In my Industrial Organization class we have been talking about price discrimination, and I thought I would share some examples to help put things in perspective for people who haven’t taken a micro class with me.

Price discrimination is selling the same good to different customers at different prices. What I find compelling about it as an economic concept is that, while there may be perfectly reasonable economic justifications for it, the practice can (and perhaps should) be illegal. There is a tension between what may at times hurt no one at all and may actually simply benefit a group of people, and the legal responsibility to treat all individuals equally. For instance, it is perfectly legal for a movie theater to charge a lower price to senior citizens; but if I were an employer and tried to pay a worker less because he was a senior citizen, I would be sued for age discrimination and probably lose. If the latter is age discrimination, how is the former not? That is a rhetorical question, as my ultimate point on price discrimination is that while it might not seem fair, in many cases it increases the benefit to consumers of a product by allowing more people to get the product at prices they can afford.

I can see how someone would look at a situation and say “person X is paying more for the good than person Y is, and that is unfair.” But what might seem like the right solutions — forcing firms to charge the same price to both — might just make person Y worse off. Allow me to provide two examples.

Prescription Drugs: U.S. vs. Canada

Studies have shown that on average, prescription drugs are about 35% cheaper in Canada than they are in the United States. That’s why a lot of seniors take trips to Canada to buy their medication. The problem is the U.S. has a drug reimportation restriction. It is technically illegal to bring prescription drugs into this country, but the FDA has a “personal use policy” that basically means they won’t prosecute people for it as long as they’re not trying to bring in more than enough supply for a month or two. It was originally implemented as a way of allowing people to bring in drugs from other countries that have not yet been approved by the FDA, and can be changed any time the FDA desires. And in fact, the FDA has said in the last few years that it would start to crack down on third parties that facilitate this — like the bus tours that take seniors from New York to Canada to load up on prescription drugs. Despite that, famed Illinois Governor Rod Blagojevich decided he would thumb his nose at the law and allow his state’s citizens to buy as much as they want from Illinois, and even wanted the state to buy its Medicaid prescriptions from Canada. Politicians in the Illinois legislature fought him — a point which Blago now uses to explain why he was impeached (the whole selling Obama’s seat thing is just a distraction according to Blago; his rivals wanted him out because he wanted to save the state money, or so he would have us think.)

Why is this such a big issue? Apparently people seem to think that the country could save billions of dollars in medical costs if we all just bought our drugs from Canada. But lost in that is any analysis of why drugs in Canada are cheaper. The Canadian government runs its health system, and it has bargained with the drug companies to get lower prices — something proponents of nationalized health care in the U.S. use as an argument in favor of nationalizing the system. But the fact that Canadians get drugs cheaper than Americans has nothing to do with nationalized health care. Just look at two demographic characteristics of the two countries: income and population. The numbers are approximations.

2008 population: US – 305M, Canada – 34M

2008 income per capita: US – $46K, Canada – $40K

Population and income are two crucial elements that determine the demand for a product, and when a firm has market power, that will affect the market price. So here you have the U.S., where income per person is 15% greater than Canada and there are 9 times as many people. OF COURSE we are going to have higher prices in this country. But let’s see what would happen if we removed the law against bringing drugs from Canada. What do you think will happen? Will the drug companies give the 305M American consumers a 35% price cut, or will they just give the 34M Canadians a price increase? That answer should be obvious. In fact, it’s obvious to the Canadian government. Canada stands ready to impose their own law preventing Americans from buying drugs in Canada if there ever comes a time when the U.S. Congress were to change its laws and allow Americans to do it. They don’t want us buying drugs over there, since they know it will just cause higher prices in Canada and make Canadians worse off. Having one market for drugs, and one price for drugs, just means that the price in all of North America will be pretty close to what it is now in the United States. And Canada will have one more reason to despise their neighbor to the south.

Prescription Drugs: Human vs. Dog

When Al Gore was running for president, he was trying to talk about how screwed up our health care system is, and he told a story about his mother-in-law and her dog ,Shiloh. As the story was told by Gore, they both take the same arthritis medication (only Shiloh’s is probably chicken-flavored). The problem is that Gore’s mother-in-law pays three times as much for the same medication. Now, this claim was thoroughly digested by right-wing bloggers and a) nobody has every provided any proof of this “fact” and b) Shiloh presumably weighs less than her owner, so of course her pill should be cheaper. But the fat is that animal versions of human prescriptions are very commonly much cheaper than the human equivalent. And when pressed about the details, Gore’s spokesman Chris Lehane said, “The point, which most people get, is that its wrong to pay three times as much for the same drug.”

Is it? Suppose Al Gore had won the presidency and signed the “Species-Neutral Drug Pricing Act” of 2001, which states that the price paid per milligram of a medication should be the same for humans, dogs, cats, and any other animal. Do you think that one price would be the low price that Shiloh paid or the high price that Tipper’s mom paid? Considering there are about 60M dogs in this country and 300M people, and the demand for drugs by people who feel their own pain is a lot less price-sensitive than the demand by dogs who are very good at hiding their pain, I have a very strong feeling that the price dogs pay for arthritis medication would just increase to something very close to the human level. Then poor old ladies like Al Gore’s mother-in-law would have to choose between buying their dogs arthritis medication and buying their own medication, the end result likely being that tens of thousands of dogs every year would suffer in pain. Why does Al Gore hate dogs so much?

The problem I have with a lot of the arguments against price discrimination is that so few people actually think about what will happen to prices if firms cannot price discriminate. The Al Gore example is a classic example: he was trying to score political points about the current prescription drug situation being “wrong,” but paid no mind whatsoever to what would actually happen in the market if we removed the injustice he whined about. I started this post by talking about senior citizens, and how it is unfair that they pay less for a movie but I can’t pay them less on a job. While technically it’s age discrimination in either case, the differences is that with movie tickets senior citizens are made better off and nobody is made worse off. How do I know this? Based on a data set I have, senior citizen ticket sales account for approximately 4% of all movie ticket sales. Four percent. If it were declared illegal to charge different prices to different people, movie theaters would not reduce the regular ticket price to the senior citizen level. They would just raise the price of senior citizen tickets, and fewer of them would go to the movies. Allowing companies to give some groups discounts means that, in some cases, more people get the product that previously could not afford it. While some may not think it is “fair,” like the guy in New Jersey that sued a nightclub because women got in free for Ladies Night and he didn’t, you have to see if anybody is actually worse off. If on Tuesdays men pay the same cover charge they pay every other night of the week, but women just get in free, how are men worse off in that situation? They might be jealous that they don’t get in free, but they’re missing the main point: there are more women there, which is probably why you’re there in the first place, dummy! Now if the nightclub doubled the cover charge for men on Tuesday nights while they let women in free, then I can start to see this guy’s point because now he’s actually worse off financially because of price discrimination. (He actually won his case in court, but the New Jersey state legislature then amended their laws to allow some businesses, like nightclubs, to discriminate based on gender.)

The bottom line is you have to look at what the company would do if it could not price discriminate. And if the answer is “they would raise the price to people currently getting discounts,” like Canadians, dogs, senior citizens, and women at nightclubs, price discrimination is not a bad thing.