(credit: Timothy Takemoto CC BY)

A fair price for everyone

Fairness is an important feature in our society. But is a fair price a fixed price, which is the same for everyone?

For billions of years, life on this planet has been subject to the iron law of the zero sum. Any resource that was appropriated by one organism was automatically unavailable for any other one. Win-lose was the name of pretty much every game — what you won, I lost and vice versa — until our distant ancestors discovered trading, and with it the ‘win-win’ concept. But there is something that complicates matters.

At the heart of every transaction are two key variables: willingness to pay (WTP), and willingness to accept (WTA). If you have something I would like, and the maximum I am prepared to give you in return (my WTP) is greater than the minimum you will take for it (your WTA), we can do business. The difference between my WTP and your WTA is the economic surplus, a measure of the wealth that is being created by the transaction. It doesn’t matter exactly how it is shared: together we are better off after the transaction than before. This is almost miraculous — it is the closest to a true perpetuum mobile humanity has got so far.

Determining our WTP seems simple enough. In mainstream economics, it should reflect the perceived value to us, the worth we attach to what we aspire to buy. Even if we do not perform a full cost-benefit analysis every time, we typically operate a kind of internal benchmark that tells us what would be a reasonable price. We should therefore be able to establish our WTP independently, without referring to anyone else.

But often that perceived value is not the only thing we consider. We also want a fair price. And to ensure that is the case we do need information about others — other buyers, and indeed the seller.

Imagine you had run out of milk and you popped over to the corner shop. By coincidence, your neighbour is just behind you with exactly the same problem. You pay for your milk (your WTP is greater than the shopkeeper’s WTA, so it seems a fair price). But as you put away the change, you notice that your neighbour is charged 20% less than you — for the same pint of milk. All of a sudden, the price you happily paid a minute ago no longer looks so fair.

Identical milk, identical price, that’s fair (image: Zeyus media CC BY)

This is the kind of issue that Robert Frank, an economist at Cornell University, takes great interest in. His book, The Economic Naturalist, has an entire chapter devoted to situations where different buyers pay different prices for the same thing, and he has recently been tweeting on the same subject.

Is it fair that some people pay less than we do? Unfairness is, ultimately, in the eye of the beholder, but there can be sound economic reasons why sellers would want to sell their wares at different prices to different people.

We all have different limits to what we are willing to pay for say, an airline seat or a pair of shoes, and that causes sellers headaches. If they fix a high price (= their WTA), they will make a handsome margin on each item sold, but only customers with an even higher WTP will buy. So they risk being left with unsold stock shoes or seats, and with a total income insufficient to cover all their costs. If they fix the price low enough, there will be enough buyers to purchase all the stock, but now the margin on each item is much lower. So the total income may, again, not be enough to cover their costs. There is no guarantee that there is a fixed price in the middle that will produce enough revenue to offset the cost, but even if there is, there will be unsold seats and shoes — and that is inefficient.

A more efficient approach is to sell at a higher price to people with a higher WTP, and at a lower one to people with a lower WTP. But then sellers must prevent the high-WTP customers from buying at the lower prices. Frank calls this hurdle pricing — the customer must jump a metaphorical hurdle to benefit from the low price. For airline seats, it may mean that you need to stay a weekend (which is not suitable for many business travellers), or that you need to wait until the last minute, and risk not flying if the flight is full; for shoes it may mean that you need to sit tight until the end of the season when the remaining stock is sold at sale prices — if a pair is left in your size.

Such hurdles can take strange shapes. Frank relates an anecdote in which he had reserved a hotel room a few weeks ahead of time for $200. As he checks in, he spots a sign inviting people to “ask about our special rates”. So he does, and the clerk tells him he can have the room for $150. Is this the lowest hurdle imaginable — just ask, and get 25% off? Why doesn’t everyone do so?

This is where we see how economics and psychology are really quite closely related. Who is most likely to ask about the best rates? Price sensitive patrons, who probably would not take the room at the standard $200 rate, but who might well do so at $150. It is better to have some such guests paying the lower rate, than to have no guests at all — a full hotel is more efficient than a partially empty one. Well-off patrons are not so price sensitive, and might not want to signal that they care about a discount, so they are much less likely to enquire. Business travellers, who can claim back their expenses, even less so — there is nothing in it for them. And curious economist with a high WTP like Frank are rare, so that is not a big worry.

Another remarkable vignette in the book is that of white goods retailers hammering dents in their cookers and fridges. Appliances with cosmetic damage, but otherwise in perfect condition, are often sold at mark-down prices — but why would they be deliberately damaged? It’s the hurdle again: make sure well-heeled customer pay the full price. They will prefer an unblemished item, while those with a lower WTP won’t be too bothered by a little dent or scratch.

All of this makes good economic sense. Sellers can get the buyers with a high WTP to cover the bulk of the fixed cost or the product development cost, and make the same product available at a lower cost to people with a lower WTP. As long as there are enough hurdles to jump, few people will consider it unfair (although some might raise their eyebrows at the deliberately damaging of products).

Prices expressed in °C? <image: Bun Oshita CC BY>

But consumers have little interest in economic efficiency if it comes at the expense of fairness — as they perceive it. About 20 years ago, Coca-Cola was planning to install vending machines that sensed the outside temperature, and raise the price of an ice-cold drink when it was hotter. The outrage was predictable. Such unfairness! A company taking advantage of thirsty people on hot days, to boost their profit!

Was it really such an unfair idea? The standard economic rationale often used to justify differential pricing is that the drinks will go to the people who get the most utility out of them, as they are prepared to pay the higher price. But Frank gives us a much more compelling reason. Demand for cold drinks is much higher on hot days — maybe twice as much. To meet that demand, the supplier either needs to install a larger, more expensive machine to hold enough stock for these peak times, or must replenish it more frequently. This represents extra cost, and ironically the fairest way of covering it is by charging those people who are the cause of it: the drinkers on the warmest days. (Note the parallel with congestion pricing on the roads.)

That is not how consumers see it, though. Coke’s plan was shelved, and its then CEO did not survive for long. Robert Frank concludes his Twitter thread, seemingly a little wistfully, by pointing out that it is a mistake to celebrate Coke’s decision to abandon the idea under consumer pressure. Instead, he appeals to economists to explain more clearly why differential pricing of this kind is no more unfair than the differential pricing between one steak and two steaks.

Until then, companies will need to recover the excess cost in another way — in this case, by charging more on ordinary days to absorb the extra cost on hot days. The fairness of this is imaginary, but the price we all pay for it is very real.

Originally published at http://koenfucius.wordpress.com on April 19, 2019.

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Accidental behavioural economist in search of wisdom. Uses insights from (behavioural) economics in organization development. On Twitter as @koenfucius

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