(This is another script for a forthcoming weekly rant. Recycling disclaimer.)
“Personalized pricing” is in the news. Companies use big data to figure out what you’re willing to pay and charge accordingly. Politicians are already passing laws to ban it and the Federal Trade Commission is threatening action, as usual, before understanding the phenomenon. Economists call it “price discrimination.”
Here is one of the hardest-to-swallow theorems in economics: Perfect price discrimination is efficient. And price discrimination is necessary to pay fixed costs.
Suppose an ice cream shop can charge each of us the maximum that we are willing to pay. Want a chocolate Sundae? The store peers in to your data, and figures out you’ll pay $7.53. You pay $7.53. They know I came in yesterday, so they can only charge me $5.22. I pay that. Suppose the marginal cost is $2.72 — just the store’s cost of ice cream. When someone walks just willing to pay $2.73, he gets that price.
The store sells the same amount of ice cream as they would if they charged everyone $2.73, the same as perfect competition. That’s economic efficiency. The amount of ice cream sold is not “distorted” by monopoly. Pricing power is only economically inefficient if the store restricts output to raise the price.
It seems massively unfair, doesn’t it? The store has sucked all the value — all the “consumer surplus” — out of the transaction. Still, “fair” is a squishy concept. If the store doesn’t charge someone more than marginal cost, the store can’t pay rent, taxes, advertising, employees, benefits, R&D, and all the other fixed costs. There wouldn’t be a store at all. Isn’t it fair that those of us who really like ice cream should pitch in a little more to keep the store in business?
Personalized pricing raises profits, sure. But you and I are stockholders too, though our pension funds and corporate taxes if not directly. Profits come back to us. They are at worst a transfer to those with more stocks. But if you’ve been following my rants at all, you know that economics says, don’t transfer income—especially tiny amounts of income—by mucking with efficient prices.
Fixed costs pervade today’s economy. Software is free after billions of development costs. Drugs and electronics are close to it. Filling an empty airline seat is nearly free. But nobody wants to pay the fixed costs. So, much of our economy and our politics are a big haggle over who pays inflated prices to cover fixed costs, and who gets to negotiate (or coerce, in the case of government) a lower price and make someone else pay more.
Now two limits. First, we only need enough price discrimination to pay the fixed costs, and to give discounts to those only willing to pay small amounts. The basic economy ticket at marginal cost matters for efficiency, not how much each seat in business class costs. Additional price discrimination is just more profit — not distorting, but not beneficial either.
Second, price discrimination is only efficient if it is costless. Most of our economy is instead one giant game of price discrimination by needless complexity, or “signaling.” You get a lower price by wasting time and effort to signal that you’re the low-value consumer. Credit cards, frequent flyer miles, airline tickets, hotels, cell phone contracts, prescription drugs, health insurance, discounts, sales, loyalty programs all seem one big trip back to a 1950s Chevy dealer. All that haggling is a waste. So the optimum is some messy middle ground where price discrimination is enough to pay the fixed costs, consumers still get a lot of benefit, and we don’t overdo the haggling costs.
The insane complexity of taxes and social programs is part of the game. To really want to squeeze tax revenue, then hit harder those not willing to devote time and effort to avoiding taxes. Filling out lots of forms and standing in line selects for those who really need help.
There is then a theoretical argument for regulation, though I doubt our regulators are competent to sort this out. And everyone hates it so much, firms have a pretty good incentive not to overdo it. Notice that shopping for cars has gotten easier over time, haggling at stores has disappeared, and sellers avoid the appearance of price-gouging.
In that context, though, personalized pricing by AI and big data could be a lot more efficient than all the games we go through now, since it’s basically costless. Maybe regulators should encourage it!
I hate it all. I’m the lazy shopper who ends up paying high prices. Still, as an economist, I have to admit there is a reason for it. Economics is sometimes hard to swallow.
In the meantime, crank up your AI agents, VPN, and anonymous browser to fight against the personalized pricing software. Or like me, curse, pay the bill, and get back to enjoying your life.
"It seems massively unfair, doesn’t it?"
It does, and I think the reason is that we evolved in bands of 40 that shared and have those preferences in us. If somebody got fat then it was evidence of cheating! We get fat now, but we're still on the lookout for cheaters.
In public, and that includes AI and the government, I'm afraid that a completely different phenomenon is subsumed under price discrimination, and that is peak load pricing, or dynamic pricing in the argot du jour. And that is completely efficient. It lands the cost of capacity with those who use capacity!
This is, of course, correct as far as it goes. But there is a huge information asymmetry. The vendors know about us in great detail. But we don’t know much about what other sellers might be willing to sell for. That is why it feels unfair. We can’t find a market price, and we often have to just be price takers at prices that are most likely above market. At least, those are the ones that make people angry.