Price Discrimination, Again
By Arnold Kling
Stores must sell their goods at a prices that cover the wholesale cost of the individual goods as well as the overhead costs of the store, like labor and the building lease. The amount of additional price that must be charged for each good to cover overhead costs is a function of the average turnover of the goods sold. Ceteris paribus, the faster a store can sell its goods, the lower the average overhead costs of each good, and thus the less that must charge to cover the stores average total costs. If a store sell three times as much on black friday than they normally do, then the overhead costs are three times as small.
He also cites a 1991 paper from Russ Roberts and John R. Lott that debunked some standard stories of price discrimination.
I think that the key issue here is that the cost of many products is dominated by overhead costs, and marginal costs are close to zero. Think of the marginal cost of another airline passenger compared with the overhead cost of running the airline route. Think of the marginal cost of manufacturing and shipping another video game console compared with the overhead cost of designing the console and writing the software.
We are seeing an increasing sector of the economy that fits this model. I wrote about this several years ago in asymptotically free goods. I see this as the product-side manifestation of the now-famous Garett Jones observation that workers today produce organizational capital rather than widgets.
Once you have high overhead costs and low marginal costs, price discrimination becomes attractive, and often necessary, as a strategy. Despite the negative connotations of the term, price discrimination is often welfare-improving in these situations. If you charge marginal cost to everyone, you fail to recover overhead costs and go out of business. If you recover overhead costs by charging everyone an identical markup over average costs, then the price is way above marginal cost, which drives away many customers who would in fact enjoy the product at a price that would recover marginal cost. Price discrimination allows you to recover overhead cost while enabling the largest number of customers to enjoy the product.
Back to Karl Smith, I don’t think that you can argue that marginal costs for retailers decline on Black Friday. So even if he is correct (and I do not believe that he is), it is not a traditional microeconomic story that he is telling.
[UPDATE: Alex Tabarrok recommends Price Discrimination Without Market Power by Michael E. Levine, which clarifies many of the points I have been attempting to make.]