Price discrimination and investment incentives

a r t i c l e i n f o JEL classifications: F13 L42 L13 D92 Keywords: price discrimination investment parallel trade pharmaceuticals net neutrality We examine a model of a monopolist selling to two segments of consumers with different preferences for quality. We show that if the firm is unable to price discriminate between the segments, then there is less investment in quality. We find that both consumer segments, and society overall, may suffer if the firm is unable to price discriminate. We extend the model to duopoly competition, and find that our results still hold. The effect of price discrimination on social welfare has been a topic of interest among economists for a long time, at least since Pigou (1920), who conjectured that price discrimination decreases welfare if the total output decreases at the same time. In 1936, the Robinson–Patman Act was passed to disallow price discrimination in the intermediary markets in the United States, and price discrimination between consumers is routinely a source of public relations problems for companies. The central question we ask is how the ability to price discriminate affects a firm's incentives to invest in quality and, in turn, how this affects consumer and social welfare. We are concerned with markets where different segments of consumers have different valuations for product quality. Business travelers care much more about their flight landing on time than do leisure travelers on the same flight going for a week-long vacation with no particular plans. A sick patient who might have a tumor cares much more than a healthy person about the kind of MRI machine his hospital has. Hospitals and welders care about oxygen quality much more than oxygen-bar owners, and a business owner cares much more about her hard drive not failing than does a consumer with nothing irreplaceable on that hard drive. In such markets, firms must make both pricing decisions and investment decisions for quality, and their incentives to invest depend critically on whether they are allowed to price discriminate between the two segments. We study a model of a monopolist supplier choosing both quality and prices. The firm operates in a market where consumers have different preferences for quality. There are two segments: discerning consumers who care about quality and undiscerning ones who do not. We examine the firm's choices under two regimes: one in which the firm is allowed to price discriminate …