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Anti-Competitive Impacts of Secret Strategic Pricing in the Electricity Industry

Fortnightly Magazine - February 15 1997

monopolies and dominant firms discriminate most deeply and systematically. Firms with large market shares, or other sources of market power, usually sell across widely varying types of customer groups, and often will attain deep, thorough price discrimination. These firms can reap large profits by this sharp discrimination, and so the discriminatory pricing becomes

an important profit-maximizing activity.

In contrast, firms with small market share and a minimum of market power usually will be able to discriminate only on a limited basis. These firms have customers that easily can shift to other suppliers. The competitive constraints of small-market positions set tight limits on how widely and deeply the small-share firm can successfully vary their price-cost ratios among customers.

In fully competitive markets, price discrimination is entirely beneficial. It is simply the stream of flexible discounting that all firms continually use in order to win customers and try to gain market share.

However, in a market where one firm dominates, price discrimination has different, more powerful impacts that tend to reduce competition, not promote it.

Discrimination functions as a dynamic competitive device. A dominant firm's pricing variations respond to (em and can anticipate (em the varying competitive pressures for its diverse customer groups. Dominant firms simply do what is natural: They cut specific prices so that the lowest price-cost ratios go to the customer groups where competition is sharpest, because that is where the demand is most elastic.

As economists and regulators have known for more than a century, discounting by dominant firms or monopolies will meet or undercut the rivals in the more intensely competitive parts of the market. At the same time, the firm skims off higher price-cost margins from its more "captive" customers, who have lower demand elasticities.

When small-share firms do it, such pricing is benign and pro-competitive. When monopolies or dominant firms do it, the whole effect is to suppress competition.

Although every firm tries to apply the discriminatory pricing as much as it can, the discrimination usually tends to suppress competition only when it is done by dominant firms.

This array of discriminatory, pin-point pricing (em adjusted and sharpened as events proceed (em tends to quell or kill specific rivals in market niches.

In this light, anyone can assess the impacts on the market by considering just two relatively direct and objective conditions: market share and thoroughness of discrimination (see figure 1). Discrimination becomes anti-competitive when it is done by firms with high market shares, and is thorough and systematic. In contrast (em and this is important (em discrimination is usually pro-competitive when it is done by firms with small market shares, sporadically and briefly.

A dominant firms's resort to dynamic strategic price discrimination always will pose dangers to moving the firm toward effective competition. As its high market share faces competitive attacks, the firm seeks systematically to apply strategic discrimination in order to retain or even increase its dominance. It is all quite natural, predictable and inevitable. The action proceeds over time, often in a dynamic, dramatic sequence. As part of its whole strategy, the firm may