Spark's new overseas roaming charges and price discrimination

I've just gotten back home from three weeks in Europe. One irksome but necessary aspect of travelling is mobile phone roaming. While I was away, Spark introduced new roaming charges, and their new options both increase the price per day of roaming for most overseas trips, and price discriminate so that those staying overseas for longer pay a higher price for roaming. As the New Zealand Herald reported:

Spark customers travelling overseas for the school holidays face new charges to stay connected, with the telco scrapping its cheapest $25 fortnightly roaming pack.

The company is overhauling its roaming plans, with the new charges taking effect this Friday, including an automatic $10-a-day fee if customers don’t turn roaming off...

Previously, pay monthly customers could use 2GB of data on one of the provider’s 14-day roaming packs, priced at $25 and $30...

Three new packs will replace the old plans, alongside a new daily roaming option.

A $30 14-day pack will still be available to prepaid customers.

The other options will provide travellers with 20GB to use over 30 days, a change the company believes will make roaming simpler and more predictable.

“This helps our customers to stay connected for longer, with fewer top-ups, less uncertainty, and greater confidence about what they’ll pay.”

While the $50 and $65 packs have a higher upfront cost, customers would receive five times more data to use than under the previous plans, the spokesperson said.

If you look at the price per gigabyte of data, the new roaming packs are clearly much better value. Customers are paying twice the price, but getting ten times the data. So, high data users are likely to be better off under these plans. I want to focus instead on travellers who are not using large amounts of data (and for simplicity, I'm going to focus on the data-only packs, not the more expensive packs that include roaming calls and texts). For those travellers, when you look at the cost per day of roaming, the new packs are far more expensive. This is illustrated in the diagram below, which shows the costs for up to 30 days of roaming. The bold green line shows the existing pricing for a 14-day data-only roaming pack ($25 for each 14-day period). The light blue dashed line shows the cost using the new $10 daily roaming rate. The orange dashed line shows the cost for the new 30-day data-only roaming pack ($50 for each 30-day period).

For a Spark customer roaming for one or two days only, the new daily roaming pack is the cheapest option. So, if you're travelling to Australia for a day or two of shopping or to attend a concert or a sporting event, the new option is a better deal than what was previously on offer. With the new options, daily roaming is lower cost than buying a 30-day pack for up to four days of roaming, and the same cost as the 30-day pack for five days of roaming. Beyond that, you would be better off buying the 30-day roaming pack, even if you are only roaming for seven days.

The comparison between the old 14-day roaming pack and the 30-day roaming pack makes it clear that anyone roaming between five days and 14 days will now be paying twice as much as before. From 15 to 28 days, the cost of roaming with the new packs is the same as for the old packs. For someone like me, who typically goes overseas for a conference and might be away for 10-14 days at a time, this is clearly going to increase the cost of roaming.

It may be that Spark has determined that the new pricing options better reflect actual customer usage. That is what a Spark spokesperson argues in the New Zealand Herald article. However, it is also clearly an example of price discrimination in action. Travellers going overseas for a few days likely have more elastic demand for roaming than travellers going overseas for a longer time. That's because of the availability of close substitutes. If you go overseas for a few days, you could make use of free hotel and airport WiFi, or be prepared to just switch off mobile data for the time you are away, rather than paying for roaming. So, travellers who go overseas for a few days are likely to be relatively price sensitive. Travellers going overseas for a longer time are less likely to be able to switch off mobile data for that length of time, making them less price sensitive. The optimal pricing therefore is to set a higher price for travellers going overseas for a longer time than for those going overseas for a few days.

Price discrimination is very common in practice. In this case, Spark is using price discrimination and that will likely increase their profits. And that means that many travellers who are not high data users, myself included, will be paying more for roaming in the future.

My 18-month detour through second-degree price discrimination terminology

When I was composing this post about price discrimination last month, I was drawn into a discussion with ChatGPT about second-degree price discrimination. ChatGPT, which I mostly use for checking for inconsistencies and grammatical errors in my draft blog posts, told me that I should refer to menu pricing as a form of second-degree price discrimination. I replied that wasn't correct, because second-degree price discrimination, as defined by Arthur Pigou in the early 1920s, involves offering a declining price for each additional unit that the consumer buys. ChatGPT responded that indeed, Pigou had defined second-degree price discrimination that way, but that in much current industrial organisation usage, second-degree price discrimination includes cases where consumers are offered different options and sort themselves into groups that have different price elasticities of demand (or different willingness to pay) for the good.

That discussion made clear that I had been on an 18-month detour in how I described the degrees of price discrimination. Only last year, I changed the definitions of the degrees of price discrimination in my ECONS101 class to match those that Pigou uses, and therefore moved menu pricing into the definition of third-degree price discrimination (or group pricing). I've held off on posting about my exchange with ChatGPT until now, because I didn't want to confuse my students in this trimester's class about what did, and did not, fall under the different degrees of price discrimination before they were tested on it (and, as it turns out, I didn't test them on that specific aspect of the topic in any case). [*]

This appears to be one of those situations where terminology changes meaning over time, and is a cautionary lesson in making sudden changes to definitions on the basis of reading about the history of economic thought. The issue here is that I had come across Pigou's definitions in one source, and initially dismissed it as it was inconsistent with the way we taught that topic. But then I read The Economics Book by Niall Kishtainy and co-authors (which I reviewed here), which made me more certain about Pigou's definitions. To be clear, I'm not blaming Kishtainy et al. They were perfectly correct in terms of Pigou's definitions. I should have checked some other sources for more current usage. One example is the excellent book Information Rules, by Carl Shapiro and Hal Varian (which I read in 2023 and reviewed here), which made the definitions used in industrial organisation clear (although Shapiro and Varian preferred to use the term 'versioning', rather than second-degree price discrimination).

Now I'm left with the task of combing through my past posts, to ensure that I update my terminology, or revert it to the original text in the few cases where I went back and made changes. I don't want to risk confusing future students, which is a risk given that I refer them to my posts for further detail and examples on topics that we discuss in class.

*****

[*] I didn't perfectly achieve this goal, because one very alert student picked up the error through her own conversations with Harriet, our ECONS101 AI tutor, an irony that was not lost on me.

A surprising example of block pricing with heterogeneous demand

My wife and I just got back from holiday in Europe, and stopped in the duty-free store at Auckland Airport to pick up some bottles of gin for my mother-in-law. The price was $45 for one bottle, $69 for two bottles, or $95 for three bottles.

Standard block pricing (as described in this post) calls for the seller to sell at a declining marginal price per unit. In this case, the first bottle is $45, and the second bottle is $24 (for a total of $69 for two bottles). However, the third bottle is $26 (for a total of $95 for three bottles). Did the duty-free store get its block pricing wrong?

Certainly, their pricing is inconsistent with the standard block pricing story, because the third bottle should be less expensive (or, at least, not more expensive) than the second bottle. However, as Nobel Prize winner George Stigler noted, the pricing strategies that we see in the real world are likely to be those that work fairly well (otherwise, the strategy wouldn't persist and we wouldn't see them). So, there must be something about this pricing strategy that makes it work.

I think that the duty-free store is doing a bit of a mix of block pricing and menu pricing. Menu pricing is a form of price discrimination, where consumers sort themselves into those who are high-demand consumers and low-demand consumers. Low-demand consumers buy one bottle (or perhaps two), and pay a relatively high price per unit, while high-demand consumers buy three bottles and pay a lower price per unit.

Now, as I noted in this post, block pricing doesn't typically work when there is heterogeneous demand, because low-demand consumers are unaffected by block pricing (they buy the same quantity as if there was no block pricing), while high-demand consumers may buy more of the good, but spend less overall (because of the lower price per unit). The duty-free store avoids this negative outcome because consumers can only buy three bottles of gin duty-free. If they buy any more than that, they have to pay duty on the additional bottles. So, that effectively caps the number of bottles that high-demand consumers can buy to three. So, the high-demand consumers are stopped from buying four, or five, or six, or twenty bottles at the lower price. That means that the high-demand consumers may buy more bottles than if there wasn't block pricing, but they don't end up spending less overall.

That also helps explain why the third bottle can be priced a little higher than the second. A plausible interpretation is that the two-bottle deal is designed to attract moderate-demand consumers, while the three-bottle deal is aimed at the highest-demand consumers who are constrained by the duty-free limit. If that is the case, then the store does not need the third bottle to be cheaper than the second. Instead, it needs the three-bottle bundle to be attractive to a different group of buyers than the two-bottle bundle or a single bottle. Again, this points to menu pricing as part of the explanation.

So, while the duty-free store isn't conducting block pricing exactly as I describe in my ECONS101 class, we can nevertheless puzzle out what they are doing. And it makes sense, even if it is surprising to see a seller that is able to use block pricing when there is heterogeneous demand.

Price discrimination in tourism... French tourist attractions edition

The latest development in pricing at French museums should be familiar to my ECONS101 students, or to regular readers of this blog. As reported by the New Zealand Herald back in January:

France is hiking prices for non-Europeans at the Louvre this week, provoking debate about so-called “dual pricing”.

From Wednesday local time, any adult visitor from outside the European Union, Iceland, Liechtenstein and Norway will have to pay €32 ($64) to enter the Louvre – a 45% increase – while the Palace of Versailles will up its prices by €3...

Other state-owned French tourist hotspots are also hiking their fees, including the Chambord Palace in the Loire region and the national opera house in Paris. 

This form of pricing is, of course, known as price discrimination - offering the same product (in this case, museum entry) to different consumers for different prices. Price discrimination works when the seller has consumers with heterogeneous demand for their product. That means that some consumers have more elastic demand for the product (and are more price sensitive), while other consumers have less elastic demand for the product (and are less price sensitive). The seller charges a higher price to the consumers who are less price sensitive.

Why do foreigners have less elastic demand for tourist attractions? As I noted in this post back in 2014, there are two reasons. First, consumers tend to have less elastic demand for goods with few close substitutes. There are few substitutes for visiting the Louvre (or other tourist attractions), making demand less elastic. Arguably, for foreign tourists there are fewer close substitutes to the Louvre. Locals can do all sorts of things with their time, but tourists tend to want to go to tourist attractions while on holiday. Second, the significance of price in the total cost of the good is lower for foreign tourists than for locals. Foreign tourists have usually also travelled a long way at great cost to get to France, so the cost of entry into the Louvre is pretty small in the overall cost of their holiday, making demand less elastic. For locals, the cost of the ticket to the Louvre is probably most of the total cost of attending, so a change in the ticket price would have a greater effect on whether they go (making demand more elastic).

The New Zealand Herald article focuses attention on the ethics of price discrimination, noting that:

Trade unions at the Louvre have denounced the policy as “shocking philosophically, socially and on a human level” and have called for strike action over the change, along with a raft of other complaints.

That criticism is not trivial, because museums are not just profit-maximising firms - they also have a public-access mission, so charging more can look inconsistent with their public access goal. However, it is important to recognise that price discrimination is not illegal or even necessarily immoral, and may provide greater support for the long-term goals of the museum.

Price discrimination is in fact relatively common at tourist attractions (see the links at the end of this post), especially in developing countries but also increasingly in developed countries like New Zealand. And:

Britain has long had a policy of offering universal free access to permanent collections at its national galleries and museums.

But the former director of the British Museum, Mark Jones, backed fee-paying in one of his last interviews in charge, telling the Sunday Times in 2024 that “it would make sense for us to charge overseas visitors for admission”.

Society should want museums to remain sustainable. However, funding purely by taxes doesn't ensure sustainability, which is one reason that museums charge entry fees in the first place. And since museums are charging an entry fee anyway, it is right to consider what is the 'best' entry fee. There is no reason why that entry fee needs to be the same for locals and foreigners. After all, locals likely already pay for the upkeep of the museum through their taxes, so having a lower price for locals (as many tourist attractions do) is in that sense a fairer option. Price discrimination therefore has fairness in its favour, in addition to being a way of increasing profits for the museum, increasing its financial sustainability.

Read more:

• Are tourism operators in NZ missing a trick?
• Price discrimination in tourism... India edition
• Price discrimination and the Great Walks
• Hamilton Gardens' entry fee for tourists as a form of price discrimination
• Te Papa Tongarewa embraces price discrimination, but other tourism operators are still missing the trick

Taylor Swift, look what you made fans buy

Taylor Swift released 27 versions of her 2025 album The Life of a Showgirl. That sounds excessive, but it offers a nice lesson in economics and pricing strategy, specifically price discrimination.

Price discrimination occurs when a firm charges different prices to different groups of consumers for the same good or service, and where the price differences do not arise from a difference in costs. One form of price discrimination is 'versioning', where the firm offers different versions of a product that each cost the same to produce, but which appeal to different groups of consumers (with different price elasticities of demand). Consumers that are more price sensitive (and have more elastic demand) would buy the version of the product that is less expensive, while consumers that are less price sensitive (and have less elastic demand) would buy the more expensive version.

We saw an extreme example of versioning last year, executed by the astute economist Taylor Swift. Paul Crosbie (Macquarie University) wrote about it in this article in The Conversation last October:

The Life of a Showgirl was released in dozens of formats, with physical and digital editions tailored to different levels of commitment.

In total, over the first week, there were 27 physical editions (18 CDs, eight vinyl LPs and one cassette) and seven digital download variants.

A range of covers, coloured vinyl, bonus tracks and signed inserts turned one album into a collectable series rather than a single product. Other artists – such as the Rolling Stones – have used this strategy before, but rarely at this scale or with such an intense response from fans.

Taylor Swift fans who are more price sensitive will have tended to buy the less expensive version of the album. More price-sensitive fans will include those who have lower incomes (where the album price is a higher proportion of their income) and those who are more casual Taylor Swift fans (where there are more substitutes available that they might prefer to spend their income on).

Taylor Swift fans who are less price sensitive will have tended to buy the more expensive premium version of the album. Less price-sensitive fans will include those who have higher incomes (where the album price is a smaller proportion of their income) and those who are more diehard Taylor Swift fans (where there is no close substitute for the latest Taylor Swift album).

Crosbie questions whether it is possible to have too many versions of a product. In this case, 27 versions do seem like a lot. It could be a very effective means of segmenting the market. However, that works best if each buyer only buys one version. There will be some fans who bought more than one version, and perhaps a substantial number who bought several. A non-trivial proportion of the most diehard fans probably own all 27 physical editions of the album.

This matters because the usual rationale for price discrimination through versioning is that consumers sort themselves across the available versions - the casual fans buy the standard version, while the diehard fans buy the premium one. But if some consumers buy multiple versions, the strategy is doing more than just segmenting the market. It is also encouraging multiple purchases from the same buyer. In that case, the different versions are not just substitutes for one another, but for some fans they become collectibles, with each version they collect adding a bit of extra value through completeness, exclusivity, or identity. So, the economics of versioning for Taylor Swift are not only about price discrimination between consumers, but also about extracting more surplus from the most committed fans.

There is a limit to how many versions even the most diehard fan is willing to buy, and that limit arises because of diminishing marginal utility. In economics, utility is the satisfaction or happiness the consumer gets from the goods and services they consume. Marginal utility is the extra utility the consumer gets from consuming one more unit of a good or service. Diminishing marginal utility is the idea that marginal utility declines as the consumer consumes more of a good. In the context of Taylor Swift's album, Crosbie notes that:

The first version of an album brings a lot of satisfaction. The fifth or sixth brings less. Eventually, another version does not add enough enjoyment to justify the price. Fans begin to feel they have had enough.

It is clear that there is a balance to be found between maximising profits by price discrimination using versioning, and the number of versions that are offered when some consumers will want to buy multiple versions. Price discrimination can be an incredibly profitable pricing strategy for firms, including for Taylor Swift. Maintaining fan engagement and encouraging diehard fans to spend more by making the versions collectible are also important. As Crosbie notes in his article:

Instead of leaving that money on the table, the strategy turns passion into profit. The cost of creating extra covers or vinyl colours is small, but the willingness of fans to pay more for them is high. That is exactly where versioning pays off.

In theory, it should be possible to work out the optimal number of versions that maximises long-run profit. The profit-maximising number of versions is not necessarily the number that best segments the market for the purposes of price discrimination, because diehard fans may buy multiple versions. It seems likely that Taylor Swift is well aware of this. Would you be willing to bet she hasn’t gotten close to that optimum? I wouldn’t.

The business economics of The Summer I Turned Pretty

I tell my students that, once they start to understand some economics, they start to notice it everywhere. It's not just a throwaway line. It really is true. As an example, one of my ECONS101 students excitedly shared with me a short example on the business economics of Prime Video's show The Summer I Turned Pretty. That show is not really my cup of tea (I prefer something like The Witcher). However, the pricing strategy that Amazon employed with The Summer I Turned Pretty is quite interesting to tease out. Specifically, when season 3 of The Summer I Turned Pretty was released on Prime Video, Amazon simultaneously released seasons 1 and 2 for free on YouTube. What was Amazon trying to do?

I believe that this was an example of Amazon using customer lock-in to increase the number of subscribers to Prime Video. Customer lock-in occurs when consumers find it difficult to change once they have started purchasing a particular good or service. High switching costs (the cost of switching from one good or service to another, or from one provider to another) are likely to generate customer lock-in, because a high cost of switching can prevent customers from changing to substitute products.

Where are the switching costs here? With a television show, viewers get invested in their favourite characters and in following particular storylines. If a viewer was to watch something else instead, they face a switching cost of missing out on knowing what their favourite characters are doing, or how the storylines that they were following play out. So, once a viewer starts watching a particular television series that they like, they are reluctant to stop. This is the switching cost in action - the viewer is locked into watching that series.

By releasing the first two seasons of The Summer I Turned Pretty for free on YouTube, Amazon is hoping that will attract new viewers, who will become locked into watching it, and then pay for a subscription to Prime Video in order to continue watching season 3. More Prime Video subscribers equals more revenue (and profits) for Amazon. And because very few consumers would be attracted to Prime Video for the first two seasons of this show, making them available for free didn't really have a high opportunity cost for Amazon (and the challenge of cancelling subscription services creates a further degree of lock-in). 

This strategy is essentially a form of multi-period pricing - setting the price low initially (free for the first two seasons), before raising the price once consumers are locked in (since they have to have a paid subscription to watch season 3). This works because locked-in customers have less elastic demand for a product (they are less price sensitive). So, charging a higher price to locked-in customers than to those who are not (yet) locked in is a profit-maximising strategy.

There is a further aspect of this strategy that I find equally interesting. The student I was speaking with noted that some of her friends had waited until the last episodes of The Summer I Turned Pretty were released, before subscribing to Prime Video for one month and binge-watching the whole season and then cancelling their subscription. In contrast, my student was more impatient and watched each episode as it was released. However, that meant paying for three months of Prime Video subscription.

This sounds a lot like price discrimination - charging different prices to different consumers for the same good or service (and where the difference in price doesn't reflect a difference in costs). In this case, super-fans of the show will be impatient and wanting to watch each episode as it is released. They have short time horizons (they want to watch now), so their demand is less elastic. And with less elastic demand, the profit-maximising price is higher. In contrast, casual fans of the show will be more patient, and happy to wait and binge-watch the whole season in a day. They have longer time horizons, so their demand is more elastic. And with more elastic demand, the profit-maximising price is lower.

By releasing one episode a week, Amazon is able to effectively price discriminate for both groups. The impatient fans (with inelastic demand) pay for three months of Prime Video (a higher price), while the patient fans (with more elastic demand) pay for one month (a lower price). Even better, Amazon doesn't even need to be able to tell these fans apart, because the fans make the decision themselves about what price to pay.

Economics is all around us. You just need to keep your eyes open, and you will see it.

[HT: Georgie from my ECONS101 class]

Price discrimination (or not) at Parisian restaurants

The Telegraph reported last month (paywalled, but you can read it free from the New Zealand Herald):

Hapless tourists in Paris are being charged as much as 50% more than French customers, the city’s leading newspaper found.

After tourists complained online about being overcharged, Le Parisien sent out a bona fide Parisian to a cafe on the Champ-de-Mars near the Eiffel Tower.

It also dressed up one of its reporters as a typical tourist, sporting a T-shirt emblazoned with the tower, trainers, dark glasses and a baseball cap, and speaking in a passable American accent – albeit with a French twang.

They both sat down at the unnamed eatery and ordered the same dish – lasagne – and drinks, a Coke and water, and discreetly filmed themselves doing so.

The clearly French customer was served a can of Coke for €6.50 ($12.65) and offered a carafe of water with his dish. Meanwhile, the “American” was not offered a small can, only a medium or large Coke. When it arrived, it was half a litre and cost €9.50 ($18.50).

As for the water, the “American” received no offer of a carafe, which is free, instead having to fork out a further €6 ($11.60) for a small bottle of Vittel...

The Telegraph spoke to Joseph, a 21-year-old waiter who confirmed that some of the techniques were widespread.

“In one restaurant I worked I was instructed to bring spring water at €7 ($13.60) a bottle unless foreign customers specifically asked for a carafe,” he said.

This sounds a lot like price discrimination, which occurs when a firm charges different prices to different groups of consumers for the same good or service (and where the difference in prices does not arise from a difference in cost). Price discrimination 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, which involves the consumer paying a declining price for each additional unit that is purchased; and (3) third-degree price discrimination (or group pricing), which involves setting different prices for known groups of consumers.

As I noted in yesterday's post, one form of third-degree is menu pricing. Menu pricing is where the firm offers the consumer different options (that the firm knows appeal to consumers with different elasticities), and consumers select their preferred option. On the menu, items that the firm knows will appeal to consumers with less elastic demand (consumers who are less sensitive to price) are priced with a higher markup (over marginal cost) than items that the firm knows will appeal to consumers will more elastic demand (consumers who are more sensitive to price).

In the case of Parisian restaurants, tourists tend to have less elastic demand for meals and drinks than locals. There are several reasons that we could use to argue this. First, tourists have likely travelled a long way, at considerable cost, to visit Paris. The price of a meal (or some water) at a Parisian restaurant is a very small proportion of the total cost of their holiday. When price is a small proportion of the total cost, demand tends to be less elastic. Second, tourists may have higher income than locals. That means that the price of a meal (or some water) will take up a lower proportion of a tourist's income than a local's, making demand from tourists less elastic. Third, tourists may not know the area well, and are less aware of substitutes (other nearby restaurants), although Google Maps, TripAdvisor and other apps have reduced the impact of this factor. When a good has fewer substitutes, it has less elastic demand. For any or all of these reasons, we may expect tourists to have less elastic demand, and firms that price discriminate would charge them a higher markup (and a higher price).

Now, the Parisian restaurants aren't practicing menu pricing as typically described, because they are essentially removing options from the menu that tourists get to see. The locals, with more elastic demand, are offered cheaper options than the tourists, with less elastic demand. The tourists are generally unaware that there are other options available that would be cheaper (like a carafe of water).

This reminded me of my several trips to Thailand (first during my PhD, and then subsequently), where tourists tend to pay higher prices for visiting various attractions than locals do (a point I mentioned in this 2014 post). The tourist attractions in Thailand hide this fact from the tourists by putting the price for locals in Thai script, so that only those who can read Thai know that the cheaper option exists. Now, the Parisian restaurants have made me wonder about various times in Thailand and China and elsewhere, where I've visited restaurants and received a menu in English (sometimes poorly translated). It's likely that the prices on the English menu are far higher than on the menu in the local language.

All of this suggests that, when we are tourists, we should be a bit savvier about our buying behaviour. The best option is to have local friends who can identify the opportunities for saving, although this won't apply to 'friends' of the type that hang out outside airports or hotels and offer to be a guide. At restaurants or attractions, ask a generative AI app to translate a photo of the local menu or price board, rather than simply accepting the English version. At the very least, we should observe what the locals are ordering and do the same (probably this is good advice generally). Price discrimination is pervasive. That doesn't mean that as tourists we need to just accept it.

Delta Air Lines moves from group pricing to personalised pricing

In my ECONS101 class last week, we covered price discrimination: where a firm charges different prices to different groups of consumers for the same good or service (and where the difference in prices does not arise from a difference in cost). Price discrimination 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, which involves the consumer paying a declining price for each additional unit that is purchased; and (3) third-degree price discrimination (or group pricing), which involves setting different prices for known groups of consumers.

Airlines typically engage in price discrimination (as I discussed here), in the form of group pricing. Specifically, they engage in a type of group pricing known as menu pricing. As I noted in this post:

Airlines don't quite have a menu. However, they do offer a range of options to consumers. Some consumers will buy a ticket close to the date of the flight, while others buy far in advance. That is information the airline can use. If you are buying close to the date of the flight, the airline can assume that you really want to go to that destination on that date, and that few alternatives will satisfy you (maybe you really need to go to Canberra for a meeting that day, or to Christchurch for your aunt's funeral). Your demand will be relatively inelastic, so the airline can increase the mark-up on the ticket price. In contrast, if you buy a long time in advance, you probably have more choice over where you are going, and when. Your demand will be relatively elastic, so the airline will lower the mark-up on the ticket price. This intertemporal price discrimination is why airline ticket prices are low if you buy far in advance.

Similarly, if you buy a return ticket that stretches over a weekend, or a flight that leaves at 10am rather than 6:30am, you are more likely to be a leisure traveller (relatively more elastic demand) than a business traveller (relatively more inelastic demand), and will probably pay a lower price. 

Menu pricing is an imperfect form of price discrimination. The ultimate form of price discrimination would be for a firm to sell to every consumer for exactly the maximum that they are willing to pay. This is a perfect form of personalised pricing (first-degree price discrimination). However, this is difficult for firms to achieve in practice, as consumers don't typically volunteer information on how much they are willing to pay. Nevertheless, firms would still really like to do this, and so estimating consumers' willingness-to-pay is important to firms. If they can achieve that, then the next step is to charge every consumer a different price.

And that brings me to this article in The Verge last month:

Delta Air Lines is leaning into dynamic ticket pricing that uses artificial intelligence to individually determine the highest fee you’d willingly pay for flights, according to comments Fortune spotted in the company’s latest earnings call. Following a limited test of the technology last year, Delta is planning to shift away from static ticket prices entirely after seeing “amazingly favorable” results.

“We will have a price that’s available on that flight, on that time, to you, the individual,” Delta president Glen Hauenstein told investors in November, having started to test the technology on 1 percent of its ticket prices. Delta currently uses AI to influence 3 percent of its ticket prices, according to last week’s earnings call, and is aiming to increase that to 20 percent by the end of this year. “We’re in a heavy testing phase,” said Hauenstein. “We like what we see. We like it a lot, and we’re continuing to roll it out.”

Obviously, Delta thinks that it has enough information about its customers to make this work. It was inevitable that firms would eventually start using artificial intelligence and machine learning to estimate the maximum willingness-to-pay for each of their consumers. This is likely to be just the beginning of a wider trend, given the potential for greater profits for firms. As I note in my ECONS101 class, there is no possible pricing strategy that could be more profitable than perfect personalised pricing. Delta's approach probably isn't perfect, but it is likely to be more profitable than the regular airline group pricing strategy.

[HT: Marginal Revolution]

Read more:

• Price discrimination and airline tickets

If airlines priced all tickets the same, then that would create other problems

Dynamic pricing has been in the news again this week, with Consumer NZ labelling Air New Zealand ticket prices a "rip off". As the New Zealand Herald reported:

Consumer NZ has found that Air New Zealand flights across the Tasman around school holidays increased 43% - almost twice the rate of rival Qantas.

It says it might not be worth flying Air New Zealand to Australia, with evidence that our national carrier is exploiting its market share and demand during the school holidays, giving travellers cause to question if what they’re paying is fair...

A recent Consumer investigation into domestic flights found dynamic pricing could increase the price of the same ticket from Auckland to Dunedin by up to four times as much...

Consumer says while supply and demand do impact dynamic pricing algorithms, “we’re not convinced it’s that simple. We think it’s likely that dynamic pricing allows Air New Zealand to make up profit margins, and it certainly looks like its practices are capitalising on New Zealanders wanting to travel during the school holidays.

“Compared to Qantas, which was consistently cheaper and didn’t have comparable price hikes during either New Zealand or Queensland school holidays, flying with our national carrier to Brisbane looks like a rip off.”

The issue here is the difference in price between a ticket purchased well in advance, and one purchased closer to the date of travel, with the latter being much more expensive. This is an example of price discrimination - selling the same good or service to different consumers for different prices. And price discrimination by airlines is a topic I have posted on before. Here's the explanation I gave then:

Some consumers will buy a ticket close to the date of the flight, while others buy far in advance. That is information the airline can use. If you are buying close to the date of the flight, the airline can assume that you really want to go to that destination on that date, and that few alternatives will satisfy you (maybe you really need to go to Canberra for a meeting that day, or to Christchurch for your aunt's funeral). Your demand will be relatively inelastic, so the airline can increase the mark-up on the ticket price. In contrast, if you buy a long time in advance, you probably have more choice over where you are going, and when. Your demand will be relatively elastic, so the airline will lower the mark-up on the ticket price. This intertemporal price discrimination is why airline ticket prices are low if you buy far in advance.

Similarly, if you buy a return ticket that stretches over a weekend, or a flight that leaves at 10am rather than 6:30am, you are more likely to be a leisure traveller (relatively more elastic demand) than a business traveller (relatively more inelastic demand), and will probably pay a lower price.

The solution is simple. If you want to pay a lower price for an airline ticket, book in advance. That's the advice that Air New Zealand gives in the article:

Customers should book early to secure the best deals, said the (Air New Zealand] spokesperson.

Consumer NZ is of course trying to do the best by consumers. They want lower prices for airline tickets, even when purchased close to the date of travel. However, taking aim at dynamic pricing might be counterproductive. Even putting aside the infeasibility of regulating dynamic pricing, if airlines were to eliminate dynamic pricing, that isn't without cost to travellers.

One thing that an escalating ticket price over time does is manage demand for airline tickets. As price increases, fewer consumers are willing and able to buy tickets. That means that there will generally be more airline tickets available close to the date of travel than there would have been if airline ticket prices remained low all along. Would it be worse to have to pay a high price for an airline ticket purchased at the last minute, or to have no tickets available at all, because the low price encouraged more people to buy, selling out planes sooner? It's not clear to me that is a better outcome.

Even in the case where tickets remain available, a second issue is that it isn't clear that ticket prices would remain low. A profit-maximising airline that no longer price discriminates would set a lower price for tickets purchased close to the date of travel, but a higher price for tickets purchased well in advance. Essentially, they would average the price out over time, meaning that some travellers would end up paying a lower price. That would likely be the leisure travellers, purchasing their tickets well in advance. Business travellers, who are more likely to purchase tickets at the last minute, would benefit greatly from airlines no longer using dynamic pricing.

Consumer NZ is trying to look after the interests of airline travellers (it's not the first time either). However, it isn't clear that they have thought through all of the implications of their attack on dynamic pricing.

Read more:

• Price discrimination and airline tickets

Te Papa Tongarewa embraces price discrimination, but other tourism operators are still missing the trick

Ten years ago, I asked whether tourism operators in New Zealand were missing a trick - why weren't they charging higher prices to tourists and lower prices to locals? In other words, why weren't these tourism operators employing price discrimination?

It may have taken ten years, but finally tourism operators are starting to see the light. As I noted last year, Hamilton Gardens' new fee structure is a form of price discrimination. Now, the national museum Te Papa Tongarewa is going to start charging a fee to foreign tourists (while remaining free for New Zealanders). As the New Zealand Herald reported last month:

Te Papa has announced it will start charging international visitors a $35 entry fee, citing the increased cost of energy, insurance and staffing.

The charge will apply from September 17 to people aged 16 and older. The national museum in Wellington will remain free for Kiwis.

Te Papa needs to raise $30 million annually to stay afloat, on top of the $44m it receives from the Government.

It’s hoped the new charge will raise several million dollars towards the museum’s portion which is currently met through existing partnerships, philanthropy donations, and commercial activities – as a conference venue - and from its cafes, retail stores and carpark.

Price discrimination occurs when a firm charges different prices to different customers for the same good or service, and where the price difference doesn't arise from a difference in costs. It costs Te Papa the same to provide the service to a New Zealander and to a foreign tourist. The difference in price (free vs. $35) is therefore price discrimination.

There are three conditions that must hold in order for price discrimination to be effective:

1. There must be 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. The firm must be able to deduce which customers belong to which groups (so that they get charged the correct price); and
3. There must be no transfers between the groups (since you don't want the low-price group re-selling to the high-price group).

Those conditions are generally met in the case of tourist attractions such as Te Papa Tongarewa. Foreign tourists have low sensitivity to price (low price elasticity of demand) for two reasons. First, for a foreign tourist, there few substitutes to visiting Te Papa Tongarewa. In contrast, locals have plenty of other activities they can do rather than visiting the tourist attraction (there are many substitutes) Second, foreign tourists have usually also travelled a long way at great cost to get to New Zealand, so the cost of entry into Te Papa Tongarewa is pretty small in the overall cost of their holiday. For a local, any entry fee for Te Papa Tongarewa would entail a significant increase in the total cost of a visit (since the local doesn't have a high travel cost to get there, compared with a foreign tourist).

For both of those reasons, foreign tourists are relatively insensitive to changes in price compared with locals (foreign tourists have less elastic demand for visiting Te Papa Tongarewa). So, raising the price of entry isn't going to keep foreign tourists away in great numbers. However, raising the price for locals would have a much greater impact on the number of visits. Therefore, keeping the price low for locals, while charging a higher price for foreign tourists, is likely to increase profits for Te Papa Tongarewa.

All of this applies to other tourist operators as well. So, I remain surprised that there isn't a price differential for visits to Hobbiton, Waitomo Caves, or Whakarewarewa (to take just three relatively local examples). Tourist operators could even use price discrimination to paint themselves as friendly to locals. Who would argue against a 'large discount' for New Zealanders to visit iconic tourist attractions? They support the local community! Other than not using that framing, Te Papa Tongarewa has made the right choice. Other tourist operators are still missing this trick.

Read more:

• Are tourism operators in NZ missing a trick?
• Price discrimination in tourism... India edition
• Price discrimination and the Great Walks
• Hamilton Gardens' entry fee for tourists as a form of price discrimination

Supermarkets' 'sawtooth pricing' of alcohol

NBR has been running a series of articles on supermarket pricing this week, based on new daily product-level data from Ordian (called PricePulse). In the latest article (paywalled) in the series this morning, Maria Slade covered the pricing of alcohol products, noting the presence of 'sawtooth pricing':

One of the clearest trends it uncovers is sharp and almost weekly movements in alcohol prices...

For example, the average price of a dozen 330ml Heineken lager bottles ranged by 39% between mid-September and this week.

The price see-sawed every seven days, from a low of $19.89 to a maximum of $32.45...

This pattern of alcohol pricing was the same in each individual supermarket NBR checked.

I was interviewed by Slade on Monday, and some of my comments on the reasons for sawtooth pricing made it into the article:

As NBR has conducted its Price Check series this week based on the PricePulse data, commentators have pointed out that huge variations in products with no seasonality attached to them are part of a strategy of obfuscation by the supermarkets.

“I think what we’re seeing is that it’s incredibly difficult for consumers to make rational decisions when it comes to groceries,” Massey University Business School professor of marketing Bodo Lang says.

Creating confusion is not the only factor driving sawtooth alcohol pricing, Waikato University professor of economics Michael Cameron says.

There are two key groups of alcohol shoppers – people who are motivated by price, and those who buy regularly; both are captured by seesawing pricing.

Regulars won’t change their habits and take advantage of a special, so retailers make a good margin on them regardless, he says.

“Then, at the same time, when the price is low, you take the consumers who are price conscious.

“So, it doesn’t make sense to price low all the time for those price-conscious ones, especially when you haven’t got much competition,” Cameron says.

I want to take this opportunity to explain my comments in a bit more detail. Obfuscation doesn't make much sense as an explanation for sawtooth pricing. There isn't much for supermarkets to gain from making consumers confused about pricing, because the consumers can see the price on the shelf and make a decision based on that. As I note in my ECONS101 class, making consumers confused about the price makes them less likely to buy it, not more likely to buy it. Obfuscation is much more effective (and profitable) if the 'true' price can be hidden from consumers until they actually have to pay. That's the strategy that is employed in 'drip pricing' for example (see here). It's also why you should always get a quote from a contractor, or risk a sharp surprise when presented with the invoice.

A better explanation for what the supermarkets are doing is a form of price discrimination. That's when a seller sells the same product to different consumers for different prices. This isn't a textbook example of price discrimination, so it requires a bit more explanation.

Consider a market with two supermarkets (A and B), and two types of consumers [*]. The first type of consumers are regular shoppers. They shop on the same day each week, at the same supermarket, and usually buy the same products. The second type of consumers are price conscious. They shop around, looking for the best deals each week.

What should Supermarket A do when pricing a product? It could set a high price all the time. The regular shoppers would buy the product, but the price conscious shoppers wouldn't. It would be moderately profitable to adopt this strategy. However, there are two problems with this. First, Supermarket B could undercut the price, capturing market share, and reducing the profits from the high price for Supermarket A. Second, if Supermarket B also sets a high price for the product, then the lack of competition in the market may come under scrutiny from competition authorities. Instead, Supermarket A could set a low price all the time. Both types of shoppers would buy the product from Supermarket A. However, that may not be very profitable (unless the supermarket can use the product as a loss leader, inducing customers to buy more of the other products that it sells), especially if Supermarket B matches the low price (since Supermarket A wouldn't gain customers at the expense of Supermarket B in that case).

A third option is to 'sawtooth' the price, alternating between a high price and a low price each week. This could actually work best because of the presence of the two different types of consumers. In the high-price week, the regular shoppers buy from Supermarket A, but the price conscious do not. In the low-price week, both types of shoppers buy from Supermarket A. This is more profitable for Supermarket A than always having a low price, because the high-price week is more profitable than the low-price week. It may (or may not) be more profitable than always having a high price, but it avoids being under-cut by the other supermarket, and avoids the unwelcome scrutiny of the competition authorities.

In this case, sawtooth pricing is a form of temporal price discrimination, since the two types of consumers end up paying different prices for the product (on average). The regular shoppers pay a relatively high price on average (the average of the high price and the low price), while the price conscious shoppers pay a low price on average (since they only buy in the low-price week). When price discriminating, a firm wants the more price conscious consumers to pay a lower price, and sawtooth pricing achieves that.

It is worth noting that there are two reasons that a sawtooth pricing strategy works in this case. First, it works because the regular shoppers are unwilling (or unable) to adjust the timing of when they buy their groceries. If these regular shoppers recognised the pattern in the prices, they might be able to hold off on buying for a week, then buy a double amount of the product in the low-price week.

Second, it only works because of a lack of competition. With two supermarkets, it is easy to maintain sawtooth pricing, since each week one supermarket can price high and the other price low, then alternating between weeks. The more additional supermarket competitors you add into the market, the more likely it is that one of them will adopt a low-price strategy, undercutting the others in every week. However, the extent to which that is possible depends on how successful the new low-price competitor can be in attracting the regular shoppers away from their usual supermarket.

These last two points provide an obvious solution to sawtooth pricing, if we believe that it's a problem. First, making consumers aware of the pricing patterns will allow them to exploit it to their advantage. I'd expect sawtooth pricing to break down fairly quickly if consumers adjust their behaviour enough. The PricePulse tool is supposed to be rolled out for consumers in due course, so that might have some effect. Second, having a more competitive market makes this pricing strategy less likely to be effective. The Grocery Commissioner has their work cut out for them in achieving that, though, even if it is on their wish list.

To me, the only thing that is left unexplained (to some extent) is why it is alcohol products that seem to be most subject to this sawtooth pricing. I haven't seen the raw data, but I wouldn't be surprised to have seen this strategy employed for many products. As yet, I don't have a good answer to this question.

 *****

[*] This explanation also works if you have many different types of consumers (what economists call heterogeneous demand), but it is simplest to explain for two types.

Movie ticket prices revisited

I've written a few times about prices at the movies (see here and here). One of the puzzling questions about movie ticket prices is why they are the same for all movies, whether they are blockbusters that will sell out the theatre, or low-rated B-movies that struggle to sell any tickets. That is the question that this recent article in The Conversation by Peter Martin (Australian National University) looks at. Martin puts the answer down to two things. First:

Queues for restaurants (or in 2023, long queues and sold out sessions, as crowds were turned away from Barbie) are all signals other consumers want to get in.

This would make queues especially valuable to the providers of such goods, even if the queues meant they didn’t get as much as they could from the customers who got in. The “buzz” such queues create produces a supply of future customers persuaded that what was on offer must be worth trying.

That makes sense for restaurants, where the queue to get in is quite visible to passing would-be diners. The queue acts to reduce customer uncertainty about the quality of the product. However, it is much less plausible that this effect works for movies. Even if there is a queue for tickets, there is no certainty which movie the customers in the queue are waiting to get tickets for. So, the queue doesn't really provide any information about quality for would-be consumers.

Second, and more plausibly, Martin notes:

Another is the way cinemas make their money. They have to pay the distributor a share of what they get from ticket sales (typically 35-40%). But they don’t have to pay a share of what they make from high-margin snacks.

This means it can make sense for some cinemas to charge less than what the market will bear – because they’ll sell more snacks – even if it means less money for the distributor.

This is a point that I have made before. Since movie theatres are constrained in their ability to profit from ticket sales due to agreements with the movie distributors, it is much better for them to keep the ticket prices low, and instead make money from selling complementary goods (like popcorn and drinks). This could even be an application of loss leading - selling the movie tickets at a loss, in order to increase the number of movie ticket sales, and make even more profits from the complementary goods.

One new aspect of movie ticket pricing that Martin didn't consider is movie theatres charging different prices depending on where the moviegoer sits. As the New York Times reported earlier this year:

Some middle seats at AMC movie theaters will be more expensive than others as part of the company’s new ticket-pricing strategy, announced this week.

AMC Entertainment, the world’s largest cinema chain, said in a news release on Monday that this new pricing system, known as Sightline at AMC, would be in place at all of its United States theaters by the end of the year.

The seats in the front row of the theater will be the least expensive and seats in the middle of the theater will be the most expensive, the company said. However, new prices will not affect showings before 4 p.m. or tickets sold at a special discount on Tuesdays, AMC said.

Notice that this is similar to how tickets to concerts are priced, and is an application of price discrimination. Some moviegoers highly value the seats in the centre of the movie theatre, as they have the best view of the screen. Some moviegoers are willing to pay a premium for those seats (I know I would be). The other seats have less valuable views, and would appeal to more price-sensitive moviegoers. The optimal price is lower for more price-sensitive customers, so charging a relatively lower price for less-preferred seats (and a relatively higher price for the centre seats) makes a lot of sense.

It will be interesting to see whether AMC's new pricing system works (or not). Regal Cinemas' trial of dynamic pricing for movie tickets (which I discussed in this post) was abandoned soon after it was announced (see here). So, we never really got to see if dynamic pricing worked or not. If the AMC system works, we can expect to see it rolled out at other cinema groups in due time. As I note in my ECONS101 class, in a Darwinian sense, the pricing strategies that we see persisting in the real world tend to be those that are working well (and contribute to higher profits for the sellers).

Read more:

• Pricing at movie theatres still defies logic. Or does it?
• Regal Cinemas to introduce dynamic pricing for movies
• The $8 bucket of movie theatre popcorn

McDonald's is price discriminating on its app, not price gouging

Once you know what to look for, you start to see price discrimination everywhere. Price discrimination is the practice of a firm offering different prices to different consumers for the same product, and where the different price doesn't depend on a difference in costs. A price-discriminating firm would want to charge a lower price to its more price-sensitive consumers, and a higher price to its less price-sensitive consumers.

One somewhat counter-intuitive example I use in my ECONS101 class is Delta Airlines charging higher prices to their frequent fliers (as noted in this Forbes article from 2015). The frequent fliers are less price sensitive (they have less elastic demand) because for them, there are few close substitutes for flying Delta Airlines. They have accumulated air miles on Delta, and they want to build up their balance. They don't get Delta air miles from other airlines, making them reluctant to switch to other airlines, even if the price is higher. Consumers who are not Delta frequent fliers are more price-sensitive (they have more elastic demand) because all other airlines are substitutes for Delta on the same route.

It seems that Delta Airlines is not alone in this counter-intuitive approach, as the New Zealand Herald reported earlier this week:

Users of McDonald’s popular mobile app have raised fears that frequent customers are being hit with higher prices than others, a practice they claim is “price gouging”.

The claims were raised on Reddit, where one user highlighted that he was being charged up to $3 more than his partner for some items, despite them both accessing the app on the same day, from the same location.

The only difference between their accounts? He had more than double the number of loyalty points, showing he had used the app more in the past.

To be clear, this isn't 'price gouging', it is price discrimination, pure and simple. McDonald's justified its actions as follows:

The Herald approached McDonald’s NZ for comment on the claims and a spokesperson said the differences might be due to lower prices being used entice customers to return to the app.

Noting that personalised deals had been in place since the loyalty programme was rolled out last year, the spokesperson said details of how benefits were offered and data was used is spelled out in the terms and conditions.

“Individual offers will differ between users, based on a variety of factors,” they told the Herald.

“Due to the personalisation of our app, not all customers will see the same deals, and as an example a deal may be offered to encourage use of the app on the customer’s next visit.”

Just like Delta Airlines' frequent fliers, frequent users of the McDonald's app are less price-sensitive. That might be because they want to build up points on the app (just like air miles), or it might simply be that McDonald's has found that the most loyal McDonald's users are less sensitive to price, and more likely to use the app. In both cases, for these consumers there are fewer close substitutes to McDonald's than there are for infrequent app users, and so the frequent users' demand is less elastic than the infrequent app users. McDonald's therefore offers lower prices to infrequent users of the app, because they are more price sensitive.

Despite any complaints that users of the app may have, none of this is illegal. Firms are free to offer different prices to different consumers. As noted in the article:

The Herald approached Consumer NZ about the claims of price gouging and the watchdog said it had not received any complaints about pricing on the app.

“The Fair Trading Act states businesses can’t mislead shoppers about prices, and the Privacy Act requires companies to disclose to consumers what data is being collected and how it’s being used,” a Consumer NZ spokesperson said.

“If McDonald’s is using personalised pricing, or their customers’ data to set different prices based on factors like what products they’ve searched for in the past, or their location – they should be upfront about it,” they added, pointing towards a Consumer guide to personalised pricing.

“While personalised pricing may not be inherently bad, it relies on businesses applying it fairly, responsibly, and transparently.”

Personalised pricing is a particular form of price discrimination (first-degree price discrimination), where every consumer may be charged a different price for the good or service (for more on this, see this post). If executed perfectly, the firm would charge a price equal to the maximum the consumer is willing to pay. Fortunately (for consumers, not for firms), personalised pricing is mostly a theoretical curiosity. However, the more data that firms have about consumers, the closer they can get to estimating their consumers' willingness-to-pay.

Apps like the McDonald's app are a very handy tool for firms to collect information about their consumers, what they are willing to pay for different goods and services (and what they are not willing to pay). That data can then be used to set prices in the future. It's a point that I've made before. Give it time - if consumers keep giving firms their data, pretty soon we'll all face personalised prices for most of the things that we buy.

[HT: Max from my ECONS101 class]

Price discrimination and taste-based discrimination, in the same market

Price discrimination occurs when a seller sells the same good or service to different customers for different prices, and where the difference in price doesn't arise from a difference in costs. There are lots of examples of price discrimination in the real world (see some of my posts here, and here, and here, for example). Many people misunderstand price discrimination, conflating it with the types of behaviour that the word 'discrimination' is often used to describe, like racial discrimination or gender discrimination. However, more often than not price discrimination doesn't mean that the firm is pricing differently for different genders or races (although it does happen).

To make things even more confusing, discrimination in pricing on the basis of personal characteristics does sometimes happen, and it can happen in markets that also have price discrimination (as described above) as well. Take this 2018 article by Huailu Li (Fudan University), Kevin Lang (Boston University), and Kaiwen Leong (Nanyang Technological University), published in The Economic Journal (ungated earlier version here). They investigated discrimination in the commercial sex market in the Geylang district of Singapore, using a survey of 176 sex workers and a dataset based on 814 transactions between those sex workers and their clients (taken from the last four to seven transactions for each sex worker that was surveyed). Specifically, Li et al. expected to find that:

...based on beliefs about their willingness to pay, sex workers would ask for higher prices from white clients than from Chinese clients who, in turn, would be asked for more than Bangladeshi clients... We also anticipated that they would charge high prices to Indian clients, the primary client group with darker skin tones (taste discrimination).

Notice that the first expectation there is price discrimination, in a similar way to what we often see in other markets - consumers with a higher willingness-to-pay, or with less elastic demand (less sensitivity to price), are charged a higher price than consumers with a lower willingness-to-pay or more elastic demand. Li et al. refer to this as 'statistical discrimination', since it is based on statistical differences between groups (in their willingness-to-pay for sex services). The second expectation (referred to as 'taste-based discrimination') is purely based on the preferences of the seller (it is what most people would recognise as discrimination). In relation to this expectation, Li et al. first report that:

The sex workers were asked to rate different ethnicities on a scale of 1 (dislike) to 5 (like very much) with 3 being ‘like.’ They consistently give high ratings to Chinese (4.2) and white (3.9) clients... In contrast, the Bangladeshi and Indian clients earn average ratings of 3.1 and 2.1...

Does that difference in sex worker preferences transfer into pricing differences? That is, do sex workers charge higher prices to clients from ethnic groups that they like less, and lower prices to clients from ethnic groups that they like more? Li et al. find:

...robust evidence that sex workers are less likely to approach Indians and that they are less likely to reach an agreement. We do not confirm the expectation of a higher price relative to Chinese clients; the initial prices demanded of the two ethnicities are similar, perhaps because sex workers also believe that Indian clients have a relatively low willingness to pay, a belief that would be consistent with the low offers made by Indians when they make the first offer. Consistent with our expectations, Indians pay a premium relative to Bangladeshis.

On the other hand, there is also statistical discrimination as well, because:

Relative to the base group (Chinese), the same sex worker suggests an initial price to whites with an 11% (10 log points) premium and gives Bangladeshis a 13% discount on the initial price offer, thus asking whites for almost 30% more than she asks from Bangladeshis.

So, there is both statistical discrimination (price discrimination based on perceived differences in willingness-to-pay), and taste-based discrimination, in this market. How confusing!

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 which involves the consumer paying a declining price for each additional unit that is purchased; 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.

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.

Hamilton Gardens' entry fee for tourists as a form of price discrimination

I missed this story when it was first reported, but Hamilton Gardens has made the decision to introduce a $10 entry fee once their new entry precinct opens at the end of the year. However, entry for Hamilton residents will remain free. As Stuff reported:

The days of free entry to Hamilton Gardens are numbered for visitors from out of town as work begins on a new precinct at the flagship attraction.

Tourists will pay $10 for entry to the themed gardens when the entry precinct is complete, possibly by the end of the year, while Hamilton residents and children under 16 will get in for free.

Work is set to start next month on the area, which is also intended to better open up the Gardens for visitors, making it easier to see what is on offer.

This is a great idea, and backed by solid economics. I've made the point before that, if tourist operators are trying to maximise profits, then tourists should be paying more for tourist activities than locals (see here, and here, and here). To see why, let's look at the example of Hamilton Gardens. As the Stuff article notes:

Hamilton & Waikato Tourism chief executive Nicola Greenwell said the Gardens are one of the region’s top offerings.

“They're incredibly important to our visitor offering, they are one of our hero products. So they do attract a large number of people to our city and to our region.”

She thinks visitors will take the $10 fee in their stride. “I think that the offering that the Hamilton Gardens has is world-class, and it is well worth an entry fee.”

Tourists will take the $10 fee in their stride, but not just because of the world-class nature of the gardens. We'll get to that a bit later. First, some theory.

Price discrimination occurs when a firm sells the same product to different customers for different prices, and where the difference in price doesn't arise from a difference in costs. In this case, access to Hamilton Gardens will be free for Hamilton residents, but cost $10 for tourists. That difference in price does not result from a difference in costs, because it costs Hamilton Gardens the same to host a visitor regardless of where the visitor is from.

For price discrimination to work, three conditions have to be met:

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. The seller needs 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 of customers (since the seller doesn't want the low-price group re-selling to the high-price group).

In the case of Hamilton Gardens, there are two groups of visitors (locals and tourists). Why does the price elasticity of demand differ between these two groups? Tourists have lower sensitivity to price (low price elasticity of demand) for a couple of reasons. First, for visitors there are few substitutes for visiting Hamilton Gardens (or other tourist attractions). Locals have lots of alternative activities (like staying at home watching Netflix). When there are fewer substitutes, the price elasticity of demand is lower. Second, tourists have usually also travelled further than locals, at higher cost, in order to get to Hamilton in the first place. So, the cost of entry into Hamilton Gardens is pretty small in the overall cost of their holiday. Whereas for locals, the cost of entry into Hamilton Gardens (if there was an entry fee) is essentially the entire cost of their visit. When the price is a smaller component of the total cost (as it is for tourists visiting Hamilton Gardens), the price elasticity of demand is lower. For both of these, tourists will be relatively insensitive to price compared with locals, and raising the price of entry for tourists isn't going to keep them away in great numbers.

That covers the first condition for price discrimination. For the second condition, Hamilton Gardens needs to be able to tell who the Hamilton residents are (because they get free entry) and who the tourists are. And for the third condition, Hamilton Gardens needs to ensure that Hamilton residents can't 'buy' free tickets, and then give them away to tourists (as that would defeat the entire purpose of price discrimination). Let's assume that Hamilton Gardens has a good way of doing these things (and we'll come back to that later).

Since those conditions are met, Hamilton Gardens can price discriminate. This is shown in the diagrams below. Both diagrams show a firm with market power (Hamilton Gardens), and each diagram corresponds to one of the sub-markets. The sub-market on the left represents the locals, who have more elastic demand - notice that the demand curve D1 is relatively flat (which means that a change in price will have a big effect on the quantity that these consumers demand). The sub-market on the right represents the tourists, who have less elastic demand - notice that the demand curve D2 is relatively steep (which means that the same change in price would have a smaller effect on the quantity that these consumers demand, than it would for the locals). The marginal cost (MC) is the same in both sub-markets - as noted earlier, it doesn't cost Hamilton Gardens any more to provide entry to a local than it does for a tourist. [*]

Hamilton Gardens will maximise profits by selling the quantity where marginal revenue (MR) is equal to marginal cost (MC) - this is the standard short-run profit-maximising condition. In the tourists sub-market, the profit-maximising quantity occurs where MR2=MC, which is Q2. In order to sell that quantity in the tourists sub-market, Hamilton Gardens should set the price equal to P2. The problem with that high price P2 is that in the locals sub-market, no consumers would be willing to visit Hamilton Gardens at all. Hamilton Gardens can increase profits if it charges a different price in the locals sub-market, from the price it charges in the tourists sub-market. In the locals sub-market, the profit-maximising quantity occurs where MR1=MC, which is Q1. To sell that quantity in the locals sub-market, Hamilton Gardens should set the price equal to P1. 

So, profit maximising across both of these sub-markets would require Hamilton Gardens to sell to the locals sub-market at a low price (P1), which may be equal to zero, while at the same time selling the same entry to the tourists sub-market at a high price (P2).

Now, there are some problems with this approach. Hamilton Gardens needs to be able to tell Hamilton residents apart from tourists. There are limited practical ways to achieve this. Perhaps Hamilton City Council issues an ID card to every resident? That would be effective, but expensive. So, perhaps Hamilton Gardens simply asks residents to bring proof of residency with them to get free entry. That could be a rates bill, or an electricity bill, or similar, with their residential address on it. Hamilton Gardens could, in theory, then match the name on the bill with some other form of ID, to make sure that the person wanting free entry is the same person named on the proof of address. I doubt they would do this, because it will take a lot of time and effort, and because sometimes you live at an address, but the bills are not in your name.

So, it's likely that all that will be required is a utility or rates bill with a Hamilton address on it, to get free entry to Hamilton Gardens. That will mean that this attempt at price discrimination doesn't strictly meet the second condition for price discrimination - Hamilton Gardens won't effectively know who is a resident, because any Hamilton resident can give a proof of address to a tourist, which would allow the tourist free entry to Hamilton Gardens. None of that means that price discrimination will fail entirely here. Movie theatres don't check ID before allowing entry, and they seem to get away with price discrimination just fine [**].

*****

[*] Notice that we are drawing a constant-cost firm here (so marginal cost is equal to average cost, and all units cost the same to produce and sell). That makes our explanations a little easier than the case where marginal cost is increasing.

[**] As far as I know, no student has ever taken up the business opportunity I point out every year, to buy tickets for people who would otherwise pay general admission at movie theatres, and pocket (some of) the difference in prices.

Read more:

• Are tourism operators in NZ missing a trick?
• Price discrimination in tourism... India edition
• Price discrimination and the Great Walks