Monday, August 29, 2011

Price discrimination on the Internet

Business and Economic Analysis

This is my individual write-up for my MBA subject BEA, about the price discrimination on the Internet. If you find this reference helpful, please leave a comment. Enjoy, and questions feel free to post. Remember do no plagiarize and also remember this content is easily google-able for checking against copying. It is meant a guidance. Forgive the formatting, it is pretty hard to republish your work onto blog templates.

Price discrimination on the Internet


Executive Summary 4

1. Non-Uniform Pricing 5

2. The Internet as a Marketplace 6

3. Price Discrimination on the Internet (Net) 6

3.1. First degree 6

3.2. Second Degree 7

3.3. Third Degree 7

4. Price Discrimination, the Internet and Privacy 8

5. Asymmetric Information 9

6. Conclusion 11

7. Recommendation 12

7.1. Information is power 12

7.2. Government Interference 12

7.3. Internets' Social Networking Power 12

8. Appendix 14

9. Reference 15

Executive Summary

Information about individual consumers' demand curves can be used by organizations to increase their profits by setting up a nonuniform pricing structure. Price discrimination is a form of such nonuniform pricing; and is divided into three degrees namely perfect price discrimination, quantity discrimination and multimarket discrimination respectively. Price discrimination on a social aspect might be negative but could increase economic efficiency and enable better distribution.

The real world internet is not free from price discrimination. The internet has continued to grow into a marketplace offering benefits and challenges to the industry allowing easier distribution of digital information thus reducing marginal costs, but also facilitates piracy. The internet is now common with products and services which are characterized by high fixed costs and low marginal costs, suitable for price discrimination. All three degrees of price discrimination occur on the net, namely auctions, bulk or volume sales and price differentiation by market segments. Search comparison sites have produced Bertrand like outcomes in the retail insurance industry. But on the other hand, other organizations thrive by getting consumer information on the net, however posing concerns over privacy. Privacy is hard to maintain on the Net and has enabled firms to manipulate such information to price discriminate effectively. Firms also focus on providing asymmetric information to negate the downward pressure brought about by low search and switching costs, by affiliating to strong internet portals, advertising and tactics to increase switching costs.

The Internet marketplace will benefit most those that are technically savvy be it the seller or the buyer. Those that choose not to understand the workings of the internet and do not protect their privacy stand to loose out and get discriminated on price. The internet therefore requires its users to be well informed. Government interference should be kept to a minimum, and should step in when clear boundaries of law are broken. The emergence of social networking like Facebook will also shape the economics of the internet marketplace with its power to influence opinion on a good, service or firm altogether.

Non-Uniform Pricing

Monopolies (and other non-competitive firms) can use information about individual consumers' demand curves to increase their profits, i.e. instead of setting a single price, firms use nonuniform pricing: charging consumers different prices for the same product, thus raising profits (Perloff 2009). Carlton & Perloff (2005) explain several types of nonuniform pricing exists including prices discrimination, two-part tariffs, and tie-in sales. A market with theoretically perfect information, perfect substitutes and no transaction costs or prohibition on reselling to prevent arbitrage, price discrimination can only be a feature of monopolistic and oligopolistic markets where market power can be exercised (Daripa & Kapur 2001; Krugman & Obstfeld 2003)

Price discrimination is broken into three types or degrees. Perfect price discrimination (first degree) is where the firm sells each unit at the maximum amount any customer is willing to pay for it. Quantity discrimination (second degree) is when the firm charges a different price for large quantities compared to smaller quantities. Finally the third degree price discrimination, i.e. multimarket is where the firm charges different groups of customers different prices but it charges a given customer the same price for every unit of output sold (Perloff 2009).

Though price discrimination sounds negative and may be viewed negatively by society, Bakos (1998) highlights that it is a powerful tool that allows sellers to increase profits, reduce consumer surplus, and service buyers who would otherwise be priced out of the market, an outcome that increases economic efficiency.

It can be deduced that for firms to price discriminate, especially for the first and third degree type, detail information, characteristics, and the socio-economy status of each customer or group of customer is required.

This paper will discuss the theory of price discrimination in the real world internet business, its implications and recommendations.

The Internet as a Marketplace

Besides personalizing product offerings, the internet has enabled (Bakos 1998):

  • Digital information such as music allow perfect copies to be created and distributed almost without cost via the Internet.

  • Search - it lowers the buyers' cost to obtain information about price and product features as well as sellers cost to communicate such information.

  • Facilitation – the cost of logistics has been estimated at more than 10% of Gross National Product (GNP). Electronic marketplaces improve information sharing, helping lower cost of logistics and promoting quick, just-in-time deliveries reducing inventories, compounded by information systems replacing physical systems.

  • Enables new types of price discovery like auction of last minute un-sold airline seats and emergence of intermediaries like Priceline and e-Bay auction.

The decline of online privacy has been a boon to organizations' increased ability to price discriminate (Odlyzko 2003).

Price Discrimination on the Internet (Net)

The ability to customize products and prices greatly improves sellers ability to price discriminate (Bakos 1998). All three types of price discrimination are more common in markets which are characterized by high fixed costs and low marginal costs – a situation endemic on the Net (Koch & Cebula 2002). The three degrees of price discrimination are evaluated in the internet sphere.

First degree

The first degree price discrimination which involves a firm selling each unit of good or service to the individual who values it most, has witnessed success in auction websites namely eBay (Guttman & Maes 1998; Koch & Cebula 2002). However one limitation exists being the seller generally cannot prevent Net users from reselling the units they just purchased (Koch & Cebula 2002)

First degree price discrimination, in which the buyer is charged his maximal willingness to pay, has long been treated in the literature as an unattainable ideal, however the erosion of privacy and improved IT systems will enable a close approximation to this ideal to be achieved (Odlyzko 2003). Though, Odlyzko (2003) argues it could lead to an Orwellian economy in which a package of aspirin at a drugstore might cost the purchaser $1 if he could prove he was destitute, but $1,000 if he was Bill Gates or simply wanted to preserve his privacy.

Second Degree

More common is second degree or non-linear dependent on the volume or units of purchase, for example internet calls through Voice-Over-Internet-Protocol (VOIP) rates offer flat rates upon certain quantity or for a month of unlimited calls, and different rates for one time calls, refer Appendix-1 (Sykpe 2011). It is noteworthy that Deneckere & McAfee (1996) demonstrated that all parties of these transactions may be better off because there is a possibility that without second degree price discrimination, low quantity / low quality consumers might not be served at all, e.g. Skype would only cater to larger customers only.

Third Degree

Third-degree price discrimination is as common, for example how Dell using its online portal sets different prices for different segments between private, government and individual buyers (Riley 2006).

Therefore the internet has resulted in a veritable orgy of Pigovian price discrimination (Koch & Cebula 2002). Differential pricing is a natural outcome of profit seeking forces and may easily contribute to economic efficiency, and as such forcing a policy of flat pricing in an industry where it is inappropriate due to the nature of the technology may have perverse consequences (Varian 1996).

Price Discrimination, the Internet and Privacy

The internet has opened a new opportunity for commerce, bringing along its own challenges in maintaining privacy. With the reduction in search and switching costs on the net, would a Bertrand-like competitive outcome where firms select independently the prices they charge for the product and that every firm has to supply all the forthcoming demand at the price it is setting be expected (Vives 2001, p. 117)? This does hold true in some sectors where intense online competition has exerted downward pressure on prices, for example in the retail insurance and computer industry (Brown & Goolsbee 2000; Daripa & Kapur 2001; Goolsbee 2000).

The internet allows sellers to collect a remarkable wealth of information about their existing and potential customers, giving retailers some market power, enable better price discrimination, and retailers will find devices to raise switching costs organically from within the product, through loyalty schemes and deliberate product differentiation, allowing them to discriminate in the future (Daripa & Kapur 2001). Electronic marketplaces support personalization and customization by using consumer tracking providing relevant demographics, consumer profiles to estimate their specific preferences, and also information-rich products lend themselves to cost effective customization like delivering an electronic newspaper tailored to the interests of an individual need not be more costly (Bakos 1998)

So since price discrimination requires market power, to what extend would growth of online price comparison services corrode this market power? Daripa & Kapur (2001) comment that existing technology allows retailers to distinguish between customers referred by price-comparison sites and those that access them directly, to the extent that the former are to be more price sensitive, it could set a lower price for those referred by shopping agents and charging higher for the latter.

According to the famous 1993 Pat Steiner cartoon in The New Yorker, "On the Internet, nobody knows you're a dog."But in practice, there are many who not only know you are a dog, but are familiar with your age, breed, illnesses, and

tastes in dog food" (Odlyzko 2003). Net firms utilize the massive experience data they collect on the Net to tailor products to specific customer, offering lower prices if we haven't purchased anything, or sending related offers e.g. travel discounts after buying a book on a tourist destination, or even offer a higher price if our characteristics suggest to them our demand for a particular good is less price elastic (Koch & Cebula 2002). So, the Internet offers not only the possibility of unprecedented privacy, but also of unprecedented loss of privacy, and so far privacy has been losing (Odlyzko 2003).

Search is far from perfect and sellers can sometimes reduce the efficiency of price search services through deliberate obfuscation, secondly the Internet makes it easier for retailers to track their rivals' price and reach rapidly, possibly even making implicit collusion likely, resulting in higher prices (Daripa & Kapur 2001). Clearly, the internet has increased the information available both to the consumer and the seller, and as such depends on how each side makes the best advantage of the available information. But on a whole the answer is not straightforward, as part of the difficulty lays in that the Internet increases the information available both to sellers and buyers, therefore depends on the relative ability of each side to manipulate and use that information to their advantage (Daripa & Kapur 2001).

Asymmetric Information

As discussed if search costs continue to fall, sellers are worse off since buyers can find the lowest-cost seller, while buyers benefit from the lower prices and their improved ability to find products that fit their needs. The dynamics of friction-free markets are not attractive for sellers that had previously depended on geography or customer ignorance to insulate them from the low-cost sellers in the market (Bakos 1998).

Therefore sellers have responded in a number of ways, through further advertisement on the web and using referral from highly regarded websites trying to get the upper hand in providing asymmetric information. Asymmetric information is likely to generate price dispersion (some consumers paying higher prices than others) and the mean price paid by all combined could be higher (Bryjolfsson & Smith 1999, 2000). Some sellers make it difficult to compare the price of alternative product offerings, and they attempt to collect information about buyers that allows more effective price discrimination. Airlines, for example, have implemented extremely complicated and ever-changing fare structures, flight restrictions, and ticket availability, sometimes offering hundreds of fares for travel between certain pairs of destinations (Bakos 1998).

In certain cases where quality may be uncertain and/or experience goods are involved, a comfortable branded portal (e.g Yahoo!) may signal consumers that a good or service advertised therein is reliable and of high quality (Kihlstrom & Riordan 1984; Nelson 1974).

Therefore significant asymmetric information is achieved through heavy marketing and affiliation. In 2001, firms were expected to spend $8.1 billion advertising on the Net and by 2004, it was projected that this spending will have risen to $24.5 billion, or 8% of all advertising expenditure (Lawrence 2001).

Basically even though some net advertising diminish search costs because they supply factual information about price and quality to consumers therefore exert downward pressure on prices, the opposite is true for advertising focusing on branding a good or service which is to diminish price elasticity of demand so that sellers have an enhanced ability to raise prices and / or retain customers (Koch & Cebula 2002)


It has been discussed that price discrimination requires some pre-requisites to work in markets and such characteristics were observed on the internet as a marketplace. Interestingly most consumer have taken the internet for granted and assumed that it always offers lower prices compared to brick and mortar shops, but the research quoted has indicated that this is not true in every case.

Instead it is those who are internet savvy, knowing how to guard their privacy that would get the best o the internet. In fact, those that can tweak their own internet profile can disguise themselves and get the best of bargains. On the other hand, the same applies for the seller, of which can best manipulate such information on the net and provide an asymmetric layer of information will likely be better off in reaping profits and market share. Interestingly though as discussed price discrimination brings out economic efficiency, and is not always a bad thing.

So the question that arises is governments role in this area which has been vague. The problem is that price discrimination often does provide real measurable gains for social and economic welfare and is not just a measure for increasing profits of sellers, as is often suspected (Odlyzko 2003). Increased price discrimination is often associated with increased competition as well as increased economic activity, and works to decrease profits (Odlyzko 2003) but Perloff (2009) states that in a perfect price discrimination compared to competition, total welfare is the same, consumers are worse off, and firms are better off .


Based on the above, recommendations are made as below:

Information is power

Consumers need to be educated and need to be aware that the internet is not free from price discrimination, and must possess the knowledge and tools to determine what information is shared and what is private. They will need to know how to safe-guard their private information, and be aware of their rights. The objective is to prevend a shift of consumer surplus to producer surplus (Bailey 1998).

Business alike will need to be aware of consumer patterns, preference and characteristics. Undeniable, providing fast, easy access to products required by customers of which prior to purchase can be checked for reviews regardless of demographic difference is one of the boons to the internet business. Customers value and prefer this convenience, and sellers will need to have such technology to continue to provide and enhance such. This is the true value of the internet, and continuing to provide such services will see further growth in the industry.

Being the 'average consumer'

Consumers may develop a strategy that while not perfect, would result in them being treated like and "average consumer" which conteracts a retailer's price discrimination strategy. Consumers can use anonymous gateways (hiding their Internet Protocol (IP) address), to create a virtual identity, as such with no information about the consumer, the retailer can only set a price for an average consumer (Bailey 1998)

Internets' Social Networking Power

The consumer now has a strong force that previously did not exist. Social networking sites like Facebook and Youtube has enabled a window for consumers to create significant impacts to companies, by either liking, complaining or demanding changes from companies, which has had snowball effects, to extent where governments are also vary of such power of the social networks. If used properly, such networks provides a strong yet free consumer powered mechanism to drive sellers to provide the best of their goods and services or risk major market share losses.

Ad-hoc institutions of Regulations

The internet community must continue developing and maintaining ad hoc institutions such as chat sites, community review sites like tripadvisor, that circulate information and provide the leverage for public pressure against inappropriate cyberspace behavior (Weiss & Mehrotra 2001). Online ventures like TRUSTe which operates much like the better business bureau, stamping its seal of approval on those digital enterprises that conform to established privacy principles should be given more prominence. The consumer should demand such seals of approval before deciding on a purchase or service (Weiss & Mehrotra 2001).

Government Interference

Government interference should be kept at a minimum and as a supervisory role. However strict regulations and determinants should be set to ensure no un-authorized sale or sharing of user information happens, and companies be liable to safe-guard such information what was provided by the customer if and when privacy was requested. Some websites have fine-print which by default opts-in a member into sharing of private information with other parties, and similar dubious tactics should be policed. However the overall sales and purchase on the internet should just be governed by the laws and norms that already exist. Putting too much pressure on online sales could dampen the industry on a whole.


Appendix 1


Bailey, JP 1998, 'Internet Price Discrimination: Self-Regulation, Public Policy, and Global Electronic Commerce', University of Maryland.

Bakos, Y 1998, 'The emerging role of electronic marketplaces on the internet', Communications of the ACM, vol. 41, no. 8, pp. 35-42.

Brown, J & Goolsbee, A 2000, 'Does Internet Make Markets More Competitive? Evidence from the Life Insurance Industry', NBER Working Paper 7996.

Bryjolfsson, E & Smith, M 1999, 'Frictionless Commerce? A Comparison of Internet and Conventional Retailers', Massachusetts Institute of Technology.

Bryjolfsson, E & Smith, M 2000, 'The Great Equalizer? Consumer Choice Behavior at Internet Shopbots', Massachusetts Institute of Technology.

Carlton, DW & Perloff, JM 2005, Modern industrial organization, 4th edn, Pearson/Addison Wesley.

Daripa, A & Kapur, S 2001, 'Pricing on the Internet', Oxford Review of Economic Policy, vol. 17, no. 2, pp. 202-16.

Deneckere, R & McAfee, RP 1996, 'Damaged Goods', Journal of Economics and Management Strategy, vol. 5, no. 2, pp. 149-74.

Goolsbee, A 2000, 'Competition in the Computer Industry: Online versus Retail', in Graduate School of Business, University of Chicago.

Guttman, RH & Maes, P 1998, Cooperative vs. Competitive Multi-Agent Negotiations in Retail Electronic Commerce, Springer Berlin / Heidelberg, Cambridge MA.

Kihlstrom, RE & Riordan, M 1984, 'Advertising as a Signal', Journal of Political Economy, vol. 92, pp. 427-50.

Koch, JV & Cebula, RJ 2002, 'Price, Quality, and Service on the Internet: Sense and Nonsense', Contemporary Economic Policy, vol. 20, no. 1, pp. 25-37.

Krugman, PR & Obstfeld, M 2003, International Economics - Theory and Policy, Addison Wesley.

Lawrence, S 2001, 'Online Advertising Growth Cools in 2001', Industry Standard, vol. 4, no. 79.

Nelson, P 1974, 'Advertising as Information', Journal of Political Economy, vol. 82, pp. 729-54.

Odlyzko, A 2003, 'Privacy, Economics, and Price Discrimination on the Internet', paper presented to ICEC, Pittsburgh, PA.

Perloff, JM 2009, Microeconomics, 5th edn, Pearson Addison Wesley.

Riley, G 2006, Markets and Market Systems, Eton College, viewed 10 April 2011, <>.

Sykpe 2011, Skype Unlimited Calls, viewed 8 May 2011, <;.

Varian, HR 1996, 'Differential pricing and efficiency', First Monday, vol. 1, no. 2.

Vives, X 2001, Oligopoly pricing: old ideas and new tools, illustrated, reprint edn, MIT Press.

Weiss, RM & Mehrotra, AK 2001, 'Online Dynamic Pricing:Efficiency, Equity and the Future of E-commerce', VIRGINIA JOURNAL of LAW and TECHNOLOGY, vol. 6, no. 11.

--> ps this entry is the 5th in my series of MBA written assignments. The previous one is titled What Makes Someone A Better Business Leader which you can read by clicking here.



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