Why Teslas are like paperback books

Tesla has lowered the price of its cars. This New Zealand Herald article from earlier this month asks whether it is because of flagging demand or a tactic to boost sales:

In explaining why Tesla Inc keeps cutting prices on its electric vehicles, the auto industry is pretty much divided into two camps.

On one side are analysts who see an aggressive move by the leading manufacturer of EVs to gobble up sales and market share from its competitors just as they’re beginning to bring more vehicles to market.

On the other side are critics who argue that with demand for Tesla’s older vehicles beginning to wane, the company feels forced to slash prices to attract buyers.

Over the weekend, Tesla cut the prices of its two costliest vehicles by between US$5000 and $10,000, or 4.3 per cent to just over 9 per cent. A Model S two-motor sedan now starts at US$89,990, with the Plaid “performance” version beginning at US$109,990. A Model X SUV dual motor starts at $99,990, the performance version at $109,990. 

Chances are, it is neither of those explanations (but, if anything, it is closer to the second). To see why, we need to recognise that this is a form of price discrimination. Price discrimination occurs when a firm charges different prices to different groups of consumers for the same product or service, and where the difference in price does not arise from a difference in costs to the firm.

In order for a firm to practice price discrimination, it needs to meet three conditions:

1. Groups of consumers that have different price elasticities of demand (heterogeneous demand);
2. Different groups of customers can be identified; and
3. No transfers across submarkets.

Let's think about Tesla's situation. Do they have different groups of consumers with different price elasticities of demand? I would say yes. When Teslas were first released, many consumers were excited and anxious to buy a shiny new-release Tesla. The waitlists were long, but those consumers didn't care. For those consumers who wanted a newly released Tesla, there were few substitutes. They didn't want just any old car. They wanted a shiny new-release Tesla. The consumers on the waitlist for a new-release Tesla had demand that was relatively inelastic, meaning that they were not very responsive to a change in price (when a good has few substitutes, it has more demand that is relatively more inelastic). With relatively inelastic demand, Tesla could charge a high price, and it wouldn't cause those consumers to walk away. Prices of new-release Teslas were high.

Fast-forward to now, and those first consumers' demand for a Tesla has been satisfied. The remaining customers aren't nearly as keen on a Tesla. For current consumers, the choice isn't a Tesla or nothing at all. There are many other EVs that would be as good as, or nearly as good as, having a Tesla. The current consumers' demand is more elastic, meaning that they are more responsive to a change in price (when a good has more substitutes, it has more demand that is relatively more elastic). Tesla cannot charge as high a price without those consumers going somewhere else for a car. Prices of Teslas should fall, which is exactly what we are seeing.

What about the other two conditions? Tesla can tell which consumers are in which group. The consumers who sign up to the waitlist before a new car is released are clearly signalling to Tesla that they have relatively inelastic demand, and are willing to pay a higher price. Consumers who are willing to wait until later have more elastic demand, and are willing to pay a lower price.

What about no transfers across submarkets? Clearly, a Tesla owner can sell their Tesla second-hand to another buyer. However, the purpose of the this condition is so that consumers who buy at a low price don't turn around and sell to consumers who would otherwise buy at a high price. That isn't possible in this case, since Tesla sells first at the high price, to the consumers with more inelastic demand. Those consumers can resell their Tesla, but the remaining consumers are only willing to pay a lower price.

Tesla isn't alone in adopting this strategy for price discrimination. There are lots of similar examples. New season fashion clothing is sold at a high price, to consumers with relatively inelastic demand, and then is sold at a lower price at the end of the season to consumers with relatively elastic demand. Books are initially released in hardcover, and sold at a high price to consumers with relatively inelastic demand, before being released as paperbacks and sold at a low price to consumers with relatively elastic demand. When a new musical is released, tickets for the musical are initially sold at a high price, to consumers with relatively inelastic demand, and then when the musical is older, tickets are sold at a lower price to consumers with relatively elastic demand. And so on. All of these are examples where the first consumers believe that there are few substitutes for the good or service, so their demand is more inelastic, while later consumers believe that there are more substitutes, so their demand is more elastic.

Price discrimination is everywhere, once you know what to look for. Tesla is selling its cars in much the same way that publishers sell books. And in the same way as for new release books, when Tesla releases a new model car, it can restart the process for that new model from a high initial price.