Price Discrimination and Buying a Car Print
Written by Michael Bar, PhD. Economics   
Sunday, 01 July 2007 10:19




Price discrimination is everywhere. Public transportation tickets are cheaper for senior citizens, supermarkets give discounts for members, movie theaters give discounts to students, and banks charge different fees from different customers and offer different interest rates on savings. Formally, price discrimination occurs when sellers charge different prices from different customers for the same good. But perhaps the place where price discrimination is the most common is in a car dealership - virtually no two customers pay the same price for the same car. Two questions arise:

  1. why do firms exercise price discrimination, and
  2. how can we, the customers, take advantage of it and save money on buying a new car.
In this article I will try to answer those questions.

Why do firms exercise price discrimination? Do movie theaters give discounts to students because they like students more than other customers? Basic economics reveals that there is a much more compelling reason for price discrimination - profit. Suppose that you own a movie theater and you need to decide how much to charge for a ticket from different customers. Further suppose that there are two customers: customer A, who is willing to pay at most $6 for a ticket and customer B who is willing to pay at most $10 for a ticket. It is clear that if you know how much they are willing to pay and you are permitted to discriminate prices, you will charge each buyer the maximum they are willing to pay (their reservation price). In this case your profit from selling tickets to these two customers will be maximized and equal to $16*.

Now suppose that the movie theater is not permitted to discriminate prices and you are forced to charge the same price from both customer A and B. In this case you need to consider two options:
  1. charging $6 from both, in which case both A and B will buy the ticket and your profit will be $12, or
  2. charging $10 from both, in which case only B will buy the ticket and your profit will be $10.
But notice that there is no way that the seller can get as much profit when he is forced to sell to all customers at the same price, as when he is permitted to discriminate prices. This example illustrates an important result in economics: sellers will always make higher profit when they are allowed to discriminate prices. There is an intuitive proof for this result. If a seller is forced to sell to all customers at the same price, this is a constraint on his freedom of action. The ability to discriminate prices is equivalent to a removal of that constraint. Imagine a runner who is forced to wear jeans while competing, versus a runner who is free to choose the most convenient running outfit; which one stands a better chance at winning?

In practice, sellers don't observe the customers' reservation prices (their willingness to pay), but they can distinguish between groups of customers with higher willingness to pay on average and low willingness to pay on average. Students and senior citizens often get discounts, because they have lower willingness to pay on average; they are similar to customer A in the above example. Sellers will try to identify groups of customers with different willingness to pay.

One popular way of discriminating prices is selling the products to different countries at different prices. When a U.S. pharmaceutical company sells drugs to the local market, it charges much more then for the same drug sold in Poland. At this point you should be able to tell why this is the case. That's right; because the average willingness to pay in Poland is lower (they are similar to customer A in the above example, simply because their average income is lower than in the U.S.).

Another popular way to identify groups of customers with different willingness to pay is using coupons and rebates. Customers with high willingness to pay don't care too much about coupons; it takes effort to find the coupons in newspapers or on the containers of products, and it takes effort to store and carry the coupons to the store and remembering their expiration date. The premise is that customers with low willingness to pay will go through the effort of bothering with coupons and rebates, while customers with high willingness to pay will not.

So let's summarize what we have learned so far:
  1. Sellers want to discriminate prices because they get higher profits doing that,
  2. Sellers cannot observe the willingness to pay of each customer, but instead are trying to identify groups of customers (students, senior citizens, those who bother with coupons and rebates, etc.) and try to sell at different prices to different groups of customers.
This is all interesting, but how does this knowledge help us to buy a cheaper car? Simple; if the car dealer thinks that you have a low willingness to pay, he will sell you the car at lower price.

One way to convince the dealer that you have low willingness to pay is to haggle or bargain for a long time. If the dealer sees that the customer is spending hours in the dealership, then he understands that this customer's time is not very costly and thus concludes that his willingness to pay is low. However, not everybody is good at bargaining, and we do not want to spend too much time. What can we do then? One technique that I found very efficient from my own and my friends' experience is to send an e-mail to dealers before arriving at the dealership.

Before buying a new car, I sent an e-mail to several dealerships, asking for a price quote. The very fact that you send an e-mail sends a signal to the dealer that you are making an effort to compare prices and therefore you are more likely to be low-willingness-to-pay customer (type A). If on the other hand, you walk directly into a dealership, the dealer will try to find out your willingness to pay. This is often a long and tedious process; the dealer will ask you a whole bunch of questions about where you are from, what do you do for a living, etc. A smart dealer will read your body language, trying to identify how patient you are and how desperate you are about buying the car now.

After I sent an e-mail to different dealerships, I got surprisingly large variety of prices for the same model of car; some of them were very attractive. I used my university e-mail, sending a signal that perhaps I am a student (which was the truth, I was in my last year of the Ph.D. program). The idea is to send a signal to the seller that your willingness to pay is not high, and surprisingly, without lengthy bargaining, this e-mail can save you thousands of dollars on buying a new car.

There is one more principle of economics that is at work here. Sending an e-mail to dealers changes the structure of trade from regular buyer vs. seller to an auction. When you send an e-mail to different car dealerships, you become an auctioneer and the dealers are the bidders who compete among themselves for the lowest price. In a sense, sending the e-mail prior to walking into the dealership, increases the competition among dealers. Such competition of course works in your favor.


* There are costs associated with running a movie theater, such as renting the place, cleaning, electricity, renting the movies, etc. But once these costs are paid, it doesn't cost the movie theater anything to accommodate two additional customers. So the revenue and the profit from selling two additional tickets to the above customers is the same.

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