Question

Price discrimination requires the ability to sort customers and the ability to prevent arbitrage. Explain how the following can function as price discrimination schemes and discuss both sorting and arbitrage: a. Requiring airline travelers to spend at least one Saturday night away from home to qualify for a low fare. b. Insisting on delivering cement to buyers and basing prices on buyers' locations. c. Selling food processors along with coupons that can be sent to the manufacturer for a \(\$ 10\) rebate. d. Offering temporary price cuts on bathroom tissue. e. Charging high-income patients more than lowincome patients for plastic surgery.

Short answer

Each situation presents a scheme that sorts customers by their willingness or ability to pay and limits arbitrage by setting conditions difficult to bypass. For instance, airline prices sort customers based on their flexibility of travel dates and prevent resale of tickets due to the commitment required. Similarly, cement is priced according to customer location and delivery prevents resale, etc. Each scenario targets different customer attributes (like geography, income, price sensitivity, or purchase behavior) to implement effective price discrimination.

Step-by-step solution

Scenario a: Airline Prices

Sort customers by incentivizing those willing to stay over on a Saturday night, generally non-business travelers, who are often more price-conscious. This prevents arbitrage as it's hard for a business traveler to resale the ticket to a non-business traveler because the commitment of a Saturday night stay is already set.

Scenario b: Cement Pricing

By insisting on delivering the cement and basing price on the buyer's location, it sorts customers geographically and according to their willingness to pay. The supplier prevents arbitrage through direct delivery, which prevents a buyer in a low-price area from reselling it to buyers in a high-priced area.

Scenario c: Food Processors and Rebates

This sorts customers into those who are willing to take the extra steps to mail in a rebate (likely price-sensitive customers) and those who do not (less price-sensitive customers). Arbitrage is almost impossible here, as the rebate is usually one per purchase or household.

Scenario d: Temporary Price Cuts

This approach takes advantage of the fact that some customers are more conscious of prices and are likely tracking them more regularly. This group will promptly respond to the price cut. Preventing arbitrage comes from the fact that the price cut is temporary, preventing a customer from buying too much and reselling during normal pricing.

Scenario e: Patient Charges

Charging high-income patients more than low-income patients effectively sorts customers by income level. It would be difficult for a high-income patient to get a low-income patient to go through surgery on their behalf for a lower price, hence arbitrage is near impossible.

Key concepts

Arbitrage Prevention

Arbitrage prevention is a crucial element when implementing a price discrimination strategy. In simple terms, arbitrage refers to the opportunity to buy a product or service at a lower price in one market and sell it at a higher price in another, capitalizing on the price differences. Companies must prevent such practices to protect their pricing strategy.
For example, when airlines offer discounts for travelers staying over a Saturday night, they mitigate arbitrage by imposing strict conditions on these tickets. Once a ticket is booked with a Saturday stay, it cannot easily be transferred or resold to someone else, especially not to a business traveler, who usually travels during weekdays.
An equally effective example is the delivery of cement. By controlling the product's delivery and setting prices based on geographical location, suppliers prevent buyers from low-cost areas from reselling it to those in high-cost regions. Moreover, temporary price cuts, like those for bathroom tissue, are also a means to prevent arbitrage, as these cuts are limited by time and restrict the possibility of stocking up large quantities for future resale at standard prices.

Customer Segmentation

Customer segmentation involves dividing the market into distinct groups that have different needs, characteristics, or behaviors. Effective segmentation allows companies to tailor their marketing strategies and offers to meet the specific needs of different groups, enhancing their pricing strategy for maximum effectiveness.
Airlines, for instance, segment their customers based on travel intent—business versus leisure—and tailor their fares accordingly. Business travelers are less price-sensitive and often have rigid travel schedules, whereas leisure travelers are flexible and can wait for better deals.
In the medical field, price discrimination is used by charging different rates for medical services such as plastic surgery based on income levels. This segmentation implies that high-income patients are more likely to pay higher prices compared to low-income ones.
Coupons and rebates, such as those given with the purchase of food processors, also segment customers. Individuals willing to go through the rebate process are often more price-sensitive and motivated by saving money, distinguishing them from less price-sensitive consumers.

Pricing Strategies

Pricing strategies in microeconomics refer to how a business sets its prices to achieve specific objectives. Effective strategies are essential for implementing price discrimination and can significantly impact a company's revenue and market position.
There are various strategies, such as offering temporary price cuts on products. These cuts attract the attention of price-sensitive customers, encouraging them to make purchases during promotions.
Geographic pricing, such as the delivery-based pricing for cement, is another strategy. It takes into account the economic conditions and competitive environment of each location.
In healthcare, differential pricing based on income, as seen in the example of varying charges for plastic surgery, leverages consumers' willingness to pay as a means to maximize revenue.

Microeconomics

Microeconomics is the branch of economics focusing on the behaviors of individuals and firms in making decisions regarding the allocation of resources. It forms the foundation of understanding and implementing concepts like price discrimination.
Price discrimination is a microeconomic concept where a seller charges different prices for the same product to different consumers. It is based on the rationale that different consumers have different valuations for a product and are willing to pay different prices.
Each pricing strategy discussed, be it offering rebates or geographic pricing, is rooted in microeconomic theories about consumer behavior, demand elasticity, and market segmentation. Companies utilize these theories to maximize profits by identifying and capitalizing on consumer diversity.
Ultimately, microeconomics helps in understanding how market factors, consumer segmentation, and pricing strategies interact to influence business decisions and market outcomes.