Explain why a profit-maximising pharmaceutical company would want to charge lower prices for the same drug in poorer countries . From the point of view of overall economic efficiency, would there be arguments in favour of such price discrimination ? What are the difficulties in implementing such price discrimination ?
Price discrimination is a well known behaviour among monopolist firms. It describes the process of 'selling the same product to different buyers at different prices depending on order-size lot and/or their geographical location' . As Joan Robinson states, 'it will clearly be to his [a monopolist] advantage to charge different prices in the different markets' . But what are the different types of price discrimination? What are the implications, for the producer and for the buyer? I am firstly going to describe the three types of price discrimination, and then focus on third degree price discrimination, with the pharmaceutical company example and the implementation problems this kind of price discrimination may present.
Before differentiating the three types of price discrimination, we need to set up the general conditions for such an operation. Firstly, the firm needs to be a price maker, otherwise it would not be able to set prices, obviously. This is why price discrimination is mostly a feature of monopolistic firms. This implies a downward sloping demand curve. Secondly, the firm needs to be able to identify the existence of different willingnesses to pay among the consumers, otherwise it would not see the point in differentiating prices. Information about different consumers' willingness to pay does not need to be complete : the firm does not need to be able to identify precisely who wants to pay what, since this can be revealed by consumers' behaviour. However, the producer needs to have a rough idea of the existence of those differences, which can be measured by the comparison of consumers' elasticities of demand for example. Thus, a consumer who has a very elastic demand for a good will be willing to pay less for this good than a consumer whose demand is very inelastic. The third condition is that consumers cannot sell the good they just bought to other consumers. In other words, for the price discrimination analysis to be viable there cannot be any consumer arbitrage . Now that we've identified the basic conditions for price discrimination, let us differentiate them. There are three types of price discrimination: first, second, and third degree price discrimination. We are now going to study them more thoroughly.
First degree price discrimination is also called Perfect price discrimination, because its main feature is that price may differ from person to person, and be perfectly adapted to each individual's real willingness to pay. This is why Armstrong calls it 'non anonymous price discrimination' .This kind of pricing is very profitable for the monopolist, because it enables it to capture all consumer surplus, i.e. the benefits consumers get from consumption . Graphically:
The starting point is quantity (Qb-1), for the price Pa. Total surplus is the pink dotted area, but it is in fact only producer surplus, because the firm gets all the surplus. At the point (Qb, Pb), the firm can sell more and the consumer would still buy it (we are still on the demand curve). Total surplus, and therefore producer surplus, increases. The firm can carry on producing more, until it gets to the point where Q=Marginal Cost, because at this point it is maximising profit, just like a perfectly competititve firm ; the consumer is still willing to buy, and total surplus (and therefore producer surplus) is maximised. Perfect price discrimination is quite rare in real life, as it implies very good information on every consumer's willingness to pay. Maybe we could find first degree price discrimination in family business. If I want to sell my home-made pieces of art, I can ask my rich uncle a higher price for one of them, than to my poor cousin.
The second type of price discrimination – or quantity discounts for Armstrong , makes price relying on the quantity bought. In other words, all consumers who buy the same quantity of the good will pay the same price; price does not vary between individuals anymore. For the sake of simplicity, we are going to assume that there are no costs, so that surplus is equal to profit.
In this graph, the two demand curves represent two groups of consumers. The highest curve represents the highest willingness to pay. The monopolist does not need to know which group of consumers has the greatest willingness to pay, because it will find this out just by looking at which price-quantity packages they decide to buy. This process, where the setting of the market forces consumers to give information to the firm, is called 'self-selection' . If a consumer chooses to buy the quantity q1, consumer surplus is zero, and the monopolist gets the red area as a surplus. For the other group, who buys q2, total surplus (which is, once again, only producer's surplus), is the three areas, i.e. the area that is under the highest demand curve. To trick the monopolist and get a consumer surplus, the consumer with the highest demand could go for quantity q1, and get the dotted area as a consumer surplus (which is better than nothing). In this situation, the monopolist still gets the vertical striped area as a surplus, for the people who still go for q2 . The monopolists can try to give incentives to high demand consumer to go for q2, instead of q1, by lowering the price of q2. There, the consumer still gets the green dotted area as a surplus, and the producer gets the rest (the two striped areas). But the firm still has another way to increase its profits.
It can offer quantity q3 to the low demand consumer, and then incur losses (pink dotted area). But this also means that the high demand consumer is less likely to buy this quantity, and would be willing to pay more for quantity q2. Here, producer surplus is the blue squared area plus the vertical striped area. This area is bigger than the losses, therefore producer's surplus increases. The firm can carry on doing this, i.e. lowering the quantity if offers to the low demand consumer, and increasing the price it charges to the high demand consumer, until losses and gains get to the same amount. This will happen when the pink dotted area and the blue squared area are the same size. An example of second degree price discrimination is phone calls. Let us say the price of one minute is £0.10, but this price falls to £0.06 after ten minutes, for people who buy the 'bla bla pack', which costs £3 per month. Talkative people would buy it, but other people might not be willing to pay those extra three pounds, and may go to another network. However, if the telephone company offers and other pack, the 'something to say quickly pack', which costs £4, but makes the price per minute drop after only five minutes, it might get new clients, who belong to the non talkative group.
Third degree price discrimination, or bundling discounts , is more common, and can be seen as a general case for perfect price discrimination. Here the monopolist can differentiate between different groups of people, whose demand is more or less elastic. If marginal cost is constant, the price only depends of the elasticity of demand. Actually, for people who have an inelastic demand, price can be set quite high, because they would still buy it ; but it is better for the monopolist to price discriminate, by charging lower prices for people who have an elastic demand, because they would just not buy the good if it was too expensive. Here we can take the pharmaceutical company example. A drug company will be willing to charge higher prices for the European market, than for the African one for example. If it does not, either the price will be too high for the African market (and the sales to Africa will be smaller than with a lower price), or too low for the European market (and profit will be smaller than they could be). Price discrimination enables the firm to maximise profits in each market, by adapting to each demand, and therefore, to maximise profits on the whole. It needs information about each market's demand, but this is easier to find than with an individual price discrimination. Such a price discrimination is efficient, if it works properly. However the condition of consumer arbitrage needs to hold strongly. Thus, if products for the African market are resold in Europe, at lower prices than the European prices, as it happened with Glaxo Smith Kline drugs , price discrimination stops being efficient. This is one implementation problem of this type of price discrimination, harder to solve when it works at global scales, and involves many participants. Other issues that should be considered are redistribution issues : it is better for African countries to get lower prices, but, as we have seen with the two other kinds of price discrimination, it enables the producer to increase its share of total surplus, over consumer surplus. Also, price discrimination might hurdle competition, as it might 'exclude (or weaken) actual or potential rivals' , if a firm has too much of a monopolistic power.
To sum up, price discrimination seems to be efficient, because it segments the markets into homogenous submarkets, and allocates efficient prices or quantities to each submarket, thus maximising profits on the whole. However, there are some implementation problems, like the issue of consumer arbitrage, and redistribution issues also need to be taken into account when we try to assess how good (in the sense of general welfare) price discrimination is. Bibliography.
Armstrong, M., Price Discrimination (University College of London, October 2006), <http://else.econ.ucl.ac.uk/papers/uploaded/222.pdf>
Business Dictionary <http://www.businessdictionary.com/definition/price-discrimination.html>
Economics Help Website <http://www.economicshelp.org/microessays/pd/price-discrimination.html>
García-Alonso, M., EC 500 : Microeconomics (University of Kent, 2008)
Robinson, J. Economics of Imperfect Competition (London, Macmillan and Co., 1946)
Szymanski, S., Valletti, T.M., Parallel trade, price discrimination, investment and price caps (Imperial College of London, March 2005), <http://www3.imperial.ac.uk/pls/portallive/docs/1/46201.PDF>