Spending and Pricing to Deter Arbitrage

When a firm sells the same good in two markets at different prices but virtually no one in the high-price market purchases in the low-price market, the absence of arbitrage is typically attributed to exogenous “blockades,” never to deliberate “arbitrage deterrence.” Such deterrence may involve not only limit-pricing but also spending to raise the consumers’ cost of arbitrage. I present examples of arbitrage deterrence from three industries: pharmaceuticals, chemicals, and automobiles. Motivated by these three examples, I generalize the standard model of third-degree price discrimination to encompass both blockaded and deterred arbitrage. I also develop a model where the lower of the two prices is negotiated as is done by foreign governments in the case of prescription drugs. In both models, if the government raises the firm’s marginal cost of deterring arbitrage, the higher price will fall and the lower one will rise but the firm will continue to deter arbitrage. In the bargaining model, if the absence of arbitrage is mistakenly attributed to exogenous factors when in fact it is the result of deliberate deterrence, econometric estimates of the firm’s bargaining power will be biased upwards.