Academic journal article Economic Inquiry

Price Discrimination with Differentiated Products: Definition and Identification

Academic journal article Economic Inquiry

Price Discrimination with Differentiated Products: Definition and Identification

Article excerpt

I. INTRODUCTION

Price discrimination is said to exist when the same product is sold to different consumers at different prices. Most economists also agree that price discrimination is at work when similar--but not identical--products are sold at prices that do not reflect differences in costs. Economics textbooks are rife with examples, such as student or senior citizen discounts, hardcover and paperback versions of books, dinner versus lunch prices at restaurants, airfares with various restrictions, and price spreads of retail gasoline products. On the other hand, some economists have criticized the identification of such apparent "price anomalies" as price discrimination. For example, Lott and Roberts (1991) argue that there are usually cost-based explanations for these phenomena and propose such explanations for the cases of airfare, gasoline, and restaurant prices. Nevertheless, the authors do not challenge the conventional wisdom that price differences that cannot be explained by cost differences are discriminatory.

In recent years a number of papers have set out to empirically assess instances of alleged price discrimination. The literature goes to great lengths to control for potential sources of cost variation among different products and thus--to the extent that it is successful--is not subject to the Lott-Roberts critique. Almost all studies conclude that price discrimination is practiced in the particular market they analyze. A skeptic, of course, could always argue that some sources of cost variation have not been accounted for and thus dismiss the results as erroneous.

Despite the mild controversy over the methodology and its effectiveness, the basic premise seems universally accepted: The existence of price variation that cannot be explained by cost differences constitutes price discrimination. This is not, however, a formal definition. In fact there is no single, widely accepted definition of price discrimination when products are not homogeneous. Some authors define price discrimination to exist when price-cost margins (absolute differences) between differentiated products are unequal, whereas others prefer to compare price-cost markups (percentage differences). Few authors have discussed the relative merits of one measure over the other. (1) The relationship between the two has never been spelled out, and the choice among them remains arbitrary.

In this article I aim to shed some light on this issue and provide some guidelines to empirical researchers interested in price discrimination. I start by providing an overview of the current state of the literature in section II. I introduce the two competing definitions of price discrimination and briefly discuss the justification that has been provided for each. I then review the empirical literature that uses one or the other definition as the basis of testing for price discrimination. I present the basic methodology and discuss the definitional choices made by researchers investigating different market environments. The picture that emerges from this overview is murky and provides little guidance to the empirical practitioner.

The absence of controversy on the choice of definition might simply reflect the fact that the two commonly used definitions are equivalent. In section III I show that this is not the case. Specifically, it is possible for one definition to indicate the presence of price discrimination and for the other one to reject it. It is also possible for the two measures to take opposite signs; that is, one product may have a higher markup and a lower margin than the other. I also show that, in general, the margin criterion is more likely to indicate the presence of price discrimination. I conclude that the choice of definition has important implications and should be given careful consideration.

The challenge is to come up with a consistent way of thinking about price discrimination that can easily be applied in a variety of settings. …

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