Amazon's Super Saver Shipping as price discrimination

Last year I reviewed Brad Stone's book The Everything Store, about the rise of Amazon. At one point in the book, Stone talks about Super Saver Shipping as an example of price discrimination. Price discrimination occurs when a firm sells the same product to different customers for different prices, and where the difference in price doesn't arise from a difference in costs. In this case, Super Saver Shipping was made available for customers who were willing to wait a little longer for their goods to arrive, and they would end up paying a lower total price (once you factor in the shipping costs). So, essentially consumers were buying the same product, but some were paying more (and receiving the good faster) than others.

For price discrimination to work though, three conditions have to be met:

1. Different groups of customers (a group could be made up of one individual) who have different price elasticities of demand (different sensitivity to price changes);
2. The seller needs to be able to deduce which customers belong to which groups (so that they get charged the correct price); and
3. No transfers between the groups of customers (since the seller doesn't want the low-price group re-selling to the high-price group).

In the case of Super Saver Shipping, consider two groups of consumers (impatient, and patient), and two options (Super Saver Shipping, and standard shipping). The first group of consumers is impatient, and they want their goods as soon as possible. This group can be said to have a short time horizon for their purchases. This short time horizon makes their demand for goods less elastic (less sensitive to price), so Amazon can charge this group a higher price. The second group of consumers is more patient, and they are willing to wait. This group can be said to have a longer time horizon for their purchases, which makes their demand for goods more elastic (more sensitive to price). So, Amazon should charge the second group a lower price.

The problem here is that Amazon doesn't know (for sure) which group any particular consumer belongs to. So, adjusting the price of the goods themselves isn't going to work. Instead, by offering different shipping options, the customers sort themselves into the impatient (less elastic demand) group and the patient (more elastic demand) group. Then, Amazon can charge the two groups different shipping rates, meaning that the impatient group pays more in total for the product than the patient group pays.

This is an example of menu pricing (or second-degree price discrimination) - where the consumers are presented with a menu of options, and they select the one they prefer. Crucially, the seller knows that some menu options appeal to consumers with more elastic demand, and other options appeal to consumers with less elastic demand. In this case, Super Saver Shipping appeals to the impatient consumers, who have less elastic demand.

To see how this works in a bit more detail, and why Amazon should price differently for these two groups of consumers, consider the diagrams below. Both diagrams show a firm with market power (Amazon), and each diagram corresponds to one of the sub-markets. The sub-market on the left represents the patient buyers, who have more elastic demand - notice that the demand curve D1 is relatively flat (which means that a change in price will have a big effect on the quantity that these consumers demand). The sub-market on the right represents the impatient buyers, who have less elastic demand - notice that the demand curve D2 is relatively steep (which means that the same change in price would have a smaller effect on the quantity that these consumers demand, than it would for the patient consumers). The marginal cost (MC) is the same in both sub-markets - it doesn't cost Amazon any more to sell a product to an impatient buyer than what it costs them to sell that same product to a patient buyer. [*]

Amazon will maximise profits by selling the quantity where marginal revenue (MR) is equal to marginal cost (MC) - this is the standard short-run profit-maximising condition (as I discussed last week). In the impatient sub-market, the profit-maximising quantity occurs where MR2=MC, which is Q2. In order to sell that quantity in the impatient sub-market, Amazon should set the price equal to P2. The problem with that high price P2 is that in the patient sub-market, no consumers would be willing to buy the good at all. Amazon can increase profits if it charges a different price in the patient sub-market, from the price it charges in the impatient sub-market. In the patient sub-market, the profit-maximising quantity occurs where MR1=MC, which is Q1. To sell that quantity in the patient sub-market, Amazon should set the price equal to P1.

So, profit maximising across both of these sub-markets would require Amazon to sell to the patient sub-market at a low price (P1), while at the same time selling the same product to the impatient sub-market at a high price (P2). And Super Saver Shipping allows them to do just that.

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[*] Notice that we are drawing a constant-cost firm here (so marginal cost is equal to average cost, and all units cost the same to produce and sell). That makes our explanations a little easier than the case where marginal cost is increasing.