What would happen if perfect personalised pricing was possible?

In my ECONS101 class, we discuss price discrimination, which comes in three forms: (1) first-degree price discrimination (or personalised pricing), which involves setting a different price for every consumer; (2) second-degree price discrimination (or menu pricing), which involves creating a menu of options for consumers to choose from; and (3) third-degree price discrimination (or group pricing), which involves setting different prices for known groups of consumers. Personalised pricing is intriguing, because if the firm knew the maximum amount that every consumer was willing to pay for the good or service, they could set that price for each consumer, thereby extracting the maximum possible amount of profit from every consumer.

To date, this sort of perfect personalised pricing remains a theoretical proposition. Although many firms collect a lot of data about their consumers, they still don't know exactly what each consumer is willing to pay. But what if they did? What other aspects of the market would then matter? Would the degree of competition in the market matter? How would a firm's competitors react?

Those are the sorts of questions addressed in this recent working paper by Patrick Kehoe, Bradley Larsen, and Elena Pastorino (all Stanford University). Specifically, they:

...take an extreme forward–looking view by supposing that personalized pricing is feasible and analyze the resulting equilibrium pricing patterns and its efficiency properties.

The paper is understandably theoretical (since perfect personalised pricing is still not possible). However, they also apply their model to eBay data on purchases of Apple and Samsung smartphones and tablets. In this context, the branding of the products matters, as does the experience nature of the goods (the consumer doesn't know what the quality of the good is until after they have purchased it. Kehoe et al. show using their theoretical model that:

...the strategic interaction among firms is complex: firms not only compete directly to attract a consumer in the current period, but also strategically manage the information flow to the consumer. Specifically, by appropriately choosing the prices for its product varieties, a firm can make a certain variety the most attractive and hence control how much is learned about a consumer’s taste for its products...

In other words, firms use pricing to obtain information about consumers' willingness to pay, and then use that information to price in the future. Would personalised pricing make consumers worse off? It seems like it should. However, using the smartphone and tablet eBay data combined with their theoretical model, Kehoe et al. find that:

...a significant fraction of consumers benefit from the introduction of price discrimination. Specifically, consumers who benefit are those with relatively similar beliefs about their tastes for Apple’s products or Samsung’s products, whereas consumers who are harmed are those who have a high taste for the products of only one firm. This latter group is more “captive” and, correspondingly, firms’ profits from these consumers are higher under discriminatory pricing than under uniform pricing.

The finding that, if personalised pricing was possible, then some consumers may actually be made better off, is somewhat surprising. However, those consumers who benefit are those who are most willing to switch products. In contrast, those who are unwilling to switch find that the price will be much higher. In my ECONS101 class, we discuss customer lock-in, and one of the ways that firms can lock customers in is through brand loyalty. Customers who are loyal to a particular brand are less willing to switch, and that may be especially the case where owning a particular brand becomes part of the consumer's identity (as is often the case for Apple users). Locked-in consumers often face higher prices, since the firm knows that those consumers will be less willing to switch to alternative products.

I hadn't considered the interaction between price discrimination and customer lock-in before, but it makes a lot of sense. It also works the other way of course. Firms will obtain a lot more information about consumer preferences from consumers who are locked into purchasing from them. Fortunately for those consumers, we are still not yet at the stage where this is any more than a theoretical possibility.