Legal Issues Surrounding Price Discrimination
We would be remiss if we did not discuss the legal issues surrounding price discrimination. At face value, the Robinson–Patman Act of 1936 appears to declare price discrimination illegal. However, the language in Sec. 2(a) bars price discrimination only if its intent is anticompetitive in nature:
It shall be unlawful for any person engaged in commerce, in the course of such commerce, either directly or indirectly, to discriminate in price between different purchasers of commodities of like grade and quality, where either or any of the purchases involved in such discrimination are in commerce, where such commodities are sold for use, consumption, or resale within the United States or any Territory thereof or the District of Columbia or any insular possession or other place under the jurisdiction of the United States, and where the effect of such discrimination may be substantially to lessen competition or tend to create a monopoly in any line of commerce, or to injure, destroy, or prevent competition with any person who either grants or knowingly receives the benefit of such discrimination, or with customers of either of them.
In judging whether a firm has violated the Robinson–Patman Act, the courts have focused on “primary line injury” and “secondary line injury.” Primary line injury occurs when the firm offering the discount threatens competition between itself and competing sellers. An example would be a firm that prices its good below its average variable cost for a significant period of time to drive rival firms out of business.
The case of Utah Pie versus Continental Baking offers insights into primary line injury. Utah Pie, a family-owned business, entered the frozen pie industry in Salt Lake City in the 1950s and quickly established market share, selling pies at a price of $4.15/dozen. Four years later, when price competition with its three largest competitors, Continental Baking, Carnation, and Pet, caused its price to fall to $2.75/dozen, the firm filed suit. The courts ruled for the plaintiff largely on the basis that the prices charged in Salt Lake City were significantly lower than what was being charged in other geographic markets. In fact, Pet did not deny that it suffered losses in the Salt Lake City market.
Secondary line injury occurs when the discriminatory act harms the competition between the favored customer who receives the discounted price and the disfavored rival firms. An example of secondary line injury is the case of FTC versus Morton Salt. Morton Salt offered quantity discounts on it premium Blue Label salt. Although the discounts were purportedly available to all supermarkets, only the largest customers, such as A&P, were capable of buying sufficiently large quantities to qualify for the discount. This would allow the large national chains to set retail prices that undercut the smaller Mom & Pop supermarkets. The intent of the Robinson–Patman Act, as expressed by Justice Black in the FTC versus Morton Salt case, is to assure that price discrimination is not implemented to reduce the level of competition:
“[I]n enacting the Robinson–Patman Act, Congress was especially concerned with protecting small businesses which were unable to buy in quantities, such as the merchants here who purchased in less-than-carload lots.”
Not all acts of price discrimination violate the Robinson–Patman Act. Sec. 2(a) establishes that cost-related or quantity-related discounts are acceptable under the law:
That nothing herein contained shall prevent differentials which make only due allowance for differences in the cost of manufacture, sale, or delivery resulting from the differing methods or quantities in which such commodities are to such purchasers sold or delivered.
The final component of Sec. 2(a) allows for most market-driven forms of price discrimination to take place legally:
That nothing herein contained shall prevent persons engaged in selling goods, wares, or merchandise in commerce from selecting their own customers in bona fide transactions and not in restraint of trade: And provided further, That nothing herein contained shall prevent price changes from time to time where in response to changing conditions affecting the market for or the marketability of the goods concerned, such as but not limited to actual or imminent deterioration of perishable goods, obsolescence of seasonal goods, distress sales under court process, or sales in good faith in discontinuance of business in the goods concerned.
The Supreme Court has also allowed for functional discounts.
A functional discount exists when the purchaser is part of the supplier’s distribution system. The implied assumption is that the discount is a reimbursement for the purchaser’s distribution or marketing functions.
Ironically, the Robinson–Patman Act is much maligned by both economists and antitrust scholars. Economic theory suggests that price discrimination allows firms to profitably reach market segments they would otherwise ignore. Other critics assert that the intent of the Act should be to prohibit anticompetitive behavior rather than to protect the financial interests of rivals. In a scholarly article printed in the Journal of Law and Economics, Thomas Ross offered this searing indictment of the Robinson–Patman Act:
The Robinson–Patman Act has the distinction of being almost universally unpopular among antitrust scholars. This is probably because it looks less like an antitrust measure than like legislative relief for small business. That the law wears an antitrust cloak is probably a measure of the cunning of its original proponents.
When the innumerable exceptions to the Robinson–Patman Act are considered, most practices described in this textbook would fall within the range of acceptability. Note that the language emphasizes the effects on competition and that most cases brought before the court involve wholesalers and retailers rather than final users.
Ethical Issues Surrounding Price Discrimination
The economic perspective of price discrimination is largely positive. If the Robinson–Patman Act were strictly enforced, price-sensitive consumers would frequently be denied various goods and services. If an airline was required to charge the same fare for all of its clientele, it would cater to the less price-sensitive business customer. As the tables in this textbook have repeatedly shown, it would be more profitable to charge the business-class price and allow seats to remain empty than to lower the price for all customers to assure no seat goes unoccupied. Given the high fixed costs of operating an airline, one wonders if the airline could even generate profits absent the ability to price discriminate. At the very least, fewer flights would be available. In fact, the airline industry has
a long history of financial struggles even with price discrimination. If the Robinson–Patman Act was strictly enforced, the number of available flights would decrease and more airlines would cease operations entirely.
The view that price discrimination is beneficial to consumers does not appear to be shared by the prospective customers. Intertemporal price discrimination (a.k.a. price skimming) is quite commonplace, particularly with electronics, yet the $200 iPhone price cut was not well received. Various forms of second-degree price discrimination, such as coupons, have existed for years. But when Netflix introduced Qwikster as a way to get its customers to self-select between DVDs and the less expensive downloads, it was met with so much resistance that it eliminated Qwikster and reverted to its traditional service. Third-degree price discrimination is not new to the business world. Discounts for children and senior citizens have been established practices for decades. Hard-copy, mail-order catalogs routinely listed different prices based on the zip codes of the recipients. Yet Amazon drew a lot of flak for selling the same DVDs to different customers for different prices based on their inferred willingness to pay. Why is “traditional” price discrimination accepted whereas dynamic pricing on the Internet is met with such resistance?
Research by Nobel Prize winning economist Daniel Kahneman on fairness may provide some insights.1 Kahneman noted various determinants of fairness judgments. A reference transaction refers to a price/profit precedent on which buyers and sellers rely. The assumption is that the reference price allows the firm to earn a fair profit. Hence, any effort to increase its profit by raising the price is perceived to be unfair. At the same time, buyers believe that firms are entitled to their reference profit. Hence, if conditions cause the firms’ profits to decrease, the firms may increase their prices to restore their profits. Buyers infer such behavior as fair.
This suggests that price increases to capture one’s willingness to pay are deemed to be unfair whereas raising prices to accommodate increases in the cost of production is justified. However, even if costs do not increase, Kahneman found that price increases are justified if other firms raise their prices. In essence, the fact that other firms are increasing prices suggests a change in the reference price. Interestingly, the key factor is that the behavior is perceived as normal rather than just.
Another determinant of fairness is how the outcomes are “coded” by consumers. Price changes that increase one’s wealth at the expense of another tend to be viewed as unfair. Out-of-pocket costs trump opportunity costs, and actual losses are perceived as more important than foregone profits. This differs from the viewpoint of economists, who tend to view them as identical. Thus, a price increase that raises the firm’s profits is more likely to be viewed as unfair than one that is implemented to avoid a loss.
Along these lines, respondents in the Kahneman et al. study were given two hypothetical scenarios, and were asked to comment as to whether the firm’s behavior was fair or unfair. In the first, an auto dealer, accustomed to selling at list price, reacted to a shortage by raising his price
by $200. The respondents viewed his behavior as unfair. In the second setting, an auto dealer who customarily offered buyers a $200 discount from the list price, decided to start charging customers the list price. Although the consumers were going to pay $200 more for cars in this scenario as well, the respondents regarded the dealer’s actions to be fair, but by a relatively small margin. Because the list price serves as a reference price,
the respondents coded the first scenario as an unambiguous gain to the firm. In the second setting, the response depended on whether the respondent coded the discounted price or the list price as the reference price.
Kahneman’s research has some interesting implications for J.C. Penney’s bold new pricing strategy. Rather than having a barrage of sales indicating marked-down prices, the discounted prices will become the standard prices. No longer will items sport a tag showing the nondiscounted and discounted prices side by side. Unlike WalMart, the intent is not to make J.C. Penney the low-priced leader, but merely to establish more predictable pricing.
But many behavioral economists are not so sure that J.C. Penney’s “permanently discounted prices” will go over well. To many consumers, the “standard price” represents the reference price. Hence, any marked-down price is a bargain. Without the undiscounted price serving as a reference, the “permanently discounted price” may be viewed as the reference price, causing the consumers to infer no bargain.
The psychology of reference pricing may explain why various forms of price discrimination were not regarded to be controversial. In the context of children’s and senior citizen discounts, the price paid by the other patrons was regarded as the reference price. The discounts received by children and seniors were perceived as gains to specific consumers. One would expect the reaction to be different if the discounted prices were marketed as the “normal” price, with “surcharges” to all other buyers. The same undoubtedly rings true for coupons. The undiscounted price is perceived to be the reference price. The coupons represent a gain to coupon-holders.
Along these lines, one assumes that the reaction to Qwikster took Netflix by surprise. As the less-expensive download option for rentals was increasing in popularity, Netflix sought to pass the savings onto its customers in terms of lower prices for online-only services. The assumption was that its customer base would self-select based on preferences. Those with quality downloading capabilities would choose the cheaper service, whereas those who did not would opt for the traditional mail-order DVD rentals. But because traditional customers subscribed to Netflix primarily for mail-order DVD rentals, and were given the ability to download movies for the same monthly charge as that sector of the market began to develop, splitting the services was inferred as doubling the price of the existing subscription. Thus, the reference price was entrenched in the minds of consumers such that the saw themselves as being overcharged, rather than being offered a less expensive option for renting movies.
Kahneman et al.’s research defines price changes that are likely to be perceived as fair. Respondents seem to believe that firms are entitled to their reference profit. Consequently, increases in wholesale or operating costs may be met with price hikes without causing consumers to feel betrayed. This does not imply that consumers expect firms to lower their prices to keep their profits constant. When asked how a firm should respond to a decrease in the cost of production, half thought it was acceptable for the firm to keep its price constant and pocket the additional profit. Less than a third thought the price should drop by the amount of the decrease in unit cost.
The public also believes firms act unfairly when they raise prices in response to excess demand. One of the most basic tenets of supply and demand is that, when confronted with a shortage, firms raise prices to clear the market. In doing so, production will increase and more transactions will occur at the higher price than would have occurred had the price remained constant. This perspective is not shared by respondents to Kahneman’s survey. Thus, whereas it is acceptable for a firm to increase its price to response to an increase in costs (a.k.a. a decrease in market supply), it is unethical for a firm to raise its price in response to an increase in market demand.
Further, when given a scenario in which a store had but one unit remaining on its shelf, the respondents thought it would be unfair for the store to auction off the last unit. Ironically, when the question added a phrase suggesting that a portion of the proceeds would go toward a charity, the percentage of respondents who judged the behavior to be unfair dropped dramatically. Putting the two scenarios together, individuals appear to be more averse to the perception that the firm gained in the transaction than to the reality that they might have to pay
a higher price.
Economic research on fairness also shows that consumers will punish firms that are perceived to behave unfairly even if it goes against their own self-interest. A great deal of research has been performed on the “ultimatum game.” One subject is given a sum of money and is permitted to offer any percentage of it to another subject. If the subject accepts the offer, the money is split in accordance with the offer. If the offer is refused, neither subject gets any money. In theory, the self-interest of the subject making the offer is maximized by making the lowest possible nonzero offer. For example, if the subject is given $100 to split with the other subject, and he offers her $1, she would rather accept the dollar than to refuse it and gain nothing. This is rarely what the experimental findings show. Most offers are at or near 50%. Perhaps more surprising is the finding that sometimes the offers are refused. These subjects would rather punish the unfair offer even if it causes them to be worse off as well. Extrapolating these results to the real world, fear of punishment may cause profit-maximizing firms not to act in their own short-term interests if it implies losing goodwill (and future profits).
What does all of this suggest for e-tailers? The actions taken by Apple with the iPhone, Amazon, and Netflix reflect textbook examples of how innovative pricing strategies can be used to capture consumer surplus and increase profits. And despite the fact that price discrimination is hardly
a new concept, the pricing strategies adopted by Apple, Amazon, and Netflix were greeted with controversy and disdain. In the context of Kahneman’s research, firms need to be cognizant of when price discriminatory acts will be viewed as acceptable or exploitative. As research on the ultimatum game demonstrates, consumers are willing to punish firms that behave unfairly to their own detriment.
Nonetheless, Kahneman also noted that psychological studies of adaptation show that any stable state of affairs is eventually accepted. Perhaps the fallout regarding the iPhone, Amazon DVDs, and Netflix subscription prices merely reflected the fact that e-commerce is still evolving. As stated earlier, haggling over prices dominated markets until the Industrial Revolution. Consumers had to adapt to the concept of fixed, posted prices, and eventually they did. Perhaps the e-world, with its movements toward personalized prices and transactions, will become the new norm, and eventually be embraced by consumers.
Summary
• The Robinson–Patman Act makes it illegal to charge different prices for the same good if the effect is to lessen competition.
• Although the general intent of price discrimination is to allow the firm to profitably reach the more price sensitive market segment, consumers may react angrily if they realize prices differ across individuals.