Recent advances in information technology have rekindled interest in the efficiency of markets as resource allocation mechanisms. Traditional economic analysis typically examines situations where the prevalent technology involves no economies of scope and constant or decreasing returns to scale. In such industries the conventional wisdom "set prices at marginal cost" is both economically viable and the likely outcome of competitive forces.
Economists say that an economic situation is (Pareto) efficient if there is no way to make one consumer better off without making some other consumer worse off. For many cases of interest, Pareto efficient outcomes can be thought of as those that maximize the sum of economic benefits minus costs .
Let us consider this example in more detail. Suppose that there are two classes of consumers for a particular telecommunications service: those with a high willingness to pay and those with a low willingness to pay. The telecommunication service in question exhibits a technology with high fixed costs (of, e.g., building and maintaining a network), but low marginal costs (of, e.g., providing additional service to existing customers).
The above analysis, simple though it is, yields an important insight: The characteristics of consumer demand are an integral part of efficiency judgments. Whether or not a particular policy is efficient cannot be based on cost considerations alone.
The requirement that the marginal user pay marginal cost is a strong one, especially in cases where the marginal cost of usage is close to zero. One prominent example is information goods: the incremental cost of stamping out another CD or printing another book is on the order of a dollar. The incremental cost of downloading a purely digital good, such as a computer program, is on the order of a few cents at most. In these cases, efficient pricing of such goods would require that users with a very low value for such goods pay a very low price.
The black triangle illustrates the efficiency loss from non-marginal cost pricing.
We have seen that efficient pricing requires that the marginal willingness-to-pay equals marginal cost, but that differential and/or nonlinear pricing will typically be required for full efficiency when the underlying technologies have significant fixed costs. We now consider conditions under which profit-seeking firms will have an incentive to price in efficient ways.
- First-degree price discrimination means that the producer sells different units of output for different prices and these prices may differ from person to person. This is sometimes known as the case of perfect price discrimination.
- Second-degree price discrimination means that the producer sells different units of output for different prices, but every individual who buys the same amount of the good pays the same price. Thus prices depend on the amount of the good purchased, but not on who does the purchasing. A common example of this sort of pricing is volume discounts.
- Third-degree price discrimination occurs when the producer sells output to different people for different prices, but every unit of output sold to a given person sells for the same price. This is the most common form of price discrimination, and examples include senior citizens' discounts, student discounts, and so on.
Under first-degree price discrimination, or perfect price discrimination, each unit of the good is sold to the individual who values it most highly, at the maximum price that this individual is willing to pay for it. If the producer has sufficient information to determine the maximum willingness to pay for each consumer, it will be able to extract the entire consumer surplus from the market.
It is important to understand the sense in which the producer who engages in first-degree price discrimination "extracts all the consumers' surplus" in the market. This is to be interpreted as the surplusabove and beyond the surplus that would accrue to the consumer if he or she had not participated in the market for this particular good or service. Even though consumers acquires no surplus in the particular market in question, they still be substantially better off that if they had not purchased the good at all.
Second-degree price discrimination is also known as the case of nonlinear pricing, since it means that the price per unit of output is not constant but depends on how much one purchases. This form of price discrimination is commonly used by public utilities; for example, the price per unit of electricity often depends on how much is bought and the price of long-distance telephone service is lowest for the largest buyers. In other industries bulk discounts for large purchases are frequently available.
We have seen that if a producer can identify users with different willingesses-to-pay, and charge them accordingly, there may be no efficiency loss at all: the producer would simply charge each user his or her maximum willingess to pay. Users with high willingnesses-to-pay would pay a high price; users with low willingness-to-pay would pay a low price, but everyone who valued the good at more than its marginal cost of production would be served.
In third-degree price discrimination, the producer is able to identify different consumer groups who have different willingnesses to pay. This is a very common form of price discrimination: senior citizen discounts, student discounts, etc. are widely used. This form of price differentiation is often used in telecommunications industries: lifeline pricing, differential pricing for business and households, etc.
- First-degree price discrimination yields a fully efficient outcome, in the sense of maximizing consumer plus producer surplus.
- Second-degree price discrimination generally provides an efficient amount of the good to the largest consumers, but smaller consumers may receive inefficiently low amounts. Nevertheless, they will be better off than if they did not participate in the market. If differential pricing is not allowed, groups with small willingness to pay may not be served at all.
- Third-degree price discrimination increases welfare when it encourages a sufficiently large increase in output. If output doesn't increase, total welfare will fall. As in the case of second-degree price discrimination, third-degree price discrimination is a good thing for niche markets that would not otherwise be served under a uniform pricing policy.
We have examined the theory of differential pricing, but what about the facts? The evidence shows that differential pricing is ubiquitous in industries that exhibit large fixed or shared costs. This is true for industries that are highly concentrated and industries that are highly competitive.
- Airlines The airline industry is highly competitive in many ways, yet it is common to see differential pricing practiced in a variety of forms. As we have seen airlines offer different types of consumers different fares (senior citizen discounts, major corporations, convention goers, etc.); they offer different classes of service (first class, business class, tourist class); they offer different sorts of restricted fares (advanced purchase, Saturday night stayovers, etc.)
- Telecommunications The long-distance telecommunications market in the U.S. involves many different forms of differential pricing. Firms give quantity discounts to both large and small customers; charge business and individuals different rates; and offer calling plans that offer discounted rates based on individual characteristics and usage patterns.
- Publishing A book which sells for $40 can be produced at a marginal cost of $2. This gap between price and marginal cost has led to a variety of forms of differential pricing. Book clubs, hardcover and paperback editions, and remaindered books are all examples of the ways that the product characteristics and adjusted to support differential pricing.
- Lighthouses This example is rather interesting from a historial perspective. Economists have often used lighthouses as an example of a good that would be best provided as a public utility due to the difficulty of recovering costs. For our purposes, their interesting feature is that the cost of servicing incremental users is negligable. As Samuelson  puts it "... it costs society zero extra costs to let one extra ship use the service; hence any ships discouraged from those waters ... will represent a social economic loss ... ." Coase  examined historial record and found that privately financed lighthouses were provided in England for hundreds of years. Even more remarkably, the pricing arrangement they used was quite efficient: they charged on a sliding scale based on the number of voyages a trip took per year. After 6-10 trips per year, the incremental price for the services of the lighthouse was zero, just as efficiency requires.
It is easy to construct examples where some consumers will not be served unless differential pricing is permitted; we have alluded to this in our discussion of "niche markets" earlier. Consider, for example a case with two consumers one of whom would pay $20 for a telecommunications service, and the other of whom would pay $5. For simplicity, assume that the marginal cost of providing the service is zero. If the firm supplying the service is required to sell at a uniform rate to both consumers, it would clearly find it most profitable to set a rate of $20.
It is sometimes argued that "essential services" should not be differentially priced. The term "essential service" is rather vague, but one might define it as a service that everyone would want to have if they could afford to purchase it. For such services, differences in willingness to pay arise primarily from differences in income rather than tastes.
We have considered differential pricing in consumer goods. However, the same principles apply to markets for intermediate goods. In particular, technologies with large fixed costs, low marginal costs and/or significant shared costs may easily require differential pricing to be economically viable.
- Sell service at marginal cost. In this case the producer sells the service at a price of $1 to each of the customers, but would then fail to recover its fixed costs, which is not economically viable.
- Sell service at a flat price. In this case the supplier would find it most profitable to set a price of $12 and sell only to customer A. Customer B would not be able to purchase the service event though it would be willing to cover marginal cost.
- Differential pricing. If differential pricing is feasible, the producer would set a price of $12 for customer A and $5 for customer B. Each customer would be serviced and the supplier would be able to cover its fixed costs.
Telecommunications services often involve large fixed costs, low marginal costs, and significant shared costs. If such services are required to be provided to a large number of diverse users, and costs are to be covered without the use of externally provided subsidies, it is very likely that differential pricing will be necessary.
We have seen that differential pricing is a natural outcome of profit seeking forces and may easily contribute to economic efficiency. Forcing a policy of flat pricing in an industry where it is inappropriate due to the nature of the technology may well have perverse consequences. The key concern in examining the welfare consequences of differential pricing is whether or not such pricing increases or decreases total output.
Hal R. Varian, School of Information Management and Systems, 102 South Hall, University of California, Berkeley, CA 94720-4700. Email: firstname.lastname@example.org URL: http://sims.berkeley.edu/~hal. Research support from NSF SBR-9320481 and Pacific Telephone is gratefully acknowledged.
R. Coase, 1974. "The Lighthouse in economics," Journal of Law and Economics, vol. 17, pp. 357-376.