Wednesday, 24 June 2015

The Why Axis, and the fairness of economic discrimination

Earlier in the year I read the Uri Gneezy and John List book "The Why Axis: Hidden Motives and the Undiscovered Economics of Everyday Life". I was looking forward to reading this book, and in general it was very good. The authors use their own field experimental research to demonstrate how incentives can be structured to change behaviour (among many other things). Field experiments are one of the most exciting recent developments in economics (and I've talked about some of John List's research briefly before). However, there was one section of the book that I took issue with, which is to do with 'economic discrimination'. Here's what they say on pages 116-119, in a section titled "Economic Discrimination: A Rising Problem":
...another variety of discrimination is on the rise today... Economists call this different kind of prejudice "economic" discrimination, and though it is more subtle than bigotry, homophobia, or sexism, it is increasingly widespread, multifaceted, difficult to parse, and often quite nefarious. And it's based entirely on financial self-interest and "looking out for number one."
You are probably already aware of economic discrimination because it shows up in your bills. If you are a smoker, your medical insurance may cost you more because, economically speaking, you run a higher risk of contracting diseases that cost a lot to treat. If your credit rating isn't stellar, banks will charge you more for loans because you present a comparatively higher risk of defaulting on them.
Another very straightforward example is car insurance. If you are a male driver, you pay as much as 20 percent more for car insurance than a woman does for identical coverage. You might wonder if this unequal treatment is illegal, because civil rights laws clearly state that discriminating on the basis of arbitrary characteristics such as race and gender is illegal. On average, however, women have fewer driving accidents than men. The costs of insuring women are therefore less than for insuring men, so the courts have ruled that charging women lower - or men higher - rates is legal...
 But, you may ask, what is really wrong with this kind of discrimination? After all, in the real world, customers often pay different prices. Anyone who has bought an airline ticket, booked a hotel room, or rented a car has faced such economic discrimination... If you are a well-heeled businesswoman who needs to fly from Chicago to San Francisco for a quick one-day meeting, you may care less about the price than if you are a teenager on a tight budget. Why shouldn't the airline charge you, the businesswoman, more?
Gneezy and List are essentially arguing that offering different prices to different customers is unfair, noting that "most people believe that this type of behavior is unfair". I'm not sure to what extent most people do believe this is unfair, but Gneezy and List argue that it is particularly unfair when customers don't know that they are paying a different price to others. Their solution is that we, as consumers, should arm ourselves with as much information as possible, including knowing what data companies have collected about us and how they are using that data.

However, I disagree that economic discrimination (in the form of different prices for different customers) is a problem. In fact, the obvious alternative (the same price for all customers) may be more unfair. And I'm going to use Gneezy and List's own examples from the quotes above to explain why. Before I do that though, I need to distinguish two reasons why consumers may pay different prices.

First, consumers may pay different prices because there are genuine differences in the cost of providing the goods or services to different consumer groups. Consumers who are high-cost pay higher prices than consumers who are low-cost. Women typically pay more for haircuts than men because women's haircuts take longer (usually) than men's, which means more time and staff costs for the hairdresser. Similarly, from the examples above (and as Gneezy and List note), young male drivers pay more for car insurance than young female drivers. Women have fewer accidents and are therefore less costly to insure than men, so women pay lower car insurance premiums than men. If both men and women paid the same insurance premiums, then women would pay more for insurance than they do now, and men would pay less. This is a great deal if you are a young male (like the boy racer from my post earlier in the week), but a pretty poor deal if you are an older women driver. Women drivers would effectively be cross-subsidising men for the men's worse driving behaviour. It's hard for me to see how the non-discriminating solution is fairer than the economic discrimination.

Second, consumers may pay different prices because of price discrimination - where different consumers (or groups of consumers) are charged different prices for the same good or service, and where the difference in price does not arise because of a difference in cost. For price discrimination to work, you need to meet three conditions:
  1. Different groups of consumers (a group could be made up of one individual) who have different price elasticities of demand (different sensitivity to price changes);
  2. You need to be able to deduce which consumers belong to which groups (so that they get charged the correct price); and
  3. No transfers between the groups (since you don't want the low-price group re-selling to the high-price group).
Consumers who have relatively elastic demand for the good or service will then pay a lower price than consumers who have a relatively inelastic demand for the good or service. This is the reason why, for example, students pay a lower price for movie tickets than general admission. Because the cost of a movie ticket takes up a higher proportion of the income of a poor student, students have relatively elastic demand for movie tickets (compared with the general public). Movie theatres can easily tell them apart from the general public (because students have a student ID card), so are able to use price discrimination to set a lower price for students.

Similarly, the businesswoman travelling from Chicago to San Francisco (in the example above) has few substitutes for the day or time of the flight (she needs to be there at a specific time on a specific day), so has relatively inelastic demand for a ticket (compared to a teenager on a tight budget who has more flexibility over their travel dates). So the businesswoman would pay a higher ticket price than the teenager for the same airline ticket. If all travellers paid the same ticket prices, then the teenager would pay more for their airline ticket than they do now, and the businesswoman would pay less. This is a great deal if you are the businesswoman, but a poor deal if you are the teenager on a tight budget. The teenager would effectively be cross-subsidising the businesswoman, who is clearly willing to pay more for her ticket. Again, it's hard for me to see how the non-discriminating solution is fairer than the economic discrimination.

So, as much as I admire the research of John List in particular, I can't agree with the authors on their point about economic discrimination. To me there are a number of cases where discriminating on price is actually fairer than having one price for all.

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