Does Price Discrimination Convey or Distort Information?

Answering that helps us identify when price discrimination increases or decreases the gains from trade

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Prices quickly and easily convey information about goods and services in an economy. How scarce are they? How difficult are they to produce? How much do consumers value them? In a competitive market, prices communicate all the relevant information dispersed throughout the economy. The price sorts out and creates incentives so that all possible gains from trade take place.

Moreover, competitive prices do this with minimal information. To use the example from Hayek (1945), when the price of tin increases, "All that the users of tin need to know is that some of the tin they used to consume is now more profitably employed elsewhere."  Knowing the cause of the change (did supply shift?) would be redundant information for the tin user; the price provides all the information about market conditions that the user needs. 

Prices and Information

However, prices don’t always convey all relevant information about fundamental trade-offs. For example, if there are price controls, the argument above is out the window. If there are externalities, there is a benefit or harm to people that is not being conveyed in the price. With a positive externality, not all gains from trade happen from simple bilateral trading at a fixed price. It may require more complex bargaining where the people receiving the positive externality encourage the trade and “internalize the externality.” Then some examples fall in between, and it is less clear how well prices work.

When firms have market power, do prices convey the relevant information about the costs and benefits to society? Consider a seller with market power, sometimes called a monopolist. Since the price is above the firm’s marginal cost, the price doesn’t fully convey all the possible gains from trade.

For a simple numerical example, suppose there are 10 buyers of burgers who are willing to pay $15 and 5 buyers willing to pay $10. The cost is $5, but the seller sets a price at $15 to maximize profit.¹ In this case, a simple, single price fails to capture the underlying scarcity: it costs $5 to make a burger.

Prices convey some information; people realize some of the gains from trade, but prices don’t convey all relevant information as they do in the baseline competitive world that started this newsletter. In the language of externalities, without price discrimination, there is a “pecuniary externality.” The people who are willing to pay $15 are imposing a pecuniary cost on the people willing to only pay $10. If the people willing to pay $15 weren’t around, the price would be $10, reflecting the underlying scarcity. All gains from trade would occur. We must be careful with pecuniary externalities and the parallels to other externalities, but maybe that language is helpful.

What if the seller could price discriminate? Would that mean that prices are conveying “more” information?

The standard response is that price discrimination distorts knowledge, just as monopoly pricing distorts knowledge. In the example above with burgers, there is no efficiency problem since everyone buys a burger with price discrimination, but we can easily imagine a more complex situation. Suppose the burger shop offers a senior discount while raising the price for non-seniors. We could have seniors getting burgers at $10 while non-seniors who are willing to pay $12 are not getting one, since their price is $15. In that case, prices are not conveying the information necessary for goods to end up with the highest valued users and for all gains from trade to occur.

In Knowledge and Decisions (there I am, always citing K&D, drink), Thomas Sowell summarizes the standard economists perspective:

Price discrimination is both a symptom of a noncompetitive market and a further distortion of economic knowledge, as it conveys different information about the relative scarcity of the same product to different users-causing them to economize differently, and thus at least one of them wrongly.

In the burger world above, price discrimination is basically a way for the seller to extract more profit and hurt consumers. This is the way most people see price discrimination. As Byrne Hobart put it this week, it’s “The World's Most Common and Effective Form of Economic Redistribution.” Combining that with the idea that most people seem to assume sellers are bad and buyers are good, price discrimination is bad.

Without taking a stand on the distribution of buyers vs. sellers, we need to think more generally about gains from trade and information. When do prices convey information that allows more gains from trade to occur?

I’m generally positive about price discrimination. Contra Sowell, price discrimination can allow for more information to be conveyed. In an early Economic Forces newsletter, I explained how the problem with a baseline monopoly is that they don’t make enough money. Before scoffing at the idea, read the post.

Monopolies don't make enough money

Casting the old post in terms of the information in prices, the issue is that the single price doesn’t convey to the seller the relative value of the good for consumers.

It is easiest to see the informational benefits of price discrimination when there are fixed costs. Suppose that to sell a single burger, the burger joint must pay the rent, which is $110. That is a fixed cost. In that case, the variable profits of $100 do not cover the fixed costs, and the burger joint does not open. Zero burgers are sold, despite the fact that the value to society of opening the burger shop and selling burgers is greater than the cost.²

Unfortunately, the single price does not convey the relative value to the burger owner. The burger owner does not know how much value she is generating. A single price has failed us! In contrast, prices with price discrimination would convey the value to consumers. In this case, price discrimination allows for markets to convey more information.

Upfront or fixed costs are everywhere, and prices need to convey that it is worthwhile to cover those fixed costs (not just marginal costs). Innovation and research—those things that drive economic growth—are upfront-cost heavy. Properly conveying the value to society of such expenses is of first-order importance.

In many ways, this post is just rehashing that sometimes price discrimination increases total welfare, and sometimes price discrimination decreases total welfare. While I’m never against repeating an important economic concept, the value is in having another tool to bring to bear on understanding the world. We can ask, why aren’t gains from trade taking place? But we can also ask, why aren’t prices conveying the appropriate information? Sometimes prices are not working because of a property rights issue, such as with externalities, but that may not be the only thing. Or maybe laws (or norms) against price discrimination are to blame. It’s an empirical question, but price theory provides the theoretical tools to start asking questions.

1. At a price of $15, there is a $10 profit per burger X 10 burgers = $100 of profit. When the price is $10, it is $5 profit per burger X 15 burgers = $75 of profit.

2. The total value of 15 burgers is $150 from the high value buyers + $50 from the low value buyers for a total of $200. The cost of 15 burgers is $110 rent + $5 per burger x 15 burgers= $185.