Price Decisions

As promised, we will tackle not only research topics in our blog, but also personal finance and economic education topics; because these are additional areas we focus on at the Detroit Branch of the Chicago Fed. This past Friday, I had the pleasure of speaking with high school students from Northwest H.S. in Jackson, MI, and one of the subjects they were interested in learning more about was the pricing of goods and services. While labor, material, and transportation costs figure prominently into constructing prices, so do the anticipated responses, or price elasticities by customers to a set price.

In the Managerial Economics class I teach at the University of Michigan-Dearborn, one of the subjects we cover near the end of the term is price discrimination. Price discrimination is the practice of charging different prices to consumers for the same good or service. In order to practice price discrimination, a firm must have some market power. Farmers are unable to practice price discrimination because they’re in a more competitive market and are forced into the position of “price-taker,” settling for the market price.

“Price-setters” can execute one of the three types of price discrimination, as explained in a video lesson by Jason Welker. Between his notes page and video lesson, Welker does a great job detailing the different degrees of price discrimination and examples of each. Third-degree price discrimination is the most common form of price discrimination practiced by firms. Every time you go to the movies, you are subjected to third-degree price discrimination. Movie theaters try to maximize their revenue by charging different prices for tickets to different groups and at different times of the day. For example, students with a student ID are charged lower prices because they are arguably more sensitive to price changes than an adult couple who are enjoying date night. Amusement parks such as Disneyland provide more examples of third-degree price discrimination. You can buy one-day or multi-day passes. You can go to Disneyland or California Adventure Park separately. Another option is for you to stay at the hotel for multiple days and visit the parks over that time. Each option comes with a different ticket price.

Second-degree price discrimination occurs when firms post a schedule of declining prices for different ranges of quantities. Consumers decide how much to purchase based on their forecasted usage. Anything you buy in bulk, in which the price per unit you pay for goods or services declines as the quantity you purchase increases, is an example of second-degree price discrimination. The various ticket plans offered by sports teams that have become increasingly popular in recent years as athletic departments and professional sports teams try to maximize their revenue could be considered as second-degree price discrimination. Historically, sports teams like the Detroit Tigers offered season ticket and group packages in addition to single-game tickets. Now, in addition to the usual 81-game season ticket package, the Tigers offer 41-game packages, weekend packages in which you can buy season tickets for weekend home games, and 15-game packages for those baseball fans that can’t make it down to the ballpark as frequently.

First-degree price discrimination is the least common form of price discrimination practiced, because it requires the firm to charge each individual consumer the respective maximum price they’re willing to pay for a good or service. This implies firms possess a lot of information about their consumers and their buying habits. Until recently, one of the best examples of first-degree price discrimination was auctions. When you buy something at an auction, you reveal how much you’re willing to pay for a particular item. However, in recent years through the use of information technology, firms have acquired consumer information that in some cases allows them to cater to individual consumers. The June 30, 2012, edition of The Economist gives examples of how firms are using information technology to develop price discrimination strategies.

Price discrimination, while it does imply that firms are exerting market power, may not necessarily be bad news for consumers. If there is competition among suppliers in a market, and few barriers to new suppliers entering a market, consumers may sometimes be well-served by more customized pricing practices. However, concerns over firms exhibiting monopolistic or oligopolistic power may arise as firms gain more market share; such practices are illegal if they result in firms violating anti-trust policies. The Supreme Court has ruled that price discrimination claims under the Robinson-Patman Act should be evaluated in a manner consistent with broader anti-trust policies. In practice, Robinson-Patman claims must meet several specific legal tests:

1. The act applies to commodities, but not to services, and to purchases, but not to leases.
2. The goods must be of “like grade and quality.”
3. There must be likely injury to competition (that is, a private plaintiff must also show actual harm to his or her business).
4. Normally, the sales must be “in” interstate commerce (that is, the sale must be across a state line).¹

Teachers who would like someone from the Detroit Branch to visit and present at their school should contact Katherine Nelson at 313-964-6170 or Martin Lavelle at 313-964-6150. We’ll do our best to accommodate your needs.

Footnotes

¹ “Price Discrimination Among Buyers: Robinson-Patman Violations,” 11 Feb 2013. Available online.

The views expressed in this post are our own and do not reflect those of the Federal Reserve Bank of Chicago or the Federal Reserve System.