Always be a new customer - price discrimination and 'loyalty taxes'

Price discrimination is one of the most pervasive pricing practices that firms use. It involves the seller the seller selling the same product to different consumers for different prices, and where those differences in prices don't reflect differences in cost. Specifically, the seller should charge a higher price to consumers who have less elastic demand (consumers who are less price sensitive, and those who are less likely to go elsewhere), and a lower price to consumers who have more elastic demand (those who are more price sensitive).

Some of the examples seem really perplexing, until you think about them in terms of the price elasticity of demand. For instance, consider the example of Delta Airlines charging a higher price to its frequent fliers than to those who are not frequent fliers (one of my favourite examples to use in my ECONS101 class). That seems to make no sense, until you realise that frequent fliers are less likely to go elsewhere, because they want to keep accumulating air miles. That means that the frequent fliers have less elastic demand than other consumers do, and a price-discriminating airline should be charging them a higher price.

Given how common price discrimination is, I was interested to read this article in The Conversation last month, by Allan Feis (University of Melbourne), about what he refers to as 'loyalty taxes':

A “loyalty tax” occurs when discounts are offered to new customers while longer-term customers pay more. Often this involves increasing premiums at the first and subsequent renewals...

Our research last year showed, on average, customers renewing their insurance policy paid 27% more than new customers. Our most recent data indicates the gap has risen to 34%. This translates to hundreds of dollars for the average home and contents insurance policy.

Loyalty taxes appear to be widespread in Australia. The Australian Competition and Consumer Commission concluded from different pricing inquiries that loyal customers of both banks and energy providers end up paying more. It also demonstrated the price difference for insurance in northern Australian – with one insurer on average charging renewing customers 15-20% more than new customers.

In Britain, regulators have calculated that customers are, by their fifth renewal, paying about 70% more than a new customer. The Competition and Markets Authority estimates the total cost of loyalty taxes in five British markets – mortgage, savings, home insurance, mobile phone contracts and broadband – to be about £4 billion (about A$7 billion) a year.

Translating this British estimate to the equivalent sectors in Australia (taking into account differences in population and GDP), the cost to consumers could be as high as A$3.6 billion, or at least $140 a year per person. This estimate does not include the energy sector, where evidence suggests the practice of charging longstanding customers more is rife.

Loyal customers are, by definition, less likely to go elsewhere. Common sense suggests that companies should look after these customers, especially if the cost of acquiring new customers exceeds the cost of keeping existing customers (apparently, five times as much). However, maybe that heuristic is breaking down, especially if loyal customers are profitable in the short term, because their less elastic demand means that firms can charge them a higher price until they leave.

In my ECONS101 class, we also talk about customer lock-in, where customers find it difficult or costly to change provider once they have started buying from one. The cost might be monetary (such as a contract termination fee), or it could simply be the time and effort required to find a new seller. One way a firm can increase the number of locked-in consumers is to offer a low price initially. Once the consumers are locked in, it makes sense for the firm to raise its price to those consumers. This is referred to as multi-period pricing.

'Loyalty taxes', as described by Feis, cover both of these situations (price discrimination, and multi-period pricing). It is difficult for consumers to avoid the loyalty tax if it arises from multi-period pricing (especially if they are locked in by a contract termination fee), but less costly to avoid price discrimination, if firms are simply charging loyal and long-term customers a higher price.

The take-away message from this for consumers should be: make sure that you regularly change suppliers, for electricity, broadband, insurance, etc. If you're not locked in by a contract, you should be checking for alternatives on a regular basis (and there are government-provided services available to help, like whatsmynumber in the case of electricity providers in New Zealand). If the firms are only giving better deals to new customers, you should be aiming always to be a new customer.