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What’s the price?

Internet companies are playing with charging different prices for the same thing depending on who you are. Is that a problem?

Prices are a funny concept. We unthinkingly treat them as if they are a physical attribute of an item — like the weight or the height. To some extent that is not even so crazy. Even if we know that they can be a bit fuzzy, we’ll have an approximate idea of what something costs (certainly for stuff we buy regularly), and so what we’re prepared to pay. Or do we?

In his 1983 paper Transaction Utility Theory, behavioural economist Richard Thaler describes a thought experiment that goes something like this. You’re on the beach on a hot day with only iced water to refresh you, and for the last hour you’ve been imagining a nice cold bottle of your favourite beer. Your friend next to you gets up to make a phone call (this is 1983!) and offers to bring you a beer from a place close to the phone box. But of course, beer at the beach might be expensive, so he asks you the maximum price you’re prepared to pay, and promises to only buy you a beer if it costs no more than your limit (which economists call the reservation price). What would you be willing to pay?

When it was stipulated that the only place selling beer was a fancy hotel, people were on average willing to pay $2.65; when it was a small, run-down grocery store, their average limit was just $1.50 (1983 prices of course). Thaler points out that this is inconsistent with standard economic theory. There is no material difference between both situations that would explain the difference, let alone one of this size.

So, we don’t really know the value of a beer — nor of pretty much everything else we regularly, or seldom, buy. Prices are emergent. In an individual transaction both parties may bargain until they settle on a price that both are happy with (and there is a whole range that would qualify). In a larger market, economists talk of the market clearing price, the price at which supply and demand are exactly equal.

This bugs suppliers, though. Obviously, at this equilibrium price, those for whom it is too high will not buy. But there are lots of people who would be prepared to pay more than the market price, but who don’t need to. The supplier is leaving money in the customer’s pocket.

So inventive sellers come up with ways to separate price sensitive customers from those with a higher reservation price. Three decades ago, for example, it was rumoured that companies supplying both computer equipment and medical systems used to charge a hefty premium for PCs for hospitals, simply because they were painted white instead of the drab Pantone 413 beige that was the norm back then. That may be a tall story, but one industry that has long been successfully using price discrimination instruments is airline travel.

An aeroplane is essentially a bunch of seats flying from A to B. And yet the people whose bums are on those seats may have paid a price that differs by a factor 20 or more. Low cost airlines correctly assume that people who need to fly at short notice will be prepared to pay more. So prices start low if you book months in advance, going up as the date of travel gets nearer. Premium airlines offer different classes (while often the seats are exactly the same), but more importantly, they try to distinguish cheapskate tourists from business travellers with deeper pockets by restricting cut-price tickets for travellers staying a weekend.

Cheap and expensive seats — can you tell which is which? Picture: StelaDi CC0]

One company (no longer in existence) was even more creative. GetGoing.com asked you to pick two different destinations. You didn’t know which of the two you’d be flying to until the moment you paid. This kind of offer would clearly only sensible for a price-sensitive holidaymakers, with no risk that even the most astute among people prepared to pay full whack would snaffle a huge discount. This is also why you see student or senior citizens’ discounts, reduced-price train tickets for families and so on.

Now with big data, of course, companies can simply rely on user profiles to figure out whether we’re a tightwad or a big spender. Amazon was exposed as early as 2000 using cookies to set the price according to whether you were a regular or a new customer. They apologized and vowed never to test prices based on customer demographics. But even if Amazon is lying low in this respect, others have happily been playing around with price discrimination, according to a study by Christo Wilson and others at Northeastern University.

Most recently, Uber (who else?) has been in the news again, as they too are looking to charge you what they think you’re willing to pay. And perhaps Amazon too is back dabbling with price discrimination, as economist Cyril Morong wonders, looking at their latest move in their battle with Walmart where they offer a discount to their Prime service if you are receiving government assistance.

Do those who cry foul at this kind of manipulative trickery have a point? Few people seem to have a problem with more conventional forms of price discrimination. On this basis, the criticism of more modern approaches seems a bit inconsistent.

That may be the case, and perhaps it is indeed economically sensible, rational and perfectly legitimate for companies to seek ever more sophisticated ways to channel as much of the economic surplus of a transaction into their coffers. That is not without danger though. Misguided as the suspicion of consumers may be, a company that is seen as manipulative and devious risks losing its reputation, and its customers to the competition.

But what if the competition too resorts to ever cleverer price discrimination methods? Will we eventually all pay our reservation price for everything we buy?

It is unlikely we will get to that point any time soon. A Bloomberg article about Uber’s latest ploy hints at ways in which riders can fool the algorithms that try to guess our willingness to pay: feed it confusing signals. Open the app at random and check prices, even if you have no intention to ride — just to make yourself look price-sensitive.

We consumers are on the whole a reasonable and tolerant lot. We don’t mind a bit of advertising, and we’re OK with websites using cookies — even if it is to help companies make more money. But when we think this kind of stuff is going too far, we strike back. In with the ad blockers and with our browser’s private mode to prevent sites tracking our moves.

And so it is more generally with the experience we get from internet companies. It’s great that we can take a ride with Uber, but any company that underestimates the resourcefulness of people who feel they’re actually being taken for a ride does so at its own risk and peril.

Originally published at koenfucius.wordpress.com on June 16, 2017.

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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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