Price discrimination in input markets.

We analyze the short- and long-run implications of third-degree price discrimination in input markets. In contrast to the extant literature, which typically assumes that the supplier is an unconstrained monopolist, in our model input prices are constrained by the threat of demand-side substitution. In our model, the more efficient buyer receives a discount. A ban on price discrimination thus benefits smaller but hurts more efficient, larger firms. It also stifles incentives to invest and innovate. With linear demand, a ban on price discrimination benefits consumers in the short run but reduces consumer surplus in the long run, which is once again the opposite of what is found without the threat of demand-side substitution.

1. Introduction

* According to the extant theory on price discrimination in input markets, more efficient firms should pay a higher price. Consequently, more efficient firms and not their less efficient, smaller competitors should lobby for a ban on price discrimination. This implication follows from the common assumption of a monopolistic supplier, which optimally charges more efficient, larger firms a higher wholesale price. (1)

More efficient firms should, however, also have more attractive alternative options. We show that the presence of a viable threat of demand-side substitution reverses the results from the existing literature. More efficient firms now receive a discount compared to their less efficient rivals. A ban on price discrimination would thus only be welcomed by less efficient, smaller firms.

We also show that a ban on price discrimination may benefit consumers in the short run, although in the long run it tends to reduce consumer surplus and welfare through stifling firms' incentives to invest and innovate. Intuitively, although this represents only one of the identified mechanisms, under price discrimination a firm that grows through becoming more efficient will additionally benefit from the subsequently obtained larger discount. For the case of linear demand and without demand-side substitution, the extant literature has obtained instead that a ban on price discrimination increases investment incentives, as it then becomes harder for the supplier to hold up downstream firms.

Our model and results accord well with the objectives that are typically pursued when passing bans on price discrimination, such as the famous Robinson-Patman Amendments to Section 2 of the Clayton Act, namely to protect smaller or otherwise weaker competitors. (2) Our findings also support the common belief that by protecting weak competitors, the imposition of uniform pricing tends to reduce efficiency in the long run.

The case where a monopolistic supplier faces no threat of substitution may be relevant in industries where, given their choice of technology, intermediate firms become highly locked into a relationship with a particular supplier. Likewise, it may be applicable to natural monopolies. Note, however, that an unconstrained monopoly position is not a necessary prerequisite for a firm to fall under the relevant antitrust provisions that prohibit or restrict price discrimination. All that is needed is that the respective supplier is to a sufficient extent shielded from effective competition. Furthermore, mandatory provisions in regulated industries, in particular in network industries, also apply to firms that do not enjoy (or no longer enjoy) a monopolistic position. (3)