Imagine you have a business that earns zero economic profit. It exactly covers its costs, including the return needed to attract investors and all that, but nothing more. Is this the end state of competition? Is there anything left for competition to do?
Sure. If another company comes along with lower costs, that will drive the price down. That’s always a possibility, and an important one in real markets. But is there anything else to do in the more traditional “entry takes time but eventually erodes profits” sense?
There’s one more way to compete. Suppose a company came along that’s not better in the technological sense. They don’t have lower costs.
Still, there is still room to compete on pricing. I said pricing, not competition on price in the usual sense of setting a lower price.
The rival can come in and change the pricing structure. They could charge an upfront fee, offer a bundled deal, or charge different customers different amounts. That last possibility takes us to price discrimination, which is usually described as a way for sellers to extract more from customers. The FTC appears to share that view; it just ordered nine companies to report whether they charge different people different prices. The FTC is worried data is being used “to estimate the highest price they can charge each consumer.”
But price discrimination can also be how a competitor offers a better deal and wins their business. To see how, we need to start with the problem of paying for fixed costs.
Fixed costs kill marginal cost pricing
Consider a customer buying electricity. The first unit is worth $120 to her, the second $30, the third $20, and the fourth $5. Producing each unit costs $10. If we have two suppliers with exactly the same cost, the price will be bid down to the marginal cost of $10.
If you charge more than $10, your competitor will offer a lower price to win the business. Charging less than $10 loses money, and we arrive at the usual competitive result that price equals marginal cost. This is the basis for so much of the way economists think about pricing.
Let’s make one small complication. Someone has to install the generator. There’s a fixed cost. Suppose install costs $100, but nothing else changes. Production still costs $10 per unit, and our customer still values the units at $120, $30, $20, and $5.
Suppliers compete by making binding pricing offers before installation, so the winning supplier installs the equipment and supplies the customer for the agreed-upon period.
The usual marginal-cost pricing no longer works because it doesn’t cover installation costs. At $10 per unit, the customer only buys $30 worth, which just isn’t enough. Notice I’ve rigged the numbers in such a way that installing a generator is still worthwhile. Those three units produce $170 of benefits at a total cost of $130. But we need something besides marginal cost pricing to generate those benefits.
So perhaps the equilibrium is a higher electricity price. A supplier charging $120 sells one unit, pays $110 in costs, and earns $10. That’s the offer. A rival can come in and offer $115 and earn $5, and so there’s room to undercut until the price is $110, where the supplier just covers its costs.
Zero profit! Competition has worked!
Except that the customer has bought only one unit, and the additional units, which are still worth more than their cost, go unserved. That’s not great.
There’s no room for more entry with further cuts in the per-unit price to come in and fix this problem. It’s not profitable. The firm is already earning zero profits. If you’d drop down to $30 to sell the second unit, you lose money, so no one does it.
It should be pretty obvious what the problem is here. You need to cover the fixed cost, so charge separately for that.
But now we are beyond simple marginal cost pricing. On the Econ 101 theory side, that’s not allowed in the simple model. You draw the line across at “the price,” which means the per-unit price. $10 per unit of electricity, each unit the exact same. You’re restricted to a single price (linear price) per unit in the standard Marshallian/Walrasian models that spit out our “price = marginal cost, so we have competition” conditions.
Maybe we need to be more creative. You’re actually selling two products: installation and electricity. Charge separately for each.
That can solve our numerical problem, but it raises a question about the theory. What exactly is the product whose price competition is driving down? Is it a unit of electricity, a connection, or an entire package delivered through the connection? Once we allow suppliers to compete over these different arrangements, the familiar instruction that “take the price as given” needs a little bit more explanation. That’s actually an area where firms can compete.
The competitor in the model is just as smart as we are, sees the fundamental problems, and offers a different pricing strategy. They don’t take the price as given. They offer a different bill to the consumer: $105 for install, then $10 for each unit consumed. Now we’re at the efficient outcome. The customer buys 3 units, pays $135 for electricity worth $170, and generates $35 worth of surplus for the consumer, compared to just $10 under the original per-unit of electricity price.
Just by changing the pricing—no technological improvements—the entrant earns a $5 profit, while also leaving the consumer better off. A rival can profitably improve the customer’s deal even when the existing supplier already earns zero profit.
Pricing is an avenue for competition.
The opportunity came for the usual reason: there was deadweight loss still on the table. Those second and third units still had room for gains from trade and the pricing was a way to generate those $30 that were being left on the table. The entrant gives $25 to the customer and keeps $5. Its total bill is actually higher than the old supplier’s bill, but the customer gladly switches because she gets more valuable service.
But other suppliers, seeing the crafty pricing strategy, can offer better terms. If the installation charge exceeds $100, a rival can lower that charge and still earn something. Competition pushes down the installation charge to $100, plus $10 per unit, and the consumer receiving all $40 of the surplus.
We could split this invoice to make it look different. Offering a package of three units for $130 would also do the same. No need to mess with install vs. electricity prices. Either way, competition is for the full contract. We need a broader conception of how competition plays out. Louis Makowski showed how nonlinear pricing can fit within a theory of perfect competition. Competition can discipline a whole pricing schedule, even when there is no single per-unit price to take as given.
Sharing fixed costs
Nothing above should be controversial or surprising once it’s laid out this way. But we can carry the logic further.
Suppose one generator can serve two customers. A workshop wants one unit worth $120, while a household wants one unit worth $40. Installation still costs $100, and each unit still costs $10 to produce. Suppose we start with the contract we just settled on, which has a $100 connection charge plus $10 per unit. Then the workshop would sign up and pay $110, but the household would decline. The supplier covers its costs.
Could a rival offer a lower connection charge to attract the household? The charge would have to fall to $30 or less, but collecting $30 from each customer would bring in only $60 towards the $100 install. Offering the same contract to everyone leaves us stuck again.
Imagine instead a rival offers the workshop an $80 connection charge and the household a $25 connection charge. Both still pay $10 per unit. The workshop’s total bill falls from $110 to $90. The household’s bill is $35. Their connection payments total $105, covering the install and leaving the entrant $5.
The rival has found another customer to help pay for the generator. The household pays $25 toward install, allowing the entrant to reduce the workshop’s invoice by $20 and keep $5. Again, a creative pricing system means both customers get a better deal, even though the supplier they displaced was earning zero profit.
These customers receive identical electricity. There is no cost-based reason for the difference; the seller regards the consumers as the same from a cost perspective. This is pure price discrimination. And still, everyone prefers the discriminatory pricing system to the uniform price.
Further competition can squeeze out the remaining profit, but it will never equalize the prices. Suppose one competitor has household and workshop rates of $33 and $87. That covers the $120 total cost. A rival cannot properly win both customers by offering lower rates. It wouldn’t cover its cost, nor can it properly serve the workshop alone for less than $87, so it can’t try to peel off one customer at a time. There are several divisions of the bill that could survive these tests, but they’re never going to equalize price.
Someone has to cover the fixed cost. That’s an ever-present thorn in society’s side. There’s no way around it. And in general, it’s going to be the people who value it more. Prices depending on value means price discrimination.
From a positive perspective, we should expect to see price discrimination where fixed costs are high. The fixed cost of a flight is high, and the marginal cost of an additional passenger is low, so airlines have done this for a long time, which increases the number of flights they offer. Software is another example. You have high development costs and low marginal costs, so the business model will involve charging some customers (business users) much more to finance the development while keeping software available for, say, students or other price-sensitive users. For drugs, this happens across countries.
From a normative perspective, fixed costs give price discrimination another potentially important benefit: making investment worthwhile. That’s why I always stress fixed costs when talking about price discrimination. The standard Econ 101 model of price discrimination, even when it is efficiency-enhancing, holds the product’s availability fixed, so it leaves out this investment margin. It’s also why I’ve proposed “more prices” in electricity to deal with data center concerns.
The constant struggle
Okay, let’s move from simple examples to why this matters. I was listening to an episode of Odd Lots, in which Lindsay Owens spends a long time worrying about pricing tools. For example, she doesn’t buy that charging some customers more would provide “a cross-subsidy for everyone else.” But the whole point of price discrimination is to lower the price for someone who isn’t buying at the uniform price. So that’s not right, even in the simple, no-fixed-cost case.
She also argued that targeted discounts for budget shoppers mean higher prices for everyone else. They could, yes, but they need not. In our example, attracting another customer lets a rival spread the fixed cost and lower the existing customer’s bill to win its business.
I’ve chosen these numbers, obviously, in a way to make the benefits clear and simple. Does it mean every pricing scheme helps consumers and raises total surplus? A seller can use price discrimination to charge more on average, leaving consumers with less surplus. There is an incentive for the seller to grab a bigger slice of a smaller pie. Maybe the title should be “Price discrimination can be competition.”
But trying to grab more is present in every market on both sides. Sellers want higher prices, buyers want lower prices. It’s also not the only force at play. Instead of just fighting for a bigger share of a fixed pie, there’s also an incentive to find a bigger pie. And pricing schemes, including price discrimination, can be one way of finding that bigger pie.
The entrant wants a profit. It finds one by changing the pricing arrangement, creating more gains from trade, and offering customers enough of those gains to win their business. Then rivals copy the arrangement and compete over its terms. That is competition at work. Even when profits under the old pricing system have disappeared, the search for a better deal continues.
Owens is a stand-in interlocutor. As I said, the FTC is making a big deal about personalized pricing. Many people come from the same perspective, which is why I spend so much time on it. They treat price discrimination as anticompetitive by definition (whether they use this framing or not), since it starts from a price that does not equal marginal cost. It’s a wrong view of the competitive process.
But it once was even more prevalent. Courts and economics said the same about exclusive dealing, tying, resale price maintenance, and vertical mergers. Their role was to reduce competition. Since then, economists have built large literatures showing how firms use each of these practices to win customers. In response, courts have dropped per se condemnation of several of them. That work begins at the same spot; a single price leaves units unsold that are worth more to the buyer than they cost to produce. Discounts, exclusive contracts, and two-part prices are ways for buyers and sellers to trade those units. Public discussion of price discrimination has not caught up.
Across those literatures, the expanding pie has been the more dominant force. Finding more gains from trade is THE big deal.