Customer loyalty and price discrimination

This week in ECON100 we discussed price discrimination - where firms charge different prices to different customers for the same product or service, and where the price differences don't reflect differences in cost. There are three necessary conditions for effective price discrimination:

1. Different groups of customers (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 customers 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).

If these conditions are met, then the firm would sell to groups with relatively more inelastic demand at a higher price than to groups with relatively more elastic demand. Which brings me to this Wall Street Journal article from earlier this year, about the insurance market:

Some car insurers hope to identify people who could potentially be their best, most loyal customers–and charge them more for their insurance.

Wait... what? Surely firms should charge lower prices to their most loyal customers, to reward their loyalty, right? However, the article continues (emphasis added):

Or so contend consumer advocates who track the insurance industry, who say the practice discriminates against low-income drivers and should be forbidden. They maintain that insurers are wrongly seeking to maximize their profits with an advanced analytical technique–known as “price optimization”— under which the companies identify consumers least likely to comparison shop and stick them with higher prices than more price-sensitive drivers. While insurers are targeting policyholders across a range of demographic groups, the activists say many lower-income people fall into that camp.

This is clearly a form of price discrimination, even though the industry sources quoted in the article argue otherwise. If you are an insurance company, you want to charge the customers who are most price sensitive a lower price. If customer loyalty is associated with customers who don't shop around, then customer loyalty is also associated with customers who are less price sensitive. Meaning that you want to charge those loyal customers a higher price.

Now you might argue (as the regulators are in this case) that this price discrimination is unfair. That would put you in good company (with John List, see my post here). The article notes:

A big concern among consumer advocates like Mr. Hunter is that poorer people may not shop around as much as others, because they may have fewer choices for insurance coverage to start with, and they may not have the Internet access that makes it increasingly easy for many Americans to get price estimates online.

However, then the case in favour of price discrimination starts to break down. Where car insurance premiums take up a higher proportion of a consumer's income, their demand should be more elastic. This will offset the price-insensitivity associated with being a loyal customer. And then of course you have pricing based on risk (which is what the insurers are arguing they are really engaging in).

Given all this, if firms are engaging in price discrimination (which they probably are) I would expect to see, for customers at the same level of risk:

• Loyal customers who have higher incomes paying the highest premiums;
• Loyal customers who have lower incomes, and less-loyal customers with higher incomes paying moderate premiums; and
• Less-loyal customers with lower incomes paying the lowest premiums.

It seems to me that helping low income people to shop around for insurance might be a good thing for those consumer advocates to be engaging in, rather than complaining about price discrimination.