Our weekly explainer on economics using lessons from popular culture. In Installment 43, the Soup Nazi carries out Price Discrimination.
In an episode of Seinfeld, ‘The Soup Nazi’, while buying soup, George Costanza is charged more for bread than the patrons before him, who were given the bread for free. Moreover, when he points out this discrepancy, he is charged a dollar more. In this case, the shopkeeper was a temperamental chef, and his rigid practices don’t make sense practically or fiscally, and most people would disagree with his blatant arbitrary price shifting. However, this is an example of a pricing strategy called Price Discrimination or differential pricing, which is, as the name suggests, the charging of different prices to different customers for the same product or service. This pricing strategy is so ubiquitous in varying forms that we don’t even realise it sometimes.
While in theory differential pricing may make one’s blood boil due to the implied unequal behaviour, in practice it is widely different. Seasonal discounts, coupons, combo pricing, bulk pricing, frequent-buyer offers, student discounts, surge pricing by cab aggregators and even airline and hotel pricing are all commonplace examples of price discrimination.
For example, two people, Kramer and Elaine both have their eyes on the new iPhone. Kramer is only willing to pay up to $700 while Elaine has a better-paying job and higher desire for the phone so she would be willing to pay upto $900. Ideally, Apple would like to charge $700 to Kramer and $900 to Elaine. However, to actually do so blatantly would be illegal. It would also be impractical; what would stop Kramer from buying an iPhone at $700 and sell it to Elaine at $900, repeat the process a couple more times with different people who are willing to pay higher than him and use the profits to buy a phone for himself finally?
Apple then looks for ways to ‘price discriminate;. It releases an assortment of models at the same time at different price points, servicing both the Kramers and the Elaines. Or it reduces prices after a couple of months when the release of the next generation models is nigh, allowing a Kramer to purchase the phone then. Additionally, it allows for bundled plans with various network carriers to introduce EMI options.
In this way, price discrimination actually helps in unlocking consumer and producer surplus which would’ve otherwise gone untapped.
Price discrimination also benefits the consumer. If the supplier were mandated to charge a single uniform price, quite a chunk of potential consumers will be unable to buy the product due to high prices, with the buyers who are willing to pay a higher price attaining a higher consumer surplus. With differential pricing, more people can buy the product, and the total revenue generated by the supplier also increases.
AC Pigou classified price discrimination into 3 broad types :
- First-degree discrimination or perfect price discrimination – charging a different price to every customer thereby capturing all of the consumer surplus. This is quite rare in practice due to the inability of knowing what is the most any customer would be willing to pay.
- Second-degree discrimination – charging different prices for different quantities or qualities. e.g. discounts on bulk purchases, combo offers.
- Third-degree discrimination – charging different prices to different groups. e.g. student discounts, corporate discounts.
Price discrimination is not a fixture of neoclassical economics, it is an ancient technique has always existed in some or the other form. In a paper, the Swedish economist Carl Hampus Lyttkens describes how medicine was practised mainly by private doctors in ancient Greece. They travelled between cities seeking demand for their services. There was no price regulation. Price discrimination was pervasive and, in fact, recommended in Hippocratic texts. Those with higher willingness to pay, the rich, were charged more. And the poor were charged much less. Doctors used the high fees charged to the rich to subsidise the costs for the poor.
However, the advent of the information economy has led to a reduced cost of gathering and storing customer data, which, coupled with the vast swathes of personal data customers share knowingly and unknowingly, allows for first-degree price discrimination to be more prevalent than ever. In a paper by Andrew Odlyzko, the central contention proposed is:
The powerful movement to reduce privacy that is coming from the private sector is motivated by the incentives to price discriminate, to charge different prices to various customers for the same goods or services. Erosion of privacy allows for learning more about customers’ willingness to pay, and also to control arbitrage in which somebody who might face a high price from a seller buys instead from an intermediary who manages to get a low price. The key point is that price discrimination offers a much higher payoff to sellers than any targeted marketing campaign.
The word discrimination has a negative connotation with various forms of it, such as those based on age, gender, caste and religion, being illegal. However, price discrimination, as shown by standard economic arguments as well as daily life, allows for optimal allocation of resources. The bad rap that it gets is largely due to its unfortunate moniker. Shakespeare wasn’t right, after all, about the futility of nomenclature.