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Email Event
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Professor William Baumol shows how regulators can be misled by oversimplified economic theory. For example, it is generally recognized that perfect competition is an artificial construct that rarely is approximated in reality. Yet it is sometimes treated as an appropriate guide to regulators, threatening to yield damaging rules. For example, since discriminatory pricing is incompatible with perfect competition, such prices are said to prove monopoly power. Yet many markets with discriminatory prices are very competitive. Baumol shows that effective competition does not impose uniform prices and demonstrates a stronger result: Where competitive pressures prevail, they can force all firms to adopt discriminatory prices if consumer arbitrage is difficult. This radically different picture of competitive markets helps to explain the near ubiquity of discriminatory pricing in reality and indicates limits to the use of discriminatory pricing as a justification for regulatory intervention.
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5:00 p.m.
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Registration
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5:15
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Welcome:
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Robert W. Hahn
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AEI-Brookings Joint Center
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Lecture:
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Professor William Baumol
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New York University
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Princeton University
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6:30
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Wine and Cheese Reception
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7:00
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Adjournment
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September 2005
How Regulators Can Be Misled By Simplistic Theory
On September 22, Professor William Baumol of New York University and Princeton University delivered the 2005 AEI-Brookings Joint Center Distinguished Lecture.
Robert W. Hahn
AEI-Brookings Joint Center for Regulatory Studies
Robert Hahn introduced Professor Baumol, noting his accomplishments in economics. Hahn described Baumol as an economist who can develop elegant theory and then explore its practical implications. Hahn went on to describe some of Professor Baumol’s most influential work, such as “Baumol’s Cost Disease,” “Optimal Departures from Marginal Cost Pricing,” and the “Efficient Component Pricing Rule.”
William J. Baumol
New York University and Princeton University
Professor Baumol started by noting the standard definition of perfect competition, which implies zero economic profit and marginal cost pricing. He explained that such a situation is hardly “perfect”: no economic profit leaves little reason to innovate, and in Baumol’s view innovation is capitalism’s gift to growth.
Professor Baumol then moved on to the heart of the lecture: his theory that competitive markets can include price discrimination, and moreover, that firms will need to price discriminate. He gave examples of firms operating in competitive markets that routinely price discriminate, like the airline industry, even though introductory economics teaches that only monopolies price discriminate.
Baumol then described the conditions under which competitive firms will be forced to price discriminate. Price discrimination in markets with zero profits will occur when firms face low barriers to entry, can separate consumers into groups with different demand elasticities, and can prevent consumers from transferring goods to each other. In such markets, firms will separate consumers to extract rents, differentiating, for example, between business and leisure airline travelers. Because entry barriers are low, however, challengers enter and profits return to zero. This process iterates until firms can no longer separate consumer groups, and the firms become price takers, not price makers. The equilibrium prices, while different across consumer groups and therefore price discriminatory, must be those with zero profits, and firms will not be able to move from these points.
Baumol concluded his lecture by addressing how regulators are misled by simple theory. His theory implies that because price discrimination can and even must occur in some competitive markets, regulators should not use price discrimination as proof of monopolistic behavior. He said that regulators ought to investigate monopolies, but regulators must not use simplified economic theory, such as the claim from introductory economics that price discrimination only occurs under monopolies. The consequences of following standard simplistic theories could hurt innovation by punishing firms deemed to be bad actors when, in fact, they may have been simply operating competitively in a competitive market.
AEI research assistant Joel Wertheimer prepared this summary.
