In response to a previous post on price discrimination by hospitals in India, commenters Apex and Chris L wondered how it is possible for price discrimination to make everyone better off, and even if you wanted to charge more to rich people, how could you do that in practice?
The general idea is that price discrimination allows firms to overcome fixed costs and thus offer products and services that they otherwise wouldn’t. But I’ll give a specific example using a really simple model.
Say there are four potential consumers of a hospital’s services. Three of them value the service at $5 and the fourth (the rich one) values it at $8. The fixed costs of a hospital are $5 and the marginal cost of treating one patient is $4. If the hospital charges a uniform price of $5, then all four will buy the service and the hospital will have revenue of $20, marginal costs of $16, and thus a total costs of $21. Thus the hosptial will not offer services at this price, since total costs are above total revenue.
At any uniform price above $5 and three of the four patients will not buy the service, and the maximum value the rich customer would pay ($8) is not enough to cover the total cost of treating him ($5 + $4 = $9). So under uniform pricing the services aren’t purchased by anyone, and thus everyone is worse off.
However, if the hospital can price discriminate by charging $5 to the three poor customers, and $7 to the rich customer then the total revenue is $22, total cost is $21, and thus profit is $1. In this case price discrimination allows the hospital to offer the services, and so being able to price discriminate makes everyone better off.
(The simpler case is where price discrimination doesn’t make all customers better off, but does increase overall welfare by making those with lower valuation and the firm better off by more than the higher valuation customers are worse off.)
How could hospitals do this in practice? They could do it rather directly by offering customers discounts if they can prove they are on food stamps (3rd degree price discrimination). Or they could allow customers to self-sort (2nd degree price discrimination) by charging a lot more for last minute reservations, better parking spots, or other “luxuries” and add-ons, which will tend to be demanded by people high time value of money (e.g. richer people).
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Saturday ~ May 29th, 2010 at 11:43 am
jazzbumpa
In actual practice we have price discrimination here, but it is unfavorable to a select, already disadvantaged group.
I recently had a medical bill reduced from (approx numbers) $250 to $90, because that is what my insurance carrier says I have to pay. They paid nothing – they just muscle the provider to accepting this amount. Whether their costs are covered is totally opaque to me.
If I were uninsured, I’d have to pay the entire $250,or deal with a collection agency.
Price discrimination – yup. Benefit to me – yup. Benefit to the provider – nope. Benefit to society – Nothing obvious.
Great ideas are fine, but putting them into practice correctly is important, too.
Cheers!
JzB
Saturday ~ May 29th, 2010 at 3:25 pm
Privacy and Tiered Pricing
[...] more important point, though is that price discrimination can make consumers better off on net even if the average price is constant. I assume, after all, that Kevin thinks a move from flat to [...]
Monday ~ May 31st, 2010 at 4:36 pm
Agustin
You could also have a system where everyone pays for the health care system based on their income, as part of their income tax.
Monday ~ May 31st, 2010 at 9:55 pm
o
Adam, I’m afraid you’re a little confused about what it means to be “better off”. Paying $5 for a service I value at $5 leaves me with zero consumer surplus, and I am no better off than if I hadn’t made this purchase. Only the fourth person, who values the service at $8 but pays $7, receives positive consumer surplus from this transaction.
That said, it is certainly possible to concoct examples where everyone is better off. This is because price discrimination has the potential to reduce the DWL associated with market power.
On the other hand, it is also quite easy to concoct examples where only the seller is better off with price discrimination, and all consumers are worse off.