By Karl Smith
By Adam Ozimek
Arnold Kling writes “that price discrimination really deserves a lot more attention than it gets in the economics curriculum. A lot of 'economic naturalist' sorts of questions are correctly answered by appealing to the concept of price discrimination”. Contrary to Arnold, I think price discrimination gets too much attention. Economists are quick to cite price discrimination and market power as an explanation when the same product sells for more than one price, when in fact cost differences are often driving the different prices.
Arnold’s George Mason colleague Russ Roberts, and coauthor John Lott, argued this case persuasively in a 1991 paper in which they use several case studies to show how variable prices that are commonly explained by price discrimination are actually better explained by cost differences. In the spirit of Roberts and Lott, I’ll try to offer a cost based explanation for “Black Friday” sales.
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.
Arnold might counter that the discounts observed on Black Friday are too large to be accounted for by decreasing average overhead costs by a factor of 3 or 4, thus the cost theory cannot explain such deep discounts. However, not all goods are discounted. Assume that volume increases four-fold on Black Friday, and thus overhead costs decrease by a factor of four. If overhead costs normally add 4% to the total price of a good, then on Black Friday overhead costs only needs to add 1% to the total price of a good in order to cover costs. This means all goods can sell at a 3% discount. However, if the cost savings are used to discount only 10% of the goods in the store, then each discounted good can be discounted by 30%.
This explanation has the benefit of requiring no market power for the stores. Given the wide range of stores that discount on Black Friday, and my skepticism that so many everyday retailers have significant market power, I find the cost explanation more believable.