Tuesday, September 15, 2009

The 'Undercover Economist' Is a Bit Fuzzy on the Definition of Price Discrimination

(Note: Many thanks to my friend and expert in industrial organization, John Lunn, for his input in the post below.)

Remember, I like Tim Harford's work at the Financial Times. I really do. That's why it didn't feel good earlier this week when I critiqued his caricature of how economists think about economic decision-making.

But looking for something totally unrelated the other day on YouTube, I stumbled on this video of Mr. Harford giving a lecture on price discrimination at the Developments in Economics Education conference in Cambridge. And it's pretty clear from the video evidence that he is more than a bit fuzzy on what constitutes price discrimination.

Take a look at the video. Then check out my response beneath it.

Well, I've watched this video over and over the last couple of days, always trying to give dear Mr. Harford the benefit of the doubt. Nevertheless, if this video were Mr. Harford's response to an exam question like, "Define price discrimination. Give examples.", he would probably not receive a passing grade--at least from me in my principles of microeconomics course. Here's why.

Unfortunately, it is not uncommon to find economists--mistakenly--referring to any pricing scheme as discrimination. But the standard definition of price discrimination in economics is this: Price discrimination is said to occur when a firm, owing to at least some monopoly power, charges different prices to different groups of buyers for an identical good or service. Real examples of price discrimination include student discounts, senior discounts, lower airfares with a Saturday-night stayover than without, and movie matinee prices.

Therefore price discrimination is not what Mr. Harford discusses--at all--in his price discrimination talk. His talk is actually about product differentiation: charging different prices for similar--but not identical--goods.

Whenever one starts talking about price discrimination, the first question should be "Where is the monopoly power?" Now Starbucks may have some, but I doubt it is all that great, and probably relates to the unique experience at Starbucks, rather than the coffee quality alone.

There were a few other points in the video that made me scratch my head. For example, I don't know all of the prices at Starbucks, but the price-volume combinations at most shops like it work out so that the per-ounce price is lowest for the venti (big) size and highest for the tall (small). So your best per-ounce value is actually the biggest drink. Yet the talk made it sound like the opposite is true.

In fairness, though, the "short" he talks about is more difficult to explain. It cannot be explained by people merely wanting a greater variety of sizes, since it is not listed on the menu. It's possible Starbucks keeps it available in order to prevent losing a sale, but keeps it off the menu to discourage many orders of that size. But I question whether that is a sufficiently reasonable explanation.

So if you are looking for a cool video about price discrimination--that also gets the economics exactly right--skip Tim Harford's. Instead, check out this one two of my students at Hope College made last year:

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