Question

Lexmark charges lower prices for its printer cartridges in some foreign countries than it charges in the United States. An article in the Wall Street Journal explained how a company in West Virginia bought Lexmark printer cartridges from retailers in foreign countries and resold the cartridges for higher prices in the United States. a. What must Lexmark be assuming about the price elasticity of demand for printer cartridges in the United States relative to the price elasticity of demand for printer cartridges in these foreign countries? b. Is Lexmark likely to be able to continue to price discriminating in this way? Briefly explain.

Short answer

Lexmark is most likely assuming that price elasticity of demand for printer cartridges is more inelastic in the United States than in other countries, which allows it to charge higher prices in the U.S. without significantly affecting demand. However, continuous price discrimination isn't likely feasible, given observable arbitrage activities, unless stricter measures to prevent such practices are put in place.

Step-by-step solution

Understand Price Elasticity of Demand

Price elasticity of demand refers to how responsive demand for a product is to changes in price. It is calculated as the percentage change in quantity demanded divided by the percentage change in price. If the elasticity is less than 1 (in absolute value), demand is inelastic i.e. less responsive to price changes and vice versa.

Discuss Lexmark’s Pricing Assumptions

Considering they charge lower prices in some foreign countries while higher prices in the United States, Lexmark must be assuming that the price elasticity of demand for printer cartridges is lower (more inelastic) in the United States relative to these foreign countries. In simpler terms, this means that Lexmark assumes that even if the prices are high, there will not be a significant drop in demand within the U.S. market.

Evaluate Ability to Continue Price Discrimination

For Lexmark to persistently engage in price discrimination, they would need to prevent channelling of products from low price markets to high price markets, otherwise known as arbitrage. From the situation described in the question where a company in West Virginia was able to buy cheaper cartridges abroad and resell in the U.S., it appears that Lexmark is not entirely successful in preventing this. Therefore, it seems unlikely that Lexmark would continue to engage in this kind of price discrimination unless there are changes in measures to control such arbitrage.

Key concepts

Economic Pricing Strategy

Determining the right price for a product is a complex task that goes beyond simply covering costs or aiming for a profit margin. An economic pricing strategy involves understanding the market conditions, consumer behavior, and competitors. One essential aspect is the price elasticity of demand, which measures how sensitive customers are to price changes. A company like Lexmark, when differentiating prices between markets, is applying a strategic approach based on perceived differences in market responsiveness. They appear to presume that U.S. consumers are less price-sensitive (inelastic demand), justifying higher prices in that region.

Implementing an effective economic pricing strategy can include techniques like cost-based pricing, value-based pricing, and competition-based pricing. Companies often employ market research and data analysis to predict how consumers will react to different pricing levels, thereby maximizing profit while maintaining a competitive edge.

Price Discrimination

Price discrimination occurs when a company sells the same product at different prices to different groups of consumers. This is not about price variation due to cost differences but is a deliberate strategy often based on customers' willingness to pay, market conditions, and the price elasticity of demand within specific segments. In the case of Lexmark, selling printer cartridges at lower prices in some countries suggests a strategy of price discrimination based on different market elasticities.

For price discrimination to be sustainable, a company must control the resale of products between markets, lest they face a situation termed arbitrage, where products purchased in lower-priced markets are resold in higher-priced ones.

Barriers to Arbitrage

Successful price discrimination often requires setting up barriers to arbitrage, such as imposing legal restrictions or technologically restricting the use of products across different markets.

Market Elasticity

Market elasticity refers to the responsiveness of quantity demanded to a change in price for a given market. It's crucial for businesses to understand market elasticity when setting prices. If demand is elastic, sales volume significantly drops with a price increase; for inelastic demand, volume changes little with price variations. Lexmark’s assumption about the U.S. having inelastic demand implies they believe Americans will maintain purchase levels despite price hikes.

Companies use elasticity to predict the outcomes of pricing strategies. Lexmark's case illustrates the importance of elasticity in economic pricing and how distinguishing between different markets' elasticity can inform pricing decisions to capitalize on potential profit margins.

Arbitrage in Economics

Arbitrage, within an economic context, involves buying a product in one market at a lower price and selling it in another market at a higher price to profit from the price differential. The story of the West Virginia company buying Lexmark's cartridges from abroad and reselling them in the U.S. is an example of arbitrage. This can undermine a company's price discrimination strategy, as it allows consumers in the high-priced market to access the product at lower prices.

Businesses, therefore, need to implement strategies to prevent or limit arbitrage, which may involve special packaging, region-specific product variations, or legal measures such as copyright limitations. Lexmark’s challenge in sustaining their price discrimination is partly due to the difficulty in controlling such arbitrage activities.