Friday, February 10, 2012

Cigarettes, a case study in price discrimination (China vs. U.S.)

Economists predict there will be price discrimination when there is a monopolist supplier (or at least some degree of market power) and arbitrage between different groups of customers is costly. The United States tobacco market meets one of the two conditions - re-selling cigarettes without a license is barred by law - but the industry is still competitive between the large tobacco companies. In China, by contrast, both conditions are met because the China National Tobacco Company has a de facto monopoly on all cigarettes sold.

There is strong evidence of price differences between types of cigarettes sold in China. This paper by Li, et al, finds
...the price differential among brands is large. The self-reported cigarette price ranged from 0.70¥/pack to 100¥/pack, which gives smokers more choices in the price of cigarettes. In other words, Chinese smokers have more flexibility in choosing different prices of cigarettes than most Western smokers.
There are two, potentially complimentary stories to explain the wide difference in price of Chinese cigarettes. First is price discrimination to take advantage of different elasticities of demand between smokers; one person may value the marginal pack of cigarettes less than another. Charging lower prices for "inferior" brands of cigarettes will enhance monopoly profits, by selling a higher quantity at a lower price.

This type of price discrimination doesn't rely on direct knowledge about consumer preferences; the tobacco company can set a variety of prices, then smokers self-segregate according to their willingness to pay. Such a strategy would be less effective in the U.S. because cigarette taxes are so high, the relative price difference between brands is always comparatively small.

Another possibility is social signaling. In the United States, smoking is not a symbol of high status, in fact quite the opposite: it's more common that poor and uneducated people will be the ones who smoke. In China, gifts of tobacco are common and socially accepted, and expensive cigarettes are used to demonstrate affluence. By offering a wide range of prices for cigarettes, more different levels of social status can be signaled. One might expect that as general affluence in China increases, new forms of social signaling will become more popular instead.

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