October 30, 2004  ·  William Fisher

In this, my final, post, I�d like to take up the troublesome topic of price discrimination � both with respect to the distribution of audio and video recordings and with respect to sales of pharmaceutical products. My own view, which I�ll try to explain briefly, is that (a) we are likely to see much more price discrimination by the providers of these goods in the near future; (b) price discrimination in the context of entertainment is, on balance, bad; and (c) price discrimination in the context of drugs is, on balance, good. Judgments (b) and (c) are tentative and surely debatable; I�m hoping to elicit reactions.

First some background (from Chapter 4 of my book): �Roughly speaking, price discrimination refers to the practice of charging different consumers different prices for access to the same good or service. Somewhat more precisely, it means charging different consumers different prices when the variation cannot be explained by differences in the costs of the versions of the good or service that is supplied to them. A traditional example of price discrimination is the practice of airlines to offer discounts to customers who �stay over� at their destinations for a Saturday night. The cost to the airline of supplying the service in question–the various expenditures necessary to carry a person in a plane from, say, Boston to San Francisco and back–is the same regardless of whether the passenger stays in San Francisco for a day or a week. The only reason for varying the price is to extract higher fares from people who are able and willing to pay more (in this case, business travelers, most of whom have expense accounts), without pricing out of the market people who are able and willing to pay less (in this case, tourists).

�Price discrimination increases a seller�s profits. Why, then, don�t all sellers engage in it? The main reason is that, with rare exceptions, price discrimination is only feasible when the seller both has some degree of market power and is able to discourage �arbitrage.� Market power exists when there are no readily available, equally satisfactory substitutes for the good or service that the seller is offering. Arbitrage occurs when a customer who purchases a good or service at a low price is able to resell it (typically at a profit) to someone who otherwise would be obliged to pay a high price for it�.�

Record companies, film studios, and pharmaceutical companies all enjoy some degree of market power. Their ability to engage in price discrimination in the past has been limited primarily by the difficulty they have had in curtailing arbitrage. (The �first sale� doctrine in copyright law affirmatively protects arbitrage, and drug companies have had trouble preventing purchasers of drugs at low prices from reselling them to others at higher prices.) This has not prevented the companies from engaging in price discrimination altogether, but has forced them to engage in relatively crude versions. The best known is the so-called �windowing� marketing system in the film industry, in which the studios divide up their markets temporally — first milking the market of especially eager or wealthy viewers by charging high license fees to first-run theatres (which, in turn, charge substantial fees for admission), then gradually releasing the film at diminishing prices in a series of secondary markets. (More detail on this practice can be found in Chapter 2 of my book.) The pharmaceutical companies, by contract, have practiced geographic price discrimination. Except when prevented by �exhaustion� doctrines (e.g., within the EU), they price their products differently in different countries, depending on the residents� ability and willingness to pay.

In the near future, I suggest, we are likely to see much more precise and ubiquitous forms of price discrimination � certainly in the entertainment industry and perhaps in the drug industry. With respect to the former, the main reason is that (assuming that an ACS is not adopted in the near term), the record companies and film studios are likely to intensify their efforts to develop digital rights management systems (perhaps with support from governments, in the form of enhanced versions of the Digital Millennium Copyright Act and its ilk). DRM systems are designed, among other purposes, to frustrate arbitrage � i.e., to prevent the first purchaser or licensee of a recording from transferring it to others. The net result: the record companies and films studios, if their DRM systems work, will begin to divide the universe of people who wish access to their works into much thinner slices and to set different prices for each subgroup. In the old days, everyone paid the same price for a CD. Soon, the price you are charged for access to a recording will vary with such things as your age, your zip code (a proxy for your income), what sort of device you will play it on, etc. Whether we will see a similar trend in the drug industry is less certain, but the overall trend toward the curtailment of international exhaustion rules, combined with intensified pressure on drug companies to lower their prices in poor regions, may enable and induce the pharmaceutical houses to further refine their price discrimination schemes.

Should we applaud or lament these trends? My contention is that there�s no blanket answer to that question � that price discrimination has both good and bad effects, and that its overall social desirability varies by context.

Its benefits include:
(a) It enables the entertainment and drug companies to make more money. If (a big �if�) we believe that augmentation of their profits will increase their incentives to engage in socially beneficial innovation, that�s good.
(b) It increases the ability of the poor to gain access to copyrighted or patented material. When the material in question consists of a life-saving drug, that means that price discrimination saves lives.
(c) Usually (not invariably), it redistributes wealth from the rich to the poor � and thus functions like a progressive income tax.

Its disadvantages include:
(d) The time and effort necessary to devise and implement price-discrimination schemes represent a social waste. Some forms of the practice (most importantly, so-called �second degree� price discrimination � in which the seller of a product induces potential buyers to reveal their resources or preferences by offering them different versions [such as business-class and coach-class plane tickets]) � are especially wasteful.
(e) In the view of at least some people, it is immoral. �Charging whatever each submarket market will bear,� �gouging,� seems improper. All people ought to have equal access (i.e., access on the same terms and at the same price) to a particular good or service.

My own view is that, with respect to drugs, argument (d) and (e) are trumped by the compelling interest in getting life-saving drugs into more hands (argument (b)). With respect to recorded entertainment, where increasing access to the products as issue is nowhere near so important, the right way to weigh these competing considerations is much less clear. Moreover, in context of entertainment, price discrimination has some additional troubling features, summarized in the following excerpt from Chapter 4:

�Sadly, [the] benefits [of enhanced opportunities to engage in price discrimination] would pale in the face of three other pernicious effects. The first is cultural. As Wendy Gordon has suggested, [a world characterized by pervasive price discrimination] would have a distressingly granular feel. Each time you listened to a song or watched a movie, you would know that a tiny meter, attached to your credit card or bank account, was whirring. Each time you bought a lobster in an upscale grocery store, you would know that your �consumer profile� was being adjusted–and that, next week, the prices you paid for all entertainment products would be one notch higher. Awareness of these effects would likely make you more calculating. Also, perhaps, less altruistic. Conscious that you are paying for each bit of entertainment you consume, you might be less inclined to �give back� freely to the culture the fruits of your own imagination. To most people, such a world seems unattractive.

�Second, creative and critical uses of entertainment products would likely suffer in this new environment�. [S]uppliers would most likely charge higher prices to people who wished to modify their products or incorporate them in other works. Cover artists, rap artists (who rely on digital sampling), and ordinary consumers who just like to �play around� with recordings, would all pay substantially higher fees. This price rise, plus inevitable imperfections in the rate-setting mechanisms, would sometimes place access to digital products beyond the financial means of such second-tier creators. Society at large, consequently, would lose the benefit of their derivative products, and opportunities for semiotic democracy would be curtailed�.

�Finally, when added to the many other opportunities to make money considered in this chapter, the ability to engage in precise price discrimination would radically increase the incomes of the creators of music and movies. The result would be a massive transfer of wealth from consumers to producers–much more than necessary to offset the losses that the producers are currently suffering or are likely to suffer in the future. That effect seems troubling in its own right. In addition, it would exacerbate the problem discussed at the end of Chapter 2 — in which the large and highly visible incomes of �star� performers draw inefficiently large numbers of aspirants into the music and movie businesses. If that problem is bad now, it would become worse in the altered legal and business environment.�

Bottom line: we should adjust legal rules to assist drug companies to engage in price discrimination, but, other things being equal, we should legal reforms that afford the owners of copyrights in songs and films similar opportunities.

Reactions?

Terry Fisher

  • Ottmar Liebert

    Thanks for your postings this week. Very thought provoking.
    1. Kowing that recording acoustic music, for example, is much more costly than recording two turntables and a microphone – having differentiating price-structures makes sense to me – like magazines or wine…
    2. The same seems true for different parts of the world. While $10 or even 15 for a CD seem reasonable in the USA or Europe it is unattainable in Africa or some Asian countries. This could possibly be solved with the price coming down as time passes. Meaning somebody in Africa might just have to wait until the price becomes more reasonable?
    3. RE ACS: if a person wanted to listen to his music collection, and add nothing new, he nevertheless would have to pay an ACS tax on his mp3 player, yes? It would be impossible to create exceptions.

  • Steve Dispensa

    Differential pricing seems like a win-win situation in lots of respects: the free-market zealots will have to like it on principle, in the sense that if this system works at all, it’s precisely because it’s the best thing for the market. The, er, more socially conscious crowd should like it because of its intrinsic ability to level the playing field.

    I think Ottmar’s examples are all traditional market economy examples, and don’t really illustrate differential pricing, as I understand it. 1 & 2 are certainly scenarios that exist in the marketplace today, (largely) absent differential pricing.

    Differential pricing is technically feasible in the digital world due to DRM, but absent complicated governmental involvement and intense worldwide cooperation, I don’t see it working particularly well for most classes of physical goods, due specifically to the arbitrage concerns you raise above. In fact, if it worked well for physical goods, it would seem to imply that DRM is less necessary. Try that argument with the MPAA.