Input Market Price Discrimination and the Choice of Technology

Abstract

Recent concerns over the effects of the Robinson-Patman Act' and so-called priceprotection policies such as most-favoredcustomer clauses (MFC's)2 on market performance have given economists new reasons to examine the welfare effects of third-degree price discrimination. In order to assess these effects correctly, it is imperative that one understand how price discrimination influences market behavior. Joan Robinson's (1933) work launched the formal inquiry into the welfare effects of third-degree price discrimination. Building on the intuition presented by Arthur Pigou (1932), she showed that, if a monopolist faces two independent linear demand curves, the use of price discrimination will not affect industry output but will reduce welfare. Richard Schmalensee (1981) extends these results to nonlinear demand curves and shows that an increase in total industry output is a necessary condition for price discrimination to be welfare improving. Hal Varian (1985) broadens these results by deriving upper and lower bounds on the welfare change due to the use of price discrimination. He shows that these results can be applied to markets in which there are nonzero cross price effects. All of this work examines how the ability of a monopolist to price-discriminate will affect the market outcome when all other characteristics of the market are treated as exogenous. Recently, two lines of research have extended this inquiry beyond the case of a monopolist in a market with exogenously fixed parameters. The first line considers the case of oligopoly. The work of Charles Holt and David Scheffman (1985) and Thomas Cooper (1986) has shown that restrictions on price discrimination imposed by the use of MFC's can facilitate collusion between oligopolists attempting to restrict output. This implies that third-degree price discrimination can be welfare-improving. The second line of research shows that price discrimination by a firm can affect nonprice decisions made by other market participants, thus affecting the market outcome. Michael Katz (1987) presents a model in which a large firm's ability to vertically integrate backward into the production of an input allows it to obtain a lower per-unit price from the supplier of the input than can be obtained by smaller firms without this ability. He shows that third-degree price discrimination reduces welfare unless it prevents inefficient backward integration. DeGraba (1987) shows that the use or nonuse of price discrimination by a national firm can affect nonprice decisions made by local firms that compete with the national firm. In this situation, third-degree price discrimination is welfare-reducing, because it induces local firms to produce a product that is overly differentiated from the product of the national firm. In all of the work cited above, price discrimination is important when sellers set prices in separate markets or charge different prices to different customers in the same market. The following analysis (which can be considered a contribution to the second line of research) suggests that price discrimination can be important even when a seller faces a single market in which all customers are identical. The intuition behind this result is that nonprice decisions made by downstream producers (such as the choice of technology) can be affected by the use or *Johnson Graduate School of Management, Cornell University, Ithaca, NY 14853. I thank Robert Frank, Robert Smiley, Richard Thaler, and the participants of the JGSM applied microeconomics workshop for their helpful comments. 'See William Baldwin (1987 pp. 438-40) for a good summary of the debate. 2See John Kwoka and Lawrence White (1989 pp. 196-7).

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