms and their shareholders are better off, as they can make some extra sales at above marginal cost to poor consumers who would not have bought at the market clearing price but are willing to pay something above marginal cost.

So overall welfare is increased by perfect price discrimination, because firms and poor consumers are better off; and the loss to rich consumers is balanced by a gain to firms; though price discrimination also has distributional consequences which benefit firms at the expense of rich consumers.

What about the rights of consumer and producers? You might think that when I buy something from you, it becomes mine, and I should be able to sell it to whomever I want. Isn’t that the free market? But an alternative view is that you should have the right to sell me something on condition that I use it myself and do not sell it to somebody else (which is what airlines and iTunes do); and if I do not want to buy it on those terms, then I don’t have to buy it at all. On this view, I have no right to make you sell me a good or service unencumbered by restrictions on whether I can sell it to someone else.

In the case of pharmaceuticals, price discrimination offers the best hope we have for allowing poor countries access to pharmaceuticals at affordable prices. If drug companies have to sell drugs at a single price all round the world, that will have be be a price which enables them to recoup their R&D investment. US consumers may pay a bit less; everyone else who can afford it will pay a bit more; and the majority of people in the world will have to do without the drugs at all because they will be unable to pay the uniform world price. But if pharmaceutical companies are able to sell more cheaply in developing countries than in rich countries, then developing countries will be able to buy drugs at or a bit above marginal cost and so they will pay something – even if it is much less than rich consumers – towards the cost of drug development.

If firms can find a way to sell to different customers at different prices, than I think that cannot be accurately described as "rigging" the market. Done well, it would increase overall welfare and increase economic efficiency. Nor does it trample on consumer rights: why should producers not be able to attach conditions to a good that they sell, provided they are transparent about doing so?

The only reason I can think of for opposing price discrimination is that rich consumers feel that they should not have to pay more for something than somebody else is paying. But that concern is nothing more than the politics of envy (to borrow a phrase from our right wing friends). If firms can find an honest and transparent way to charge more to people willing and able to pay more, and to charge less to people who would only buy at lower prices, for example by contract
ually restricting what those people may do with the goods once they have bought them, then good luck to them.

2 thoughts on “Free trade and price discrimination”

  1. This is interesting for I fully agree with your analysis. It’s one of the areas where I disagree with Alex and the GI and with several of the other such groups (there’s a London based one who’s name escapes me right now).
    Price discrimination, as you detail, can be a net gain to welfare. I’m sure you’ll also be delighted to know that it’s also roughly the Techcentralstation view.

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