On September 22^nd, 2005 Professor William Baumol of Princeton University and New York University presented the AEI-Brookings Joint Center Distinguished Lecture.  His lecture was entitled, “How Regulators Can Be Misled by Simplified Theory.”

Robert W. Hahn

Executive Director of the AEI-Brookings Joint Center

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.

Baumol then moved on to the heart of the lecture: his theory that competitive markets can include price discrimination, and moreover, that firms will have 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.  His new theory shows that not only will there be price discrimination in certain competitive markets, but that the firms will be forced to price discriminate in some markets.

Professor 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, for example business and leisure airline travelers.  Because entry barriers are low, however, challengers enter and profits return to zero.  This process iterates until firms can not further 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 the title issue: 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 monopoly to prove that they are acting as 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.