Marginal Cost Pricing

Sometimes firms can charge different prices to different customers. This is known as price discrimination (this sort of discrimination is not based on race or sex but instead on elasticity of demand, and is actually a good thing). Consider airlines. If an airplane is going to fly from Chicago to St. Louis and the average cost of flying a passenger over that distance is $100, they should not let me on the plane for $50, right?

Maybe they should. If there is an empty seat on the plane and I am not willing to fly for a price of more than $50, they may be able to increase their profits by letting me on the flight. Their profits will rise if the marginal revenue they gain (the price I pay) is greater than the marginal cost of having me fly (the increase in their costs from having me be a passenger). What would be the marginal cost of having me fly on their plane? It might cost fifty cents to handle my baggage, one dollar to print my ticket, I would eat one bag of pretzels (cost ten cents) and drink one drink (cost fifty cents). So by adding me to the flight, the airline's costs rise by $1.60. If no one else was going to buy the seat and I was willing to pay more than $1.60 to fly on the plane, they would increase their profits by selling me the $50 ticket.

Consider a university. Central to a university's ability to charge a high tuition is the reputation for having a smart student body. Admitting low quality students who are willing to pay full tuition may increase a school's revenue right now but may hurt the school's reputation and so decrease its revenue in the long run. Can a school get enough high quality students willing to pay full tuition to fill all the slots in its freshman class? Or should it admit students who are less qualified but who are willing to pay full tuition (even though this may bring down the school's reputation and ability to attract good students in the future)? Or should a school admit students who are high quality but who cannot afford to pay full tuition? What is the marginal cost of adding one more student to a college? $5000 for room and board, $10 for using the library, and $5 for shuffling papers down at Crown. So the marginal cost of adding a student is $5015. If the university cannot find enough high quality students willing to pay full tuition, it can still increase its "profits" by admitting students who are willing to pay more than $5015. If you get financial aid, how grateful should you be? [Hint: Princeton, Stanford, MIT and a number of other top schools have in recent years tended to announced large tuition increases matched with large increases in financial aid.]

This system works if the following things are true. If firms have some monopoly power over some of their customers, and these customers differ in terms of willingness to pay, and if these customers can't hide what type they are and buy at a lower price (or alternatively, the customers who buy at a low price can't turn around and sell the good at a high price), then firms may want to engage in price discrimination (charging different prices to different customers). In this, firms will engage in marginal cost pricing (the firm may charge less than its average cost of production, as long as it is getting at least as much as its cost of producing that "marginal" unit) and elasticity pricing (charging more to customers who have a greater willingness and ability to pay). If you signal that you are not very price sensitive, expect to be charged more! Examples: quantity discounts, airlines, university financial aid, coupons, outlet malls far from the city, pseudo-textbooks, electricity especially at peak demand periods, telephone service, prescription drugs in various countries, etc.

[For other examples of price discrimination in action, check out these articles.

Here's a New York Times piece on article about how much various people paid to fly from Chicago to LA on the same plane.

Here's an article by Krugman on how Amazon.com plays this game on him.

Here's an article by Hal Varian on how drug companies use these principles in pricing pharmaceuticals.]

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Comments, questions, or typos? mwitte@northwestern.edu