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Price Discrimination Without Market Power
Michael E. Levinet
Politicians, regulators and antitrust analysts have often used the
presence ofprice discriminationas an indicator of market power. They are
often motivated by politicalpressurefrom buyers facing the higher of the
discriminatoryprices to regulate or to pursue antitrust remedies in pricediscriminating industries. Their justification for doing so is provided by
economic models that equate deviation from marginal cost with market
power. In the unusual case where costs are completely separable, this
position may have validity. But most commonly, real-world goods and
services are produced under conditions where costs (sunk or not) like
R&D, advertising or production or distribution costs like common
facilities,are shared with otherproducts. Under these common conditions,
firms constrained by competitionfrom earning monopoly rents will adopt
price discrimination as the optimum strategy to allocate common costs
among buyers. Not only is this very often welfare-enhancing (as Ramsey
pricing suggests it is for certain monopolists), it is not evidence of the
unilateral or collusive power to affect industry output, which is at the
heart of the "monopoly power" or "market power" concepts. A version of
price discrimination also can be used to recover sunk costs in a
competitive environment, thus providing a solution to the "destructive
competition "problem that hasplagued regulatory economicsfrom the late
nineteenth century to the late twentieth. This view of price discrimination
also helps to explain and justify network pricing behavior that has been
accused of being predatory.Price discriminationcan, of course, be used to
facilitate andpreserve the exercise of market power. But while some price
discriminatingsellers can earn monopoly rents, price discriminationalone
is not evidence of market power and should not be used to justify
regulatory intervention.
Introduction ..........................................................................................

.. 2


The Problem, Viewed Historically .................................................



Modem Developments of the Theory ............................................


Harvard Law School. I am grateful to Richard Craswell, Einer Elhauge, David Friedman,
Andy Hansen, Henry Hansmann, Daniel Kasper, Louis Kaplow, Lewis Komhauser, Kristin Madison,
Ariel Pakes, Alan Schwartz, Matthew Spitzer and participants in workshops at Harvard, Yale, Stanford
and NYU for helpful comments on earlier drafts and presentations. Alan Schwartz was particularly
helpful on the issue of the uniqueness of the price equilibrium and, as noted, David Friedman supplied
an important example. Richard Craswell provided invaluable commentary on a wide variety of points.
Despite all this help, errors undoubtedly remain. Needless to say, no one else is willing to take
responsibility for them, so they are mine.
Copyright 0 2002 by Michael E. Levine

Yale Journal on Regulation

Vol. 19:1, 2002

III. A More Comprehensive Explanation ..............................................
A. ClassicalModels Do Not Adequately Reflect the
Impact of Common Costs.......................................................
B. Difficulties ofAllocating Common Costs............................... 10
C. PriceDiscriminationEfficiently Allocates
Com m on Costs .......................................................................
D. The Price Equilibriumand Its Implications.......................... 17
E. SustainingPrice Discrimination..........................................
IV. Airlines: A Real World Example ...................................................



Examples from Other Industries ...................................................


VI. Regulatory Im plications ................................................................


VII. Misusing Price Discrimination in Competition Analysis .............. 32
C onclusion ............................................................................................


Price discrimination often bothers disadvantaged buyers and
stimulates regulators to action. As buyers find that their particular
consumption needs can only be satisfied at prices higher and apparently
more profitable than those paid by others to satisfy their similar needs,
they complain. The complaint usually involves suggesting that only a
monopoly or a conspiracy stands between them and lower prices and that
someone should do something about it. The "someone" is usually a
politician acting through a government regulator or prosecutor who is
asked to intervene to eliminate the price discrimination or the market
structure that is presumed to sustain it. Academic economists often support
the buyers, imagining that market power underlies the price discrimination
and reasoning that even if price discrimination can be an efficient way to
ameliorate the effects of market power, eliminating the market power is a
more certain road to efficiency.
For example, even as airline deregulation has made airline markets
generally competitive, airline fare structures have become more complex.
Aggressive market segmentation has become a feature of most airline
markets, as it is in telephone markets and other network businesses, and its
existence has generated discussions of just how competitive the
deregulated airline industry is. This price discrimination has engendered
accusations of persistent market power (particularly focused on airline
"hubs") and calls for further government intervention to reduce or
eliminate it. Airline executives have responded, among other things, by

Price Discrimination Without Market Power
pointing out that returns to capital remain substandard, which they say
should be taken as evidence that the industry is competitive.
Of course, not all airline price segmentation is discriminatory. Some
price differences in airline tickets and elsewhere are supported by product
cost differences and some by opportunity cost differences. But many are
not. Since airline price segmentation has generated accusations of
predation and proposed regulatory responses,1 and these accusations and
responses have broader implications, there is a need for clearer
understanding of market segmentation through complicated pricing
Pricing structures designed to accomplish segmentation are not
limited to the airline industry. They can be found elsewhere in the
economy in services like restaurants and hotels, and in complex
manufactured goods like automobiles and computers. In fact, they are
probably typical rather than unusual. This phenomenon is widely
misunderstood, even among some economists, partly because the classical
formulation of economic theory has defined efficient markets as those
pricing at marginal cost and partially because price discrimination has
been most explicitly addressed in natural monopoly industries or industries
regulated due to some claimed market imperfection. Additional confusion
is caused by the fact that some of the techniques designed to extract
relatively more revenue from some classes of customers than others look
like traditional price discrimination (different prices for the "same"
product) and others work the same way by devising and using product
variations to segment markets. A better understanding of how widespread
the.-various forms of price discrimination are and their relationship to
competition will improve public policy and highlight gaps in existing
economic theory.

The Problem, Viewed Historically

In thinking about price discrimination, economists have historically
constructed the following argument: In a competitive market, price equals
marginal cost. Wherever there is price discrimination, price deviates from
marginal cost. Therefore, if there is price discrimination, the market must
not be competitive and there must be market power. In the historic
formulation, economists then often go on to say that, given that market
power already exists, price discrimination can be output-increasing and is

See for example the proposal of the U.S. Department of Transportation to regulate
competitive responses by airlines for the purpose of promoting competition to eliminate the market
power presumed to underpin high fares at hubs. 63 Fed. Reg. 17,919-22 (Apr. 10, 1998).

Yale Journal on Regulation

Vol. 19:1, 2002

therefore not necessarily bad.2 Indeed it is often desirable. However, there
is still a general assumption that the existence of price discrimination
implies the existence of market power.
In the hands of those who make economic policy, this formulation is
dangerous. Price discrimination is often unpopular, at least among those
paying the higher of the discriminatory prices. And the existence of market
power is inefficient, since it implies a state of the world in which it is in
the interest of producers to reduce output and distort price signals to
buyers compared to those that would prevail under competition. Thus,
political pressure generated by resentment of price discrimination is
usually expressed as calls for measures that eliminate the market power
assumed to underlie it. And given that perfect regulation is as rare as
perfect markets, those measures can easily produce results inferior to those
they were intended to remedy. This imperfect regulation is a particular
problem when the market power does not exist. Especially pernicious are
measures designed to eliminate the price discrimination itself, thus
attempting to ameliorate the effects of apparent market power by
controlling one of its symptoms. For reasons addressed below, these
measures almost always produce less efficient outcomes than the ones that
they were designed to change.
Note that the historic discussion depends heavily on the association of
price discrimination with market power (usually modeled as monopolistic
competition or oligopoly) and with the presumed inefficiencies that attend
it. But economists have long understood that price discrimination where
there is market power often enhances efficiency.3 In fact, it can alleviate or
cure the output-reducing incentives where market power exists. It is a
commonplace of economic theory that a monopolist who could perfectly
price discriminate would not reduce output and hence cause inefficiency (a
"welfare loss") although it would transfer wealth from consumers to itself
(which might have political or social effects that would prompt
intervention). And less-than-perfect price discrimination often, if not
usually, allows a monopolist to suboptimize by producing more output
An interesting beginning at making a systematic modification of this argument can be
found in the work of J.M. Clark, who explicitly associates price discrimination with efficiency in
normally competitive markets, but is unclear about whether market power is required to support it.

Katz disputes the conventional view, maintaining that price discrimination in
monopolistically competitive markets can be welfare reducing. M.L. Katz, Price Discriminationand
Monopolistic Competition, 52 ECONOMETRICA 1453-72 (1984).
Armstrong and Vickers use an innovative model-firms market utility directly to consumers,
abstracted from the products and services that provide it-to assess the welfare effects of various
forms of price discrimination in a wide variety of market structures, including effective competition.
They find that price discrimination in competitive markets generally but not always enhances utility,
but the exercise is an entirely abstract one. They provide no institutional structure or intuition as to
how the discrimination is generated or maintained. M. Armstrong & J. Vickers, Competitive Price
Discrimination,32 RAND J. ECON. 579 (2001).

Price Discrimination Without Market Power
than it would produce at a single price. But perfect price discrimination is
extremely difficult to accomplish in practice and unregulated pricediscriminating monopolists almost always price in ways that reduce output
and welfare compared to the results that obtain under competition.
Allowing price discrimination by these monopolists has generally been
described as a "less-bad" outcome than forcing a single-price solution, but
it has been generally assumed that at least some market power is required
to maintain a price-discriminating equilibrium.
In this Article I do not address the traditional line of argument,
although I am certainly in general agreement with it. Unlike that argument,
in this Article I do not seek to answer the traditional question, "given
market power, can price discrimination enhance efficiency?" Rather, I
address the question, "given price discrimination, can we assume market
power?" The assumption that we can assume market power wherever we
find price discrimination underlies much of the literature of competition
A typical example linking monopoly power and price discrimination
can be found in a recent Special Report of the Transportation Research
Board to the U.S. Congress supporting an evaluation of competition policy
in the airline industry.' Referring to airline price discrimination as a form
of Ramsey Pricing, 6 a long-accepted variety of beneficial price
discrimination, the Report states, "In the long term, sustaining such a
pricing scheme usually
requires government regulation or monopoly
power to bar entry.",

The conventional view that price discrimination implies market power is summarized in
H. Varian, Price Discrimination, in I HANDBOOK OF INDUSTRIAL ORGANIZATION 599 (R.
Schmalensee & R. Willig eds., 1989), which states, "First, the firm must have some market power." In
a later article, Varian discusses the application and welfare implications of price discrimination in
industries with declining or very low marginal costs. H. Varian, Differential Pricingand Efficiency, at
http://www.firstmonday.dk/issues/issue2/different/index.html (last visited Dec. 3, 2001). However, he
is ambiguous about the competitive conditions required for maintaining discrimination. He seems to
suggest that this discrimination is limited to situations of quasi-public goods or services with unusually
high ratios of fixed to variable cost, whereas this Article argues that the existence of significant
common costs and resulting discriminatory pricing is the norm in markets in which there is no market
Most economists would agree that, if market power could be eliminated without negative side
effects, doing so would be a superior policy alternative to allowing a monopolist to price discriminate.
See infra note 25.


Yale Journal on Regulation

Vol. 19:1, 2002

Modem Developments of the Theory

In the last decade, work by economists has extended the concept of
price discrimination to situations where there is no market power.8 Baumol
posits a case where single-product firms have differently shaped cost
curves, requiring that efficient production be shared between them in an
equilibrium that requires price discrimination (but not pricing above
marginal cost). 9 Prescott' ° and Eden" have observed that price
discrimination and price dispersion can occur in a competitive
environment. Associated with this kind of price discrimination can be a
price dispersion equilibrium in which competitive firms all charge
discriminatory prices, but the mix of prices varies among firms. Dana has
extended this model to airline capacity management under uncertain
demand and has noted the apparent paradox that as the industry he studied
(airlines) became more competitive, price dispersion apparently increased.
At the same time, he notes that there are other discriminatory features of
airline pricing under competition that apparently have their genesis
elsewhere. He characterizes his framework as, "too simple to satisfactorily
explain airline or hotel pricing, but nevertheless informative.' 2 Dana
extends the analysis further-still under uncertain demand-to cover
"yield management" systems that allocate seats to different customers at
different times and at different prices and finds that there are many
circumstances under which this is efficient. He then warns "the model...
serves as another warning against the use of price dispersion or yield
management as evidence of price discrimination or market power." He
further points out that "policy makers should consider other evidence of
market power before concluding' 3 that behavior that appears to be
discriminatory is anticompetitive.'

In an explanation of discriminatory equilibria that reaches a result
analogous to the one reached here but focuses on supply rather than price,
Earlier, Borenstein postulated that price discrimination can exist under zero-rent
conditions of monopolistic competition with fully separable costs. I am making a more general claim
here, since I assert that the phenomenon can exist even when firms are price-takers and that it is linked
to the recovery of common costs, the more usual case. (In contrast to the other work cited here,
Borenstein has difficulty proving an equilibrium, but uses empirical techniques to suggest that his
result is robust). Severin Borenstein, Price Discrimination in Free-Entry Markets, 16 RAND J. OF
ECON. 380 (1985).
William J. Baumol, Predationand the Logic of the Average Variable Cost Test, 39 J.L. &
ECON. 49, 65-69 (1996).

E.C. Prescott, Efficiency of the NaturalRate, 86 J. POL. ECON. 1129 (1975).

Benjamin Eden, Marginal Cost Pricing When Spot Markets are Complete, 98 J. POL.
ECON, 1293 (1990).
James D. Dana, Advance Purchase Discounts and Price Discrimination in Competitive
Markets, J. POL. ECON. 395, 396 (1998).
James D. Dana, Using Yield Management To Shift Demand When the Peak Time Is
Unknown, 30 RAND J. ECON. 456, 473 (1999).


Price Discrimination Without Market Power
Carleton argues that transaction costs may make it less than optimal to
clear markets at a single price when there is stochastic (random and
unpredictable) variation in demand among purchasers.' 4 Fluctuations in
demand may make it difficult or impossible to find a single price that
efficiently recovers costs that persist from one period to another (a form of
common costs). In that situation, a producer may choose a price that
recovers total cost under certain demand states and avoid taking on new
customers while rationing demand among existing customers according to
their presumed or learned demand characteristics. In this situation, a
discriminatory supply equilibrium analogous to a Ramsey price
equilibrium can exist as a way of recovering costs common to more than
one period.
In another article that addresses an aspect of the phenomenon6
addressed by this Article, Klein" has argued in the context of the
antitrust case that the existence of a tying arrangement designed to
segment customers' use was neither inefficient nor evidence of market
power on Kodak's part. He argues that many firms face sloping demand
curves but do not have market power in any ordinary or useful sense of the
term, and that they segment customers by varying product characteristics
and availability.17 He goes on to provide a rationale for Kodak's practice
of tying its customers to Kodak spare parts that does not depend on market
power. Klein rejects the historic definition of market power, noting that
even if product heterogeneity and branding give firms negatively sloped
demand curves, they still do not have the power to earn rents. He
concludes that no useful definition of market power depends on firms
facing the horizontal demand curve of a wheat farmer, who loses all her
sales if she prices above the market price. In an extended discussion of the
relationship between market power and pricing discretion, he cites with
approval Judge Easterbrook's formulation that market power consists in
"the ability to cut back the market's total output and so raise price."' 8 That
definition captures what seems to be the only necessary condition for
market power, and I will adopt it for this Article. 9


Dennis W. Carleton, The Theory of Allocation and its Implicationsfor Marketing and

IndustrialStructure: Why Rationing Is Efficient, 34 J.L. & ECON. 231 (1991).

Benjamin Klein, Market Power in Antitrust: Economic Analysis after Kodak, 3 SUP. CT.

ECON. REv. 44,71-85 (1993).

Eastman Kodak Co. v. Image Technical Servs., Inc., 504 U.S. 451 (1992).
This argument is developed in an earlier and particularly lucid exposition by Richard

Craswell & Dr. Mark R. Fratrik, Predatory Pricing Theory Applied: The Case of Supermarkets vs.
Warehouse Stores, 36 CASE W. REs. L. REv. 1 (1986).
Ball Mem'l. Hosp. v. Mut. Hosp., Inc., 784 F.2d 1325, 1335 (7th Cir. 1986).
The formulation preferred here is: "The unilateral or collusive power to effect total
industry output of a good or service."

Yale Journal on Regulation

Vol. 19:1, 2002

III. A More Comprehensive Explanation
I argue in this Article that it is possible to extend the basic thrust of
these modem results to a very broad set of circumstances. It is my
contention that, contrary to the standard formulation, price discrimination,
in the sense of price differences unsupported by identifiable cost
differences, is typical even in competitive industries in the real world.
While price discrimination can be associated with and used to exploit and
sustain market power, much or most of it is not itself an indicator of
market power.
Price discrimination without market power and a price dispersion
equilibrium can occur without the special production cost functions
postulated by Baumol, without the transaction costs, information costs,
product heterogeneity, location, and other impediments to perfect
substitutability described by Craswell and Fratrick in their article on
predatory pricing 0 and by Klein, and without the uncertainty of demand
modeled by Carleton and by Dana. These are important characteristics of a
real-world economy and are very widely found, but there is yet another,
perhaps even more nearly universal, underpinning to the phenomenon of
price discrimination without market power. Price discrimination and a
price dispersion equilibrium very often occur in competitive markets as a
way of recovering costs common to producing more than one unit of a
good or service. These costs may be common to simultaneous production
or common to production over time. 2' In these instances, price
discrimination is simply a way of distributing the burden of common costs
among customers in the least output-restricting way.22 In a competitive
market, all producers of goods or services involving substantial common
costs will need to adopt discriminatory prices or product strategies to
Common costs are sufficiently widespread that the existence of price
discrimination alone can never be taken as evidence of market power,
which needs to be inferred either from structure or conduct independent of
market segmentation. Accordingly, even where price discrimination
generates complaints, it should not be the basis for efficiency-justified
regulatory intervention based on the market power supposedly associated
with it.

Craswell & Fratrik, supra note 17, at 1.
As used here, "common costs" means costs which are either "fixed" (or "sunk") or
variable costs necessarily incurred in a way which is common to more than one unit of output, whether
of the same product or not.
The logic of this is entirely consistent with Dana's "capacity conserving" rationale.

Price Discrimination Without Market Power


ClassicalModels Do Not Adequately Reflect the Impact of Common

In addition to the demand uncertainty and impediments to perfect
substitutability discussed above, economists have had difficulty applying
the classical model of perfect competition to a world that has obstacles
(temporal or physical) to perfect separability of costs. At the same time
that they note the presumed efficiency of marginal cost pricing,
economists also regularly note that marginal costs are often indeterminate
and that marginal cost pricing, while efficient, may not allow the recovery
of various forms of common costs. 23 Since the recovery of total costs is
necessary to sustain production in the absence of government intervention,
this presents a problem.
There is a substantial literature devoted to this problem focused on
declining-cost industries (that is, industries in which average unit costs
decline with greater total output over the entire relevant range). These
industries will never recover total cost if they price at marginal cost. A
variety of solutions was urged historically, from subsidy and government
ownership-which then had better reputations than they have today-to
multipart pricing. The solution usually advocated now is one or another
form of multipart pricing 24 or Ramsey pricing, 25 that combines multiple
prices with some form of rent limitation through regulation, rent extraction
by taxation, or rent redistribution by a combination of the two.
Ramsey pricing is a form of price discrimination by which a natural
monopolist can increase output and cover total costs without collecting
monopoly rents. In Ramsey pricing, consumers are charged prices that are
derived in inverse ratio to the slope of their demand curves, and a total
revenue constraint is imposed to prevent monopoly profits. Higher prices
are charged to those consumers with relatively inelastic demand curves
and lower prices to those with more elastic demand curves. The common
and sunk costs are recovered in greater part from those consumers paying
the higher prices. In a perfect world using this pricing, no consumer
willing to pay marginal cost or more would ever be priced out of the
market and the producer would recover the inframarginal costs of
production.2 6
Ramsey pricing is regarded as benign and preferable to alternatives
because the declining cost structure of the industries for which it is

See R.H. Coase, The Marginal Cost Controversy, 13 ECONOMICA 169 (1946).
For an excellent short exposition of Ramsey Pricing, see William J. Baumol, Ramsey
See id.

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