The European Union''s (EU) prohibition of price discrimination by dominant manufacturers is beneficial for the economy as a whole and particularly for small retailers. That is the conclusion of new research by Fabian Herweg and Daniel Müller, published in the June 2014 issue of the Economic Journal.

Their study provides a theoretical underpinning for the EU''s current legal treatment of quantity discounts offered to retailers by manufacturers – that is, to regard them as a justifiable strategy as long as they are not discriminatory in the sense of applying different conditions to identical transactions with different trading partners.

The researchers note that with manufacturers often negotiating different wholesale conditions with different retailers, price discrimination is an almost ubiquitous business practice in vertical supply relationships. But it is deemed illegal under European competition laws if the manufacturer has a dominant position – that is, if it has a relatively high market share compared with its competitors.

Recent economic research has suggested that the EU''s legal treatment of price discrimination by dominant manufacturers is undesirable from a social perspective. But the new study shows that this criticism is not justified if retailers are better informed about downstream demand conditions or retailing costs than the manufacturer.

Whether the effects of banning price discrimination are desirable – for example, reducing prices for final consumers – has been discussed by legal and economic scholars since the 1930s without reaching a firm conclusion. Recent research suggests that it is detrimental from a social perspective and typically leads to higher prices for final consumers if the wholesale contracts negotiated by a dominant manufacturer with its retailers feature quantity discounts, which typically is the case in practice.

The main result of the new research is that this conclusion is incorrect in most cases if the manufacturer is at an informational disadvantage compared with its retailers with regard to the demand conditions downstream or the costs of retailing.

Engaging in price discrimination is profitable to the manufacturer because it makes it possible to extract rents from its retailers more effectively by adjusting wholesale contracts according to the idiosyncratic characteristics of each retailer. Under price discrimination, retailers on average pay higher wholesale prices to the manufacturer and thus on average obtain lower profits.

This reduction in retailers'' profits is the main driver of the idea that price discrimination is welfare-harming. But the effect of price discrimination on prices faced by final consumers is more ambiguous.

Whether the manufacturer engages in price discrimination also has a direct impact on retailers'' incentives for cost-reducing process innovations or demand-shifting advertising. When engaging in price discrimination, the manufacturer adjusts the supply conditions of a retailer according to the latter''s investment.

In other words, price discrimination allows the manufacturer to extract the rents generated by retailers'' investment more effectively than non-discriminatory contracts. But this reduces retailers'' incentives to invest in cost reduction or marketing in the first place. Hence, price discrimination destroys the investment incentives of retailers and therefore – typically – reduces overall welfare and consumer surplus.

Earlier research argued in favour of discriminatory – retailer-specific – quantity discounts because these kinds of tariffs can completely eliminate the problem that the manufacturer charges a mark-up on its costs and the retailer charges an additional mark-up on the wholesale price plus its own cost (''double marginalisation'').

If the retailers have private information regarding retailing costs or downstream demand, retailer-specific tariffs cannot fully eliminate the double mark-up problem. In this case, as the new study shows, the negative effect of price discrimination on overall welfare typically outweighs the positive effect of a mitigated double mark-up problem.

The researchers therefore conclude the EU''s current legal practice regarding price discrimination by dominant manufacturers is, by and large, beneficial for overall welfare and in particular for small retailers.

''Price Discrimination in Input Markets: Quantity Discounts and Private Information'' by Fabian Herweg and Daniel Müller is published in the June 2014 issue of the Economic Journal. Fabian Herweg is at the Ludwig-Maximilian-University of Munich and Daniel Müller is at the Rheinische Friedrich-Wilhelms-University Bonn.