Feb 07 2009

McAfee on Price Discrimination: a must-read for teachers of Microeconomics

Professor Preston McAfee on Price Discrimination

(you must have RealPlayer to view this video. Mac users can download it here)

CalTech Economics professor Preston McAfee is an expert on prices. His research spans three decades and examines the pricing behavior of firms in various market structures. In the lecture linked above the professor shares several examples of firms practicing price discrimination. I was surprised to see that many of the examples he discusses are ones that I have been using in my own lectures on price discrimination for the last few years.

McAfee presents a mathematical formula for monopoly pricing, which no AP or IB text that I’ve seen has included:

Monopoly Price = [PED/(1-PED)] x MC where PED is the price elasticity of demand of the customer and MC is the firm’s marginal cost of production.

The basic idea is that the more inelastic the customer’s demand, the higher price the monopolist should charge over its marginal cost. The implication, therefore, is that a monopolist prefers to charge higher prices to customer’s whose demand is inelastic and lower prices to customers who are “price sensitive” or whose demand is elastic. The charging of different prices to different consumers for the exact same product is what economists call price discrimination.

McAfee begins talking about price discrimination at minute 8:44 in the video. His examples include:

  • Movie theaters: Charge different prices based on age. Seniors and youth pay less since they tend to be more price sensitive.
  • Gas stations: Gas stations will charge different prices in different neighborhoods based on relative demand and location.
  • Grocery stores: Offer coupons to price sensitive consumers (people whose demand is inelastic won’t bother to cut coupons, thus will pay more for the same products as price sensitive consumers who take the time to collect coupons).
  • Quantity discounts: Grocery stores give discounts for bulk purchases by customers who are price sensitive (think “buy one gallon of milk, get a second gallon free”… the family of six is price sensitive and is likely to pay less per gallon than the dual income couple with no kids who would never buy two gallons of milk).
  • Dell Computers: Dell price discriminates based on customer answers to questions during the online shopping process. Dell charges higher prices to large business and government agencies than to households and small businesses for the exact same product!
  • Hotel room rates: Some hotels will charge less for customers who bother to ask about special room rates than to those who don’t even bother to ask.
  • Telephone plans: Some customers who ask their provider for special rates will find it incredibly easy to get better calling rates than if they don’t bother to ask.
  • Damaged goods discounts: When a company creates  and sells two products that are essentially identical except one has fewer features and costs significantly less to capture more price-sensitive consumers.
  • Book publishers: Some paperbacks cost more to manufacture but sell to consumers for significantly less than hard covers. Price sensitive consumers will buy the paperback while those with inelastic demand will pay more for the hard cover.
  • Airline ticket prices: Weekend stayover discounts for leisure travelers mean business people, whose demand for flights is highly inelastic, but who will rarely stay over a weekend, pay far more for a roundtrip ticket that departs and returns during the week.

McAfee also goes into a fascinating discussion of price dispersion which is essentially a theory of oligopoly pricing. All Econ teachers should watch this video and find examples of price discrimination and oligopoly pricing that they can incorporate into their own class.

If you’re up for a challenge, try deciphering some of the mathematics in McAfee’s free, downloadable intro to economics text, available here.

About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

6 responses so far

6 Responses to “McAfee on Price Discrimination: a must-read for teachers of Microeconomics”

  1. Andrew McCarthyon 09 Feb 2009 at 3:46 pm

    Hi Jason,

    Thanks for publishing the above post and article. Nice to get some good ideas for teaching price discrimination. I am new to teaching IB Economics in Singapore, previously teaching the New Zealand Curriculum and have enjoyed reading your blog for ideas and discussion items for class.

    Keep up the good work, I will offer to write something from a Singapore / New Zealand perspective when I get a chance.


  2. Jason Welkeron 09 Feb 2009 at 6:12 pm

    Hi Andrew,

    Thanks for reading! Nice Econ wiki, by the way! Did you know that as an educator you can have ads removed from your wiki for free? Contact my friend who represents Wetpaint's educational program at jutecht@gmail.com and he can help you get the ads removed!

    Please contact me at welkerswikinomics@yahoo.com if you would like to write a post for this blog! Enjoy that Singapore sunshine! – Jason

  3. Mike Fladlienon 13 Feb 2009 at 7:47 pm

    thanks for this link to his book…i sent it to my printer and will begin reading it saturday…you're the best…flad

  4. Maren Rackebrandton 02 Mar 2009 at 5:09 am

    I liked this article because it was something I had never thought about or noticed before. I didn't think that something like price discrimination is possible, because I would think that people notice it and even if they have an inelastic demand, would still buy the cheaper stuff, because everybody always tries to make the best deal possible. Of course avoiding price discrimination is not always possbile, which can be seen with the example of telephone plans or hotel rooms rates.

    Personally I was always wondering why the gas prices at some gas stations were always cheaper than on other ones. With the concept of price discrimination of course this makes sense. But doesn't this also has to do something with what kind of gas station it is?

    So it's always good to get and ask for the best deal possible in order to not get price discriminated.

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