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504 CHAPTER 12 CAPTURING SURPLUS

to how it stretches when it bears a load), making it es- to worry about resale if it sold aluminum externally
pecially useful in cables for bridges. Since other mate- at two prices. If it announced that cookware buyers
rials could not be substituted for aluminum in these could purchase primary aluminum at a low price,
uses, Alcoa knew that the demand for primary alu- every buyer (including makers of airplane wings and
minum was relatively inelastic for its sales to manu- cable) would claim to be a cookware manufacturer.
facturers of airplane wings and bridge cable. Even if Alcoa knew that a buyer made cookware,
In the manufacturing of other products, the ad- what would prevent that buyer from reselling the
vantages of aluminum over other materials are less aluminum at a higher price to a maker of airplane
important. For example, aluminum can be used to wings?
make pots and pans. But so can copper, steel, or cast To prevent resale, Alcoa decided to make alu-
iron. Given these substitutes for aluminum, Alcoa’s minum pots and pans itself (that is, it integrated for-
demand for primary aluminum in making cookware ward into the cookware business). It could then pro-
was relatively elastic. vide aluminum to its own cookware manufacturing
Alcoa wanted to use third-degree price discrimi- division at a low price. It did not sell primary aluminum
nation by selling aluminum at a high price to cable to any external buyers at the low price. Its only exter-
and aircraft manufacturers and at a low price to mak- nal sales were at high prices. By vertically integrating,
ers of cookware. However, Alcoa knew it would have Alcoa could price discriminate and prevent resale.

SCREENING
Have you ever wondered why businesses, such as movie theaters, airlines, urban mass
transit authorities, and restaurants, often give discounts to senior citizens and stu-
dents? One possible answer to this question is that this form of price discrimination
helps businesses capture more surplus. 14 Most students and many older people, par-
ticularly those who are retired, live on limited incomes. Both students and senior cit-
izens typically have more free time to shop around than many people who work full
time. Consequently, senior citizens and students often have relatively elastic demands
for goods and services. The inverse elasticity pricing rule therefore suggests that busi-
nesses ought to set prices lower for these consumers.
Businesses often use observable characteristics, such as age and student status, as
screening A process for screening mechanisms. Screening sorts consumers based on consumer characteristics
sorting consumers based on that (1) the firm can observe (such as age or student status) and (2) that are strongly
a consumer characteristic related to other consumer characteristics that the firm cannot observe but would like
that (1) the firm can see to observe (such as willingness to pay or elasticity of demand). For example, the movie
(such as age or status) and theater manager would like to see the consumer’s elasticity of demand or willingness
(2) is strongly related to a
consumer characteristic to pay when he walks up to the ticket counter, but she cannot observe that informa-
that the firm cannot see tion directly. If she were to ask the consumer how much he would be willing to pay,
but would like to observe he might lie, knowing that the manager might charge a higher price if he reveals that
(such as willingness to pay he has a high willingness to pay.
or elasticity of demand). However, the manager can observe characteristics such as the consumer’s age or
student status. Most students and senior citizens have more elastic demands, so the
manager can set lower prices for these consumer segments. To prevent arbitrage, the
manager can require the consumer to present an identity card to verify age or student
status when the consumer enters the theater.

14 There are surely other reasons to offer discounts to senior citizens and students. For example, regulators
of urban mass transit systems may view a lower price for these consumers as a socially noble objective,
perhaps as a means of creating more purchasing power for deserving sets of consumers.