While studying marketing and economics, I encountered the topic of price discrimination employed by various companies to boost their sales. At that time, I delved into this subject from a marketing perspective and found that, at times, it can be a brilliant strategy – raising prices when willingness-to-pay is high, thereby increasing profits. This approach benefits everyone involved, including companies, investors, and sales teams, except for the customers who end up paying higher prices for the same products or services.

I revisited the concept of price discrimination during my first semester in the JD program at law school. A friend of mine paid a different price than another buyer for an identical service, which led him to question its legality. Consequently, my primary focus shifted from the advantages of sales to the legal aspects of price discrimination. In this article, I will offer an overview of price discrimination, explaining what it entails and its practical application. Furthermore, I will elucidate how the line is drawn between legal and illegal price discrimination.

I. What is price discrimination?

Price discrimination occurs when “a buyer pays a price that is different from the price paid by another buyer for an identical product or service.” [4]. One of the most appealing examples of price discrimination that nearly everyone encounters in their life is when it occurs on hotel or flight reservation websites, offering different prices for identical services. Even if you plan to book a seat on the plane right now for a flight three months in advance, you will notice that the price increases for the same seat on the same flight as the date approaches.

II. Types of price discrimination

Price discrimination can take various shapes depending on the correlation between the price and the willingness-to-pay, the number of products sold, and the group to which this price is going to apply (the buyer). Many established businesses employ this pricing strategy to capitalize on disparities in supply and demand, capturing a surplus that customers are willing to pay. Currently, the traditional classification identifies three types of price discrimination: first-degree, second-degree, and third-degree price discrimination [2].

First-degree price discrimination involves selling a product or service at a price that precisely matches the customer's willingness to pay. This type of discrimination is rarely feasible in the real world due to the challenges associated with obtaining perfect information about each customer's willingness-to-pay.

Second-degree price discrimination enables businesses to provide reduced prices to specific customer groups through bulk purchases. The pricing in this scenario depends on the total quantity of units bought. This form of price discrimination is commonly employed for certain types of goods that permit bulk orders. Nonetheless, the primary issue with this pricing strategy is that various types of customers may end up making bulk purchases, preventing the producer from fully capitalizing on their varying willingness-to-pay.

Third-degree price discrimination occurs when prices are determined based on certain demographic characteristics of customers and remain consistent. This is the most commonly employed form of price discrimination, where a seller establishes different prices for distinct customer groups, such as charging one price for individuals aged 65 and older and another for those younger than 65, or one price for drinks served before 4:00 pm and another for drinks served after. While it takes advantage of the excess willingness-to-pay from high-value consumers on one side, it also creates opportunities for trade gains among customers who might not have otherwise made the purchase.

III. Application of price discrimination

As I mentioned earlier, price discrimination is a common practice in marketing. Interestingly, I unwittingly employed this tactic in my first business, a medical spa, where we adjusted prices for the same services based on the time of day the client booked (with after-hours appointments being more expensive) and the day of the week (charging double on days leading up to holidays). Now, let's explore how businesses deliberately incorporate this pricing strategy into their sales and marketing strategies by examining a few key ways of application.

The first instance of applying price discrimination involves charging the same delivery price without taking into account the customer's location ("spacial" application) [3]. Naturally, delivering within the city of Manchester, NH would be less expensive than shipping from New Hampshire to Hawaii. However, delivery costs are often bundled into the overall price. As a result, customers with lower delivery expenses end up paying more. The company then covers the discrepancy and absorbs the additional transportation costs borne by customers.

Another way to implement price discrimination is by considering the temporal aspect. In this scenario, a product is initially introduced at a higher price to capture the surplus from customers who require the product immediately and are willing to pay a premium. Subsequently, the same product is made available to customers with a lower willingness-to-pay at a reduced price. A prime example of this strategy can be found in the publishing industry, particularly with books. At times, the sales strategy involves offering a limited edition of a book at an exceptionally high price in hardcover format during special events. Then, the same book is released in a still relatively expensive hardcover edition for the next group of buyers. Only after capturing all possible surplus does the book become available in a more affordable paperback version.

However, the temporal approach may not always maximize profits, and it might be more profitable for a company to offer a limited number of pricing options right away when demand for a product is high. Additionally, customers may become aware of the pricing strategy employed by a publisher and choose not to purchase a book during the initial and subsequent rounds, opting instead to wait for a lower price later on.

The third method of applying price discrimination that I would like to discuss here involves quality differentiation. An example of this is charging varying prices for the same transportation services, such as flights, between identical destinations on the same aircraft. You have the option of flying either in business or economy class. By adjusting the quality of the flight experience and offering additional features, the company can profit from different levels of willingness-to-pay and charge distinct prices for the same transportation service that ultimately takes you from point A to point B. Nowadays, airlines are employing this form of price discrimination even more effectively by providing a wider range of quality choices to customers, thereby meeting their self-selection preferences (such as extra legroom, expedited boarding, etc.).

IV. Legal aspects of price discrimination

While price discrimination is widely accepted by economists and marketers, the legal community has expressed concerns about it for a considerable duration. The main reason behind the desire to restrict price discrimination stems from the concept of fairness: Is it equitable to charge different prices for the same product or service? [1] To address this question, delving into the philosophical debate surrounding fairness is a topic I will reserve for another occasion. In this context, I will focus on the two main aspects that can render price discrimination illegal – constitutional and antitrust considerations.

People often assume that price discrimination is automatically unconstitutional when they hear the word "discrimination." However, this is not always the case. There has long been debate about the extent to which the Constitution provides protection and for whom. The Equal Protection Clause of the Fourteenth Amendment guarantees “the equal protection of the law” to every person, primarily encompassing protection against discrimination based on gender, race, or national origin. Nevertheless, some states may offer more extensive protection than what the U.S. Constitution provides.

For example, California has adopted a more comprehensive approach than any other state by enacting the Gender Tax Repeal Act of 1995, which prohibits price discrimination based on gender. However, while acknowledging the potential challenges and added costs associated with providing services that may vary by a client's gender, the law permits different pricing when it can be justified by factors such as the amount of time, complexity, or expenses involved in delivering the service. So, if you are an esthetician specializing in waxing, charging different prices for Brazilian waxing for women and men is generally not permitted unless you can provide a valid justification based on the additional time required for the procedure.

Furthermore, antitrust and price-fixing laws render price discrimination illegal in certain situations. There are three primary antitrust acts worth mentioning in this context: the Sherman Antitrust Act, the Clayton Antitrust Act, and the Robinson-Patman Act.

The Clayton Antitrust Act, for instance, was enacted by Congress with the specific aim of prohibiting price discrimination, especially when a company engages in predatorily low pricing tactics that could lead to market monopoly. Subsequently, the Clayton Act was further amended with the Robinson-Patman Act. This amendment took a different approach by addressing the competitive advantage enjoyed by larger grocery chains over smaller competitors who were losing business due to the lower prices offered by the larger retailers. These larger chains operated more efficiently and had access to lower procurement prices through bulk purchases.

However, nowadays, the Robinson-Patman Act has become less influential, and courts have become hesitant to rule against the defendant retailer without strong economic evidence of affecting a competitor adversely. Even though the Act aimed to protect smaller retailers, its impact has waned in recent times.

References:

1) Gifford, D., & Kudrle, R. (2010). The Law and Economics of Price Discrimination in Modern Economies: Time for Reconciliation?. University of Minnesota . https://scholarship.law.umn.edu/cgi/viewcontent.cgi?article=1362&context=faculty_articles

2) Horton, M. (2023). 3 degrees of price discrimination. Investopedia. https://www.investopedia.com/ask/answers/042415/what-are-different-types-price-discrimination-and-how-are-they-used.asp

3) Varian, H. R. (1989). Price Discrimination. Boston University. https://sites.bu.edu/manove-ec101/files/2017/11/VarianHalPriceDiscrimination1989.pdf

4) USX Corp. v. Adriatic Ins. Co., 99 F. Supp. 2d 593 (W.D. Pa. 2000).