Milking consumers for every penny they have

Erik Nelson

For all the credence economists are given in industrialized countries, it might seem odd that modern capitalist societies often refuse to act upon economists’ findings. Growth models, whether on the national or household level, show that savings and investment are necessary for robust growth. Yet most governments and many first-world households overconsume and run increasingly higher deficits.

Economists have shown that lump-sum taxation – taxing everyone the same amount no matter their wealth or consumption levels – is the least distortionary tax. Yet, all modern economies continue to tax income, consumption and savings. Economists have also noted that government subsidy programs – Medicare, welfare and various agricultural programs in the United States, for example – often create inefficiencies in economic systems and argue that many social program objectives can be met using less distortionary, market-based tools. Yet, Medicare is poised to receive the biggest benefit expansion in its history.

Economists’ findings are sometimes not implemented in modern economies for very good reasons – lump-sum taxation is not fair; a privatized medical insurance system for seniors could see service failures as health-care companies looked to improve profits. Yet, the trend is clear: Industrialized societies are heeding economic reasoning more and more. Economic principles and theories, especially those related to free-market economics, are increasingly being used throughout governments, industries and households. Proponents of infusing the U.S. economic system with more market-based principles contend such a move could dramatically improve the U.S. economy and increase consumer satisfaction. But buyers beware; savvy businesses are increasingly using economic principles that will, in fact, reduce consumer satisfaction and, for many consumers, be seen as unfair. In this case, the incorporation of basic economic theory into our economic system will prove to frustrate many Americans.

The economic principle that an increasing number of businesses are using is variable pricing, otherwise known as discriminatory pricing. This practice has been crudely used by several businesses for years, including American-based airlines. Airlines have two types of customers: business flyers who are willing to pay large amounts of money for the convenience of making last-minute flight arrangements and no flight re-strictions, and budget-conscious travelers who are willing to buy tickets long in advance and agree to restricted travel. Therefore, airlines offer two basic ticket prices for the same flight in order to satisfy both types of demand – the high-and low-willingness-to-pay types – and maximize profits.

Many businesses have not used discriminatory pricing for several reasons. If a business cannot relatively cheaply determine the types of customers it has, the types’ demand for the products, and the types’ willingness to pay for the products, a discriminatory pricing scheme can lead to suboptimal profits. Further, businesses have avoided discriminatory pricing schemes because they can confuse customers and could be construed as unfair by some customers. Therefore, many businesses have traditionally offered one price for a good.

For many consumers the use of one price can create large amounts of welfare or consumer surplus. For example, a film buff might have been willing to pay $100 to see the premier screening of The Matrix Reloaded but the movie house charged only $8 – in this case, the filmgoers’ net benefit, or consumer surplus, is $92.

Yet many businesses are now implementing aggressive discriminatory pricing schemes, and looking to sop up the welfare or surplus that formerly went to consumers. Businesses cite increasing global competition and the data-analysis capabilities of an increasingly wired business world as reasons for this shift. For example, an entrepreneur in England is using a unique discriminatory pricing scheme at the movie theaters he owns. Tickets for his theater can only be ordered online, and the first few seats are offered at much reduced prices, but as demand for a particular showing increases and seats become scarcer, ticket prices quickly rise. While this theater owner might not capture all the consumers’ surplus welfare, the consumers who pay for tickets priced above the previously offered single price are losing surplus they previously retained. In this case it pays to shop early, but if the theater owner knows beforehand that a movie will be popular or that a particular ticket buyer is a diehard fan of a certain genre or film series – gleaned from Internet consumer profile data – prices could be customized so it exactly matches a consumer’s willingness to pay, thus completely extinguishing the consumer’s surplus. Expect movie theaters like this to open in the United States soon.

Major League Baseball has begun to introduce discriminatory pricing. Knowing that die-hard Chicago Cubs fans would pay big bucks to see the historic match-up with the New York Yankees at Wrigley Field earlier this month, the Cubs organization sold seats at a 20 percent markup. The Cleveland Indians now charge a $5 across-the-board premium for 10 “showcase” games. The discriminatory pricing scheme in professional baseball is still crude, but it promises to get more exact as baseball clubs learn more details about their customers’ preferences.

As businesses get to know more about us via electronic networks and databases of credit cards, Internet profiles, etc., discriminatory pricing schemes will more accurately reflect our willingness to pay for a good; in fact, it might come to the point where we are offered individualized prices. Naturally, this exact price individualization is what economists call perfect price discrimination.

Increasingly, if something is in demand, popular or important to you, it is going to cost you more than it has in the past. Bargains – products that you are willing to pay a lot for but cost well below your willingness-to-pay price – will be harder and harder to find in a world of sophisticated discriminatory pricing. Far from being a boon to consumers, the implementation of this economic principle in our economic system has the potential to seriously reduce our welfare.

Erik Nelson is The Minnesota Daily’s editorial director. He welcomes comments at [email protected]