The likes of Uber, Airbnb and other ecommerce platforms have re-energised discussion about price discrimination strategies. More recently, we have learned that the Queensland Performing Arts Centre is investigating so-called dynamic pricing, which it defines as:
The practice of varying the price for a product or service to reflect changing market conditions, in particular in times of greater demand.
At first glance, the notion of charging different prices for the same product seems to undermine the idea of fairness in the market. However, benevolent price discrimination does exist. Indeed, this article will go about demonstrating how price discrimination can be used to benefit consumers, producers, and even the environment.
Before we can talk about price discrimination, we must firstly look at the fundamental tension between sellers and buyers in the price-setting process. For any product, consumers will have a maximum willingness to buy and producers will have a minimum willingness to sell. A transaction will only take place when the consumer’s maximum willingness to buy is greater than the seller’s minimum willingness to sell.
The difference between a consumer’s maximum willingness to buy and the actual price paid represents the consumer surplus, or the consumer’s satisfaction with the transaction price. Conversely, the difference between a producer’s minimum willingness to sell and the actual selling price represents the producer surplus, or the producer’s satisfaction with the transaction price.
By virtue of differing circumstances and preferences, different consumers will not exhibit the same willingness to buy. For example, if John and Jill enter a bid over a bottle of water and John has just finished running a marathon, John may be willing to pay $10 while Jill may only be willing to pay the standard $2.50. If the vendor is aware of John’s higher willingness to buy, the selling option is clear; John wins out. However, what would have been $7.50 of consumer surplus to John has now been handed over to the vendor in the form of producer surplus.
Most price discrimination models seek to maximise revenue by charging higher prices to those who are willing to pay.
If the cost of producing a certain good remains the same over time and the seller charges different prices, this is known as inter-temporal price discrimination. Airlines are well known for such pricing strategies; the cost of flying is set at a certain price, but the actual price charged to the consumer changes drastically over different time periods. As Air Asia explains in a refreshingly honest manner:
Want cheap fares, book early. If you book your ticket late, chances are you are desperate to fly and therefore don’t mind paying a little more.
Regardless of the justification, this form of inter-temporal price discrimination is founded on differences in consumer willingness to pay. Consequently, the consumer surplus is replaced by gains in producer surplus. In other words, the consumer loses out.
But, what about scenarios where the cost of producing a good changes with the level of demand? Such a pricing strategy is known as peak-load pricing. Crucially, peak-load pricing models do not exploit differences in consumer willingness to pay. Instead, higher prices reflect the higher costs of production when the capacity to produce/supply is constrained. Thus, under such pricing models, neither the consumer nor the producer surplus can be improved.
Uber’s “surge pricing” mechanism is often regarded as an example of a peak-load pricing system. Indeed, Uber justifies its higher prices with the following statement on its website:
When a lot of people in the same area are requesting rides at the same time, trip prices might be higher than normal… You can wait a few minutes while more drivers get on the road, or you can pay a little extra to get a ride when you need it.
Arguably, the cost of transportation does not increase at 1am every night, and Uber’s “surge pricing” could be interpreted as an example of inter-temporal price discrimination. However, such an interpretation would disregard the greater minimum willingness of producers to sell their services at those times of the night. Alfred Marshall’s scissor metaphor does well to explain this interaction between supply and demand:
We might as reasonably dispute whether it is the upper or the lower blade of a pair of scissors that cuts a piece of paper, as whether value is governed by utility or cost of production.
Taking this into account, Uber’s higher prices do partly reflect the higher cost of production when the supply capacity is limited. Therefore, it can be regarded as a peak-load pricing system because higher “surge” prices are needed to bring out sufficient drivers (supply) to match demand.
Utility companies also use peak-load pricing to contain consumer demand within manageable levels of production. A few weeks ago, we published an article that spoke briefly about the negative electricity spot prices faced by CS Energy. As explained by CS Energy CEO Andrew Bills, such prices could be attributed to low demand (pleasant temperature getting people out of the house during the day), and high energy supply (44% of the electricity grid made up of renewable energy at some points in the day, and coal generators cannot easily be switched off).
If the inverse of this situation is to be considered – high demand and limited supply – then we are presented with a situation where energy operators are forced to increase prices. In Australia’s current context, expensive so-called peaking plants, typically gas, are switched on to cope with the excess demand that coal generators are unable to handle. Gas plants are able to switch on and off quite easily, but they run at marginally higher expense, which explains the added cost of producing energy when coal generators approach full capacity.
Recently, the Australian Energy Market Commission (AEMC) released a worrying report on the state of Australia’s energy grid. In particular, the report focussed on managing the integration of renewable energy in such a way that would benefit “consumers… innovation and competition”. One of the recommendations made to facilitate a smooth transition process was “live and more granular energy data… to assist consumers in managing their own energy usage”. At the core of this recommendation are peak-load pricing tools that would encourage consumers to use electronic appliances during less expensive parts of the day.
From this perspective, we can begin to appreciate how price discrimination can be used to assist not only the producer, but also the consumer and the environment.
This article was prepared by Ben Scott, Research Assistant, and Gene Tunny, Director, of Adept Economics. Please get in touch with any questions or comments to firstname.lastname@example.org.