In a recent episode of Marginal Revolution University, George Mason's Tyler Cowen relates a curious anecdote to explain the principles of price discrimination and arbitrage.

Price discrimination means charging different prices to different consumers for the same product. It most often occurs when a monopolist has an opportunity to increase profits by charging higher prices to consumers with a more inelastic demand for its product (because the higher price won't greatly affect how much they buy) and lower prices to consumers with a more elastic demand (because they are more sensitive to price).

For example, the chemical company Rohm and Haas produced one kind of plastic that had uses both in industry and in dentistry. The plastic had lots of substitutes in industry but few substitutes in making dentures, meaning that industrial users had an elastic demand curve for it (because they could get cheap substitutes elsewhere) and dentists an inelastic demand curve (since they could not).

Given these two markets, what did Rohm and Haas do? It charged an average of $0.85 per pound to industrial consumers and $22 per pound for use in dentures, maximizing profits in both markets.

But with a huge price difference, an arbitrage opportunity was created. Entrepreneurs started buying up the plastic from industry at the low price and converting it to make plastic for dentures, resold near the high price. As the two markets started to blur, the effective price difference started to converge, hurting profits.

R&H had a simple solution: poison the industrial plastic so that people would stop using it to make dentures. As Cowen tells it, they eventually decided that was too risky and decided to simply spread a false rumor that they had contaminated the industrial plastic with arsenic — effectively stopping the arbitrage and separating the two markets without the risk of hefty lawsuits.

What does this have to do with ethanol and gasoline?

The government heavily subsidizes corn ethanol for use as fuel in cars, but because ethanol is exactly the same kind of the alcohol as that found in alcoholic beverages, it is possible to convert it to make alcoholic drinks, while capturing the subsidized price.

The government's solution? Require ethanol to be poisoned.

This is actually not the first time the government has poisoned alcohol to discourage arbitrage.

In 1906, the government started requiring that industrial alcohol be "denatured" (mixed with chemicals to make it undrinkable) to avoid paying taxes on spirits. After Prohibition began, bootleggers started acquiring industrial alcohol and hiring chemists to "renature" it to make it drinkable again.

The government then ordered that more aggressive poisons be used.

According to Slate's Deborah Blum,

Stolen and redistilled alcohol became the primary source of liquor in the country. So federal officials ordered manufacturers to make their products far more deadly. By mid-1927, the new denaturing formulas included some notable poisons — kerosene and brucine (a plant alkaloid closely related to strychnine), gasoline, benzene, cadmium, iodine, zinc, mercury salts, nicotine, ether, formaldehyde, chloroform, camphor, carbolic acid, quinine, and acetone. The Treasury Department also demanded more methyl alcohol be added — up to 10 percent of total product. It was the last that proved most deadly.

Thousands died as a result — a rather grim lesson in arbitrage — but it still makes an interesting econ story.

Check out the full episode below (the relevant parts begin around the 4:10 mark) and see the rest of MRUniversity's lessons for free here.