I’d Unravel Every Riddle
Posted by Robert Whaples on October 8, 2009
Yesterday before class a student came to my office hours to ask a few questions about Chapter 12 of Cowen and Tabarrok, “Price Discrimination.” I said to her, “There’s a lot of interesting stuff in this chapter.” She replied, “Yes, a LOT of interesting stuff.”
While most introductory textbooks make the determination of prices a rather cut-and-dried, mathematical proposition, C & T explain the creativity that goes into the determination of prices — the immense amount of ingenuity on the part of sellers to figure out just the right price for each market and how to tweak pricing policy in order to grasp fleeting profits. Telling examples include arbitragers smuggling life-saving drugs back into their country of origin, airlines trying to deduce who will pay more, price differences between hardcover and paperback books, IBM slowing down one of its laser printers, the mystery of why ink cartridges are so expensive while printers are so cheap, why Microsoft bundles its software, cable TV pricing … the list goes on. The chapter offers up one insight after another, demonstrating the power of applying just a little economic theory in the right way. The chapter has only 3 graphs and two of them are essentially the same as a graph already explained in the previous chapter– the point being that the avalanche of insightful examples is what makes this chapter work.
At the end of class, I actually (briefly) broke out in song. (Several students had very skeptical looks on their faces — what is this guy pulling?). I watched The Wizard of Oz with my wife on Saturday night and explained to the class that I felt just like the Scarecrow — with useful economic theories like these, “I’d unravel every riddle for every individdle in trouble or in pain …”
However, I do think C & T went overboard in their example about price discrimination and Williams College. Their premise is that Williams — just like American Airlines, Hewlett Packard, or GlaxoSmithKline — aims to maximize profits. Since I teach at a private liberal arts college, we discussed this issue for about 5 minutes in class. Williams/WFU don’t have shareholders who get to claim their share of profits, so modeling them as profit-maximizers is iffy. What are private colleges trying to maximize, if not profits? My bet is that they are trying to maximize something akin to “prestige” — which is often fuzzy and oftener quite a bit different than maximizing profits. A college like mine has many more apllicants than spaces available, so it turns away a lot of people willing to pay list price while accepting many who pay far less and simultaneously refusing to expand output significantly. It’s hard to square this with profit maximization. How would the University of Phoenix behave in this circumstance?
Robert Whaples and the Modern Principles 
Alex Tabarrok said
Excellent riddle! So how could we distinguish (and test) a profit-maximizing college from a something else maximizing college? Would both price discriminate but in different ways? I would be happy to offer any student in your class a copy of the just published micro-macro hardback of Modern Principles for the best answer! And who knows perhaps this will show up in the second edition!
Best
Alex Tabarrok
James Rex said
Both colleges will price discriminate because this will increase their revenue. They will both use the same methods of price discrimination (using FAFSA and tax return forms), but they will differ their admission rates. If a college wants to gain prestige, they will reduce their admission rates to drive up their demand (increasing their prestige). If a college wants to be a profit-maximizer, they will have a high rate of admission. By having a high rate of admission and perfectly price discriminating, the college will have lower mean SAT/GPA/ACT levels, but higher revenue. Prestigious universities remain prestigious by limiting their admission and being selective in their entrants, thus boosting their SAT/GPA/ACT levels, implying their prestige (An interesting cause-effect analysis would be the discussion of whether Harvard is prestigious because of its education or its selectivity or both). By increasing prestige, colleges can boost their future endowment because firms will pay higher premiums for selectively chosen students. Students that attend profit maximizing colleges will have a tougher time receiving a high paying job [than students attending prestige-maximizing colleges] because of more students, which results in more competition for jobs, and thus lower wages. In the end, prestige-maximizing universities will boost their endowment by gaining prestige and thus will reduce admission and profit-maximizing universities will boost their revenue by increasing admission rates. Both university systems will use perfect price discrimination with their entrants, because it is the most efficient means of satisfying both consumer and producer.