Price Discrimination: You Paid What for This Ticket?

In a recent post, consumer advocate website The Consumerist detailed how wireless telephone provider Cingular chooses the discounts customers get when they are finished with their contract. The short version is that Cingular uses a ranking system called Life Time Value (LTV), which is a ranking of how much you spend. If you are a high LTV customer, you receive greater discounts than lower LTV customers. According to the documents posted on The Consumerist, Cingular says, “Some customers contribute more value to Cingular … we are most interested in keeping the most valuable customers.” Airline Ticket

Also found in the same set of documents is that Cingular calculates the “churn potential” of a customer. The idea here is that some customers are more likely to leave than other based on past history, number of other lines they have with Cingular, and other factors. This type of treatment makes sense on the part of Cingular as they want to keep their best customers and jettison customers who do not make them money. Also, customers that are more likely to leave will get better discounts than those who will stay. This type of pricing falls within an area of economics called price discrimination.

Briefly defined, price discrimination is the process of charging different buyers different amounts based on some identifying criteria about them. This behavior can happen when a seller has some ability to prevent the consumer from choosing from a different vendor who is selling a nearly identical product. A common example of price discrimination is the pricing of airline tickets which go at much higher prices to business travelers who must fly at certain times on certain days. Another example are student discount or senior citizen discounts which go to people who are simply willing to pay less than most consumers.

The essential idea behind price discrimination is that a vendor tries to determine the most a person is willing to pay and then charges them that amount. In practice, there are usually categories that different people fit into, and they pay the price for that category. For example, at the movie theater, the companies have decided that student, children, and seniors are less willing to pay the see a movie than adults, so they charge adults more than the other categories. In the case of airline tickets, airlines use cues such as whether or not you stay over a Saturday night, what days of the week you fly, and what times you fly to determine whether the company is paying for your ticket or if it is coming out of your pocket.

We can also see price discrimination at the movie theater in more subtle ways. Everybody wants to see a movie, and so we buy a ticket. Some people are willing to pay more than others, however, for the movie experience. The experience includes the ability to see the movie, eat the popcorn, drink the soda, and the likes. If all you are willing to do is pay $9 for the movie experience, you pay $9 and just go see the movie. On the other hand, if your willingness to pay is $25, the movie theater has created all sorts of opportunities to extract that extra $16 in willingness to pay by offering you popcorn, sodas, and cherry slushies.

How do vendors get away with this type of pricing scheme? Let’s take for example a good that is difficult to sell in a price discriminatory manner. Usually, these are goods with lots of substitutes, such as other vendors or similar products. A competitive good like this might be an apple. If I were a vendor, I can only charge one price for the apple because two things might happen: 1) The high priced customer will go elsewhere and 2) The low price customer will buy the apple and sell it to the high price customer at a slightly lower price than I was offering. Number two is called arbitrage, and it must be prevented in order for price discrimination to work. Airlines do this by making the name on the ticket match the name of the flyer. Movies do this my making it impossible for you to sell popcorn to others within the theater. The point is that some goods are better suited to price discrimination than other.

The next question is why do vendors do this? The simple answer is that it makes them more money. By being able to charge multiple prices they can capture business from all the customers who would not have bought at a higher price while still getting money from those willing to pay the higher prices. A corollary question is, is it fair for vendors to do this. That is a much harder question to answer, but I will make this one point people will buy something, be it a car, a movie ticket, or a plane ticket, only if they believe they are paying a fair price. Due to many different factors, what constitutes a fair price is not the same for any two consumers. What price discrimination allows businesses to do is charge a fair price to each and every one of us. In doing so, they are able to sell their product to more and more people. In other words, with out price discrimination plane tickets would cost more than they do now, and fewer people could fly. Under price discrimination, more people can afford to fly, even if they cannot afford to pay the high prices that business travelers do. Economists refer to this situation as efficiency. Price discrimination makes imperfect markets more efficient.

Coming back to the Cingular Wireless example. Sure it is not fun to be the one charged a higher price (by receiving a poor discount), but this is simply Cingular’s attempt at charging people their willingness to pay. On the other hand, they are not kicking any of this increased profit back to the consumer; they are keeping it for themselves instead. In the end, I guess, it’s like most problems in economics. Some people end up better off, and some people end up worse off, but we can make things as well off as possible by allowing the market to become more efficient.