Sorting by

Skip to main content

Price Discrimination and Fairness

By April 16, 2004 No Comments


Elderly people board busses to Canada to buy prescription drugs for less than they are priced in the U.S. Savvy travelers use “hidden cities” and split tickets to qualify for lower airfares. Couch potatoes disconnect their TV cables every three months so they can qualify for “new subscriber” rates. Supermarket cashiers swipe their own “preferred customer” cards for consumers who “left their card at home.” People think about hiring CPAs to figure out what telephone plan will be the best deal for them. Workers boycott Wal-Mart for driving down the prices their employers can charge for goods, leading to demands for wage concessions. These behaviors can be understood simply as people gaming the system for their own advantage. I think, though, that they are more usefully understood as popular resistance to pricing policies that consumers view as unfair and unjust. Economists define “price discrimination” as differences in prices charged to different customers that are not based on differences in the costs of serving those customers. (There is no particular reference to race or sex discrimination here.) As price discrimination has become an increasingly common business practice, this popular resistance has grown.

It is time for a discussion of the ethics of price discrimination. It is important to understand why businesses find this practice increasingly acceptable, while among many consumers (and voters) it continues to be perceived as unfair. As with so many issues in America today, we will find a cultural divide between those who accept price discrimination as a just and acceptable business practice, and those who do not. Though Christians can be found on both sides of this divide, it is not a matter of indifference. Price discrimination can be accepted as ethical only if efficiency is all that matters, and justice or fairness don’t matter, or alternatively if we accept the libertarian idea that anything that is voluntary is ipso facto fair. Christians should refuse to accept either of these premises.

The Economics of Price Discrimination

The place to begin this discussion is with the economic analysis of price discrimination. For price discrimination to exist, there must be monopoly or monopsony (single buyer) power somewhere in the market. There also must be some way for the seller to differentiate customers and to prevent some of them from buying at a low price and reselling the good at a higher price.

For a long time, economists simply took price discrimination to be evidence of monopoly power, and therefore an indicator of market failure. Monopolists might use price discrimination simply to enhance their profits, or they might employ it as a barrier to the entry of new competitors into the market. Either way, it just made things worse. The only case to be made for price discrimination was the few instances where it made goods available that the market might not otherwise support. The favorite example was the small-town physician who, by charging his clients different amounts based on their incomes, could support the fixed costs of keeping his office open, and make his own income approach that of his big city colleagues, thus justifying his quiet, semi-rural lifestyle.

This opinion changed rather radically in the 1980s, when it was demonstrated that, under certain conditions, monopoly with price discrimination produced a more economically efficient outcome than monopoly without price discrimination. At the same time, developments in public-utility regulation led to the examination of cases where price discrimination helped utilities to cover their high fixed infrastructure costs (pipes and wires) while charging low incremental-cost prices (just covering the delivered gas, water, or electricity) to the most price-sensitive customers. For example, long-distance telephone callers paid very high prices that subsidized inexpensive local service, and urban phone users overpaid to support expensive rural networks. This generalized the small-town-physician case. Price discrimination became the second-best solution to the problem of monopoly power. To many economists, it became quite acceptable, especially in markets with cost structures like the utilities’. These would include the airlines, or businesses with high fixed research and development costs but low per-unit manufacturing costs, like software and pharmaceuticals.

Prices, Costs, and Fairness

Economists usually propound the principle that prices should be related to costs. Prices that reflect costs provide information to buyers about the relative scarcities of various goods and the resources that go into producing them. Buyers can then arrange their purchases to satisfy their requirements while economizing most on the things that are most scarce. Economic efficiency requires that the market price of a good be equal to the incremental cost of producing the last unit of the good. In long-run competitive market equilibrium, the price will also be equal to the average cost, the total cost divided by the total output.

This relationship between prices and costs appeals to people because of its efficiency but it is also perceived as fair. It suggests that the market itself is not rigged in favor of any particular party. Price increases not related to cost increases are regarded as unfair.

This assures that the profits of the industry are in line with the rate of return to capital in the economy in general, and that allocation of capital among industries is effi- cient. If prices are stable, or at least predictable, then buyers can plan their purchases over a period of time to be as economical as possible.This relationship between prices and costs appeals to people because of its efficiency, but it is also perceived as fair. The situation in which equilibrium market prices are equal to costs is described as “competitive.” That is to say, no agent has the power to manipulate prices so as to increase her own income at the expense of others. This is certainly no guarantee of equality or anything like it, because different parties may come to the market with different amounts of wealth or talent or access. Nevertheless, it suggests that the market itself is not rigged in favor of any particular party. That is appealing, and people generally perceive it as fair or just. Research on laypeople’s perceptions of fairness indicate that while a simple markup pricing rule is not required for fairness, price increases not related to cost increases are regarded as unfair. Unfortunately, this research has not yet extended to directly test people’s perceptions of the fairness of price discrimination.

Price discrimination breaks this connection between prices and costs, in a way that is obvious for all to see. Several consequences follow. First, prices can no longer be relied on as an indicator of scarcity or a signal to the universe of buyers about where they need to economize. Though the most price-sensitive customers may face an incremental-cost price under price discrimination, other customers will not, and may not make efficient decisions as a result. Because economizing behavior then no longer guarantees efficiency in the allocation of resources, the social utility of the price system is compromised.

Second, sellers use price discrimination to raise their profits above the competitive level. These high profits would ordinarily serve the purpose of attracting new investment into the industry, but if there are barriers to entry in the industry, new investment will not follow. Barriers to entry could include patents, high fixed costs (of infrastructure or research), regulatory restrictions, or even price discrimination itself (by leaving no group of underserved consumers). If high profits do not attract new investment and entry, then they have no social purpose, and could be perceived as simply unfair. The perceived fairness of the price system could also be undermined simply by the evidence price discrimination provides that there is monopoly power in the system, so the monopolist is able to benefit at others’ expense from the structure of the market.

The use of price discrimination to support the provision of goods with high fixed costs that might not otherwise be provided by the market might be tolerated as fair in certain circumstances. The classic case of the small-town doctor derived some of its appeal from the fact that the discrimination practiced was the “size-up-the-income” variety. Poor people got a break under this practice, and the price discrimination was progressive in its distributional effect. It also counted on a general principle that people will go to the doctor when they need to, so high prices would not discourage people from seeking medical help. If higher prices for the affluent discouraged the more frugal among them from getting preventative health care, the system may not have been very efficient at all.

The modern pharmaceutical industry makes a much less appealing case for price discrimination. The way it works in this industry disadvantages those who buy their prescriptions at retail with their own after-tax dollars. In most cases, these are not the affluent, who have prescription coverage from their insurance and pre-tax accounts for the copayments and buy at discount prices from mail-order pharmacies. The ones who pay more are elderly low and moderate income folks, the kind who take the busses to Canada. The industry’s claim that its enhanced revenues support research and development would be more convincing if its marketing budgets were not so large and its profits so outsized.

The Libertarian Argument

The libertarian position holds that all trades or transactions are fair or just as long as they are voluntary on both sides, that is, as long as physical coercion was not employed to force either party into the trade. The fact that the transaction is consummated means that both parties perceive themselves to be better off having traded than they would have been without the trade. This makes the transaction just no matter how unevenly the gains from trade are split between the parties, and no matter how unequally it may treat equals.

The conservative politicians and pundits who have adopted this position as their own often refer to the justice of “capitalist acts between consenting adults in private.” The point of this comparison between market transactions and sex acts usually seems designed to tweak those liberals who prefer that government regulate markets but stay out of bedrooms. It also underscores the libertarian nature of the argument. To be consistent, these conservatives would have to argue that the government should keep out of both markets and bedrooms. Most of them are not consistent libertarians. Of course, Christians do not accept the idea that mutual consent is enough to make a relationship, whether business or sexual, right or fair. Exploitation can occur even where there is mutual consent.

An elderly heart patient pays $800 for a miracle statin drug because it offers a 10 percentagepoint reduction in the probability of undergoing a $50,000 coronary artery bypass operation. Clearly the drug is worth that much to the buyer, even if it only costs about $50 to make.

But the libertarian approach to market fairness appeals to many business managers with responsibility for pricing decisions, and seems to have prevailed over the cost-based fairness standard in the corporate sector.Libertarians try to justify price discrimination by pointing out the gains from trade that even disadvantaged buyers realize. The business traveler is willing to pay $1,000 for an airline ticket because she is off to close a multi-million dollar deal. She can hardly complain about paying five times the price paid by the tourist in the next seat, since the trip is worth so much to her. It is not worth as much to the tourist, for whom driving is an acceptable alternative. As long as the airline has not held a gun to anyone’s head, they have not done anything wrong by appropriating a largerthan- normal share of the business traveler’s gain. An elderly heart patient pays $800 for a miracle statin drug because it offers a 10 percentage-point reduction in the probability of undergoing a $50,000 coronary artery bypass operation. Clearly the drug is worth that much to the buyer, even if it only costs about $50 to make. Some lowincome customers may get it for less, but their budgets make them more likely to simply do without the drug or the operation, and so are more sensitive to price. The same goes for countries where health care is rationed, and not everyone with coronary artery disease gets bypass surgery. The libertarian argues that the customer should be grateful for the technological miracle the drug represents, even if the pharmaceutical manufacturer gets a disproportionate share of the pecuniary gain.

Perceptions, Politics, and Policy

The culture war over price discrimination has the economists, with their utilitarian perspective, lining up with the business community that leans toward the libertarian position. Both groups tend to see price discrimination as a legitimate practice. Rank-and-file consumers are more likely to hold views in which a close relationship between prices and costs leads to a fair division of the gains from trade between buyers and sellers. There is a popular perception of price discrimination as an unfair practice, since it breaks the connection between prices and costs.

In response to this, price discrimination is being scaled back in some industries, though it rarely disappears completely. Resentment of complicated pricing schemes and resistance to high business fares have recently driven the airlines to simplify their prices and reduce pricing disparities.

Commutative justice would suggest that the appropriate reward for a seller of goods is the recovery of the costs incurred to provide it, including the opportunity cost of the seller’s time and investment in the business. This way the gains from trade are appropriately distributed between buyer and seller.

The airlines still cling to frequent-flyer plans, however, since they provide an entry barrier in some markets. Periodic threats by the politicians to re-regulate cable television have led to some simplification of pricing in that industry. The frustration of consumers with telephone service pricing has led to some simplification there, too. Supermarket’s preferred-customer cards seem to have disappeared from most markets.The pharmaceutical companies have been the most transparent in their efforts to justify price discrimination in public statements, and the most effective in their lobbying efforts to prevent any regulatory constraints on their pricing practices. So far they have blocked efforts to make re-importation legal, and to have the government regulate prices under the new Medicare drug benefit. They have also attempted to make price discrimination more palatable by providing drugs at reduced prices in poor countries, and by making a special discount card available to low-income people in this country. At the same time, they have greatly increased their marketing efforts, especially the controversial practice of brand-name product advertising in the mass media, traditionally seen as an enhancement of market power. The struggle over industry practices looks likely to continue.

The monopsony power of national chain stores like A&P, Woolworth’s, and Sears led to the passage of the Robinson- Patman Act in 1935, which nominally forbade manufacturers and wholesalers from offering more favorable prices to one retailer over another. Partly through the efforts of economists, that law became a dead letter by the 1960s, but the controversy has resurfaced with the emergence of Wal-Mart as the dominant firm in retailing. Reviving the antitrust approach to the Wal-Mart problem is not promising. But the forces that eventually brought down those earlier retailing giants are likely to work on Wal-Mart too, and if their working can be accelerated, some of the retailing competition might be saved. This probably means helping the spread of Wal-Mart’s logistical methods more widely in the industry.

Some Ethical Conclusions

The presumption of justice is that equals should be treated equally. Furthermore, commutative justice would suggest that the appropriate reward for a seller of goods is the recovery of the costs incurred to provide it, including the opportunity cost of the seller’s time and investment in the business. Sell for less!This way the gains from trade are appropriately distributed between buyer and seller, with neither exercising disproportionate power over the other. When prices are related to costs, it is also more likely to be the case that the allocation of resources will be efficient.

Therefore price discrimination should be presumed to be wrong, and prices should reflect production costs. In particular, it is unethical for sellers to use their market power to extract from the buyers the bulk of the value they receive from the use of the good, or for large and powerful business buyers (Wal-Mart) to be subsidized by smaller and less powerful upstream manufacturers.

What of the cases where there are high fixed costs and low incremental costs for providing a good? What do we do about the high research and development costs of drugs, the high cost of establishing a medical practice, or the high fixed cost of bringing scheduled airline service to a community? Price discrimination might be justified in such a case, as long as it can be designed to be progressive in its distributional effect.

Here is where the cleverness of economists comes in handy. Two-part prices involve a fixed periodic customer charge together with a modest charge for service. Think of your phone bill–high monthly fee, low per-minute charge. This kind of pricing is considered by some to be a form of price discrimination, but it at least has the virtue of reflecting the cost structure of the industry–in the case of phones, high cost of installing the network, and minimal incremental cost of using it to make a call. With phones, most states also have implemented “lifeline” charges, with low monthly fees and higher per-minute charges, so that customers who use the phone very little can have a lower total bill. This works with prepaid cell phones, too.

Airline price discrimination tends to be progressive as it is now, but it may become less so as businesses increasingly resist subsidizing leisure travelers. With many forms of transportation, the high fixed costs are subsidized by government, and riders are charged something close to the incremental cost of service. Busses and trains work this way for the most part. A similar model could be applied to the airlines, and has been in other countries.

Applying a model like this to the pharmaceutical business will be more difficult. Some economists have suggested that the government pay a bounty to companies that bring products to market successfully, underwriting the Research and Development budget. Or insurance companies and government agencies could buy access to a company’s formulary by paying a lump sum up front, and then the clients could pay the unit cost of manufacturing the drugs. Though these approaches suggest greater government funding of the industry, they need not lead to government control of the research agenda, or stifle the creativity of the private drug companies.

Fairness and efficiency both demand that we find new ways to avoid price discrimination while still encouraging investment in networks and technology. Libertarian arguments that bless price discrimination do not satisfy commonly held ideas about either fairness or efficiency. Achieving a just result is not impossible, but it requires a pragmatic approach, in which government and business cooperate. This is possible when leaders in both business and government view the achievement of justice as their goal. Ideological approaches that pit business and government against one another, or that glorify self-interest, are not helpful. It is time for Christians to put forward a view of justice that has practical implications for this common business practice.

John P. Tiemstra is professor of economics at Calvin College in Grand Rapids, Michigan.