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.

How home loan customers can use switching costs against the banks

Economists often consider switching costs to be a problem for consumers. High switching costs can lock a consumer into buying a particular product, or lock them into buying from a particular seller. Often, the seller extracts additional profits from their locked-in customers by charging them a higher price, or selling them complementary products. However, sometimes locking in can benefit consumers, especially when they can play off one seller against another, where both sellers want to lock the customer in. Consider the example of banks, on which the New Zealand Herald reported last month:

Home loan borrowers are taking cashback incentives to stay with their current banks, as competition continues in the mortgage market.

The focus on cashback incentives intensified through the end of last year, when ANZ offered cash payments equal to 1.5% of loan amounts to new home loan borrowers.

In a competitive environment, banks really want home loan customers, and are willing to pay to attract new customers. Retaining their existing customers is important too, and banks may be willing to pay to keep their customers. However, not all customers will be able to extract the same 'retention payments' from their bank. The bank needs to weigh up how likely it is that they will lose a customer:

Helen Stuart, a mortgage adviser at Compass Mortgages, said she had seen “retention payments” offered by several banks lately, especially when someone had all their lending come off a fixed term...

It is harder to change to lenders when some of the loan is still fixed, because it usually means a break fee has to be paid.

That makes sense. When a bank customer has a fixed rate mortgage, they have to pay a 'break fee' in order to change banks. Their current bank can feel quite secure that the customer is going to stay with them, and so the bank is unlikely to offer a retention payment (or, if they do, any retention payment is likely to be quite small). On the other hand, when the fixed rate on the mortgage expires, the bank customer can change banks without paying a 'break fee', and so the bank would be more likely to offer a retention payment (or would offer a more generous retention payment). Of course, the retention payment itself is likely part of the bank’s lock-in strategy, since cashbacks often come with conditions that make future switching more costly to the customer.

Thinking further:

Jeremy Andrews, of Key Mortgages, said what people could get would depend on how long a customer had had their loan, whether they had taken a cashback previously and whether they had more than 20% equity.

“Some banks will refuse retention cash if the clients are already fixed in and they see it as of no benefit to the client to refinance to another bank. Some examples include if it’d be detrimental either in break fees – they’re already on higher than market rates, or if they would need to move to higher rates in the market, or the legal costs associated exceed any cashback benefit of moving.

So, in general, the bank is weighing up how likely it is that the customer will change banks. If changing bank would lead the customer to end up paying a higher interest rate on their mortgage, the bank infers that the customer is less likely to leave, and the bank will therefore be less likely to offer a retention payment. It is a similar story if legal costs are high - the customer is less likely to move, and the bank will be less likely to offer a retention payment.

Bank customers should be savvy about this though. Any time that they have the 'upper hand', through low switching costs, they could use their position to extract a large retention payment from their bank. This happens when their home loan comes off a fixed rate, and especially when other banks are offering enticements for the customer to switch. Of course, they need to consider not just the retention payment, but the interest rate, break fees, legal costs, the hassle of switching, as well as whether accepting the retention payment locks them in and for how long. If it makes sense overall, then playing off the banks against each other may allow the home loan customer to reverse the logic of switching costs to their advantage.

The Australian government has 'subscription traps' in its sights

As I noted in a post last week, firms are increasingly selling subscriptions rather than products because consumer inertia can make them substantially more profitable. Once a customer starts a subscription, they tend not to cancel the subscription as soon as they should, simply because it requires some thought and attention (as well as a little bit of time) to execute a cancellation of the subscription. This 'customer inertia' is a form of switching cost, which locks customers into buying the subscription. However, sellers can easily amp up the switching cost by making it more difficult (and therefore more costly) to cancel. This makes customer lock-in more effective, and can 'trap' customers into their subscription.

In this article in The Conversation last year, Jeannie Marie Paterson (University of Melbourne) provides a couple of examples of 'subscription traps', each of which represents an instance of the firm increasing the switching costs for the consumer:

One example is when consumers sign up for a service quickly and easily online, but can only cancel on the phone (sometimes needing to ring another country)...

Another example, known as “confirm shaming”, involves requiring consumers to click through multiple screens before they can cancel.

Typically, each of those screens has a message asking consumers to reconsider, often reiterating the service’s purported benefits and even offering new discounts on the price not previously available.

When the switching costs are higher for the consumer, the customer lock-in is more effective (it is harder for the consumer to cancel, or switch). The firm can then profit through selling at a higher price, or by selling complementary goods and services to the locked-in consumer.

It is deceptively easy for a consumer to get locked in as well. I'm sure that you will have been offered the first month free on a subscription. That is how the firms get you. Firms often offer subscriptions at a low price initially (or free), then once the consumer is locked in, the firm can raise the price (this is referred to as multi-period pricing).

However, governments are wising up to the 'subscription traps' that Paterson highlights. She notes that:

Making it hard to cancel – commonly called a “subscription trap” – isn’t currently illegal. But now the federal government has announced a plan to ban subscription traps and other hidden fees.

Since then, the policy process in Australia has advanced, with draft legislation released in early 2026 that would impose disclosure, notification, and easy-cancellation requirements on subscription contracts from 1 July 2027, if the legislation is passed.

It is worth noting that banning subscription traps is not the only policy solution here. Anything that reduces the switching costs will likely be effective at reducing customer lock-in. One example that Paterson notes is:

California’s “click to cancel” rules also mean consumers must be able to cancel using the same method of communication they used to subscribe. And businesses must offer consumers information on how to cancel.

So, if signing up for a subscription requires a single click, then cancelling a subscription must also require a single click. That minimises the switching costs, and minimises customer lock-in. Making subscriptions easy to cancel would allow consumers to retain the genuine benefits of subscriptions (including lower transaction costs and fewer service interruptions) while reducing the unnecessary costs from subscriptions they no longer use. Firms may still be able to offer discounts or reminders to retain customers, but the cancellation process should inform consumers rather than obstruct them. Reducing these artificial switching costs is therefore likely to improve consumer welfare overall.

Read more:

• The subscription economy as price discrimination
• The switching costs of online subscriptions
• More on the switching costs of online subscriptions
• Cancelling subscriptions and customer lock-in
• Why do firms increasingly prefer to sell subscriptions, rather than products?

Why do firms increasingly prefer to sell subscriptions, rather than products?

An increasing number of goods and services that were once sold as one-off purchases are now offered as subscriptions. Newspaper subscriptions and gym memberships have existed for a long time, and 'software as a service' is now commonplace. But the model has spread much more widely: consumers can now subscribe to meal kits (such as HelloFresh), razors (such as Dollar Shave Club), and a growing range of other products. Why are firms that once sold products outright increasingly choosing to sell subscriptions instead?

That is the question addressed in this 2025 article by Liran Einav (Stanford University), Ben Klopack (Texas A&M University), and Neale Mahoney (Stanford University), published in the prestigious American Economic Review (ungated earlier version here). They start by noting that the rapid growth in subscriptions is often attributed to the rise of digital products, and the convenience of a subscription for consumers. However, Einav et al. focus their attention on a third factor:

Because subscriptions are automatically renewed, consumers who are inertial may continue to pay for subscriptions they no longer value... If consumers do not fully anticipate their inertia at sign-up, this may create supply-side incentives to offer subscriptions to exploit inertial consumers, amplifying the growth of subscription offerings.

My ECONS101 students will be familiar with this explanation for subscriptions, because we literally covered this in the lecture today. Einav et al. test for the extent to which inertia matters using transaction data from "a large payment card network in the United States between August 2017 and December 2021". Their final dataset includes over 800,000 accounts, and about 870,000 account-service pairs (each account-service pair is a set of observations of a payment card account that subscribes from one of the ten largest subscription services).

Einav et al. exploit the fact that when a card expires and is replaced, consumers typically have to update the billing information for their subscriptions, prompting them to either update or cancel each subscription. To the extent that card replacement decreases the retention rate of subscriptions, this provides evidence of customer inertia. If consumers cancelled subscriptions whenever they stopped making use of them, then there would be no difference in subscription retention between months with card replacements and months without.

Unsurprisingly, Einav et al. find evidence of customer inertia, and the effects are large and consequential for firms selling subscriptions:

We use the estimated model to perform counterfactual exercises that assess how much more quickly consumers would cancel their subscriptions if there was no inertia, which corresponds to fully attentive consumers (inattention model) or default cancellation every month (switching cost model). We find that seller revenues (or equivalently average subscription durations) are significantly higher due to subscriber inertia with important heterogeneity across services. Specifically, in the inattention model, we find that inertia increases seller revenues by 87 percent on average, with increases that range from 14 percent to more than 200 percent depending on the service. In the switching cost model, inertia raises revenue by 120 percent on average, with a range of 17 percent to 259 percent.

So, there are strong incentives for firms to engage in the selling of subscriptions, and to take advantage of customer inertia in subscriptions. However, many consumers are clearly spending more on subscriptions than they need or necessarily want to. Think about yourself as an example - how many subscriptions do you have right now that you rarely use and probably should cancel? I don't have any, but that's only because writing this post made me think about this and cancel one that I was no longer really using!

Subscriptions can provide important benefits for consumer though, including reducing transaction costs (it is simpler to pay a monthly subscription than to buy goods or services individually over and over), and reducing service interruptions (because a subscription makes it more likely that the consumer won't run out of the good they are buying a subscription for). However, we might still be concerned that customer inertia makes some customers with subscriptions worse off overall. So, Einav et al. then turn to evaluating what the most appropriate policy response is. They focus attention on a rule requiring firms to provide consumers with an active renewal decision at regular intervals. Using their two models, Einav et al. find that:

In the inattention model, we find that requiring active choices at a six-month frequency would reduce the excess revenue from inattention by 45 percent. The switching cost model makes a similar quantitative prediction; moving from default renewal to default cancellation once every six months would reduce excess revenue by 48 percent.

Those are quite substantial effects, which again illustrates just how much consumers are giving away to subscription firms for subscriptions that they no longer make the best use of and should be cancelling. What becomes clear from this paper is that one important reason why firms that previously would have sold products instead prefer to sell subscriptions is that consumer inertia can make them substantially more profitable.

Read more:

• The subscription economy as price discrimination
• The switching costs of online subscriptions
• More on the switching costs of online subscriptions
• Cancelling subscriptions and customer lock-in

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.

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]

The economics of pricing LLM tokens

Ethan Ding had a really interesting post on Substack last month, discussing his view on the future costs of tokens for large language models (LLMs), and what that means for the viability of subscription-based generative AI. I want to focus on two aspects of Ding's post. First, this (the lack of capitalisation is Ding's style):

the math has fundamentally broken.

prisoner’s dilemma for everyone else

this leaves everyone else in an impossible position.

every ai company knows usage-based pricing would save them. they also know it would kill them. while you're being responsible with $0.01/1k tokens, your vc-funded competitor offers unlimited for $20/month.

guess where users go?

classic prisoner's dilemma:

• everyone charges usage-based → sustainable industry
• everyone charges flat-rate → race to the bottom
• you charge usage, others charge flat → you die alone
• you charge flat, others charge usage → you win (then die later)

so everyone defects. everyone subsidizes power users.

Ok, so let's look at this prisoners' dilemma. Consider two AI firms (Firm A and Firm B), each with two strategies to choose from (Usage-based pricing, or flat-rate pricing). The game is outlined in the payoff table below. The payoffs are expressed in +'s and -'s, with more +'s obviously being better.

To find the Nash equilibrium in this game, we use the 'best response method'. To do this, we track: for each player, for each strategy, what is the best response of the other player. Where both players are selecting a best response, they are doing the best they can, given the choice of the other player (this is the definition of Nash equilibrium). In this game, the best responses are:

1. If Firm B chooses usage-based pricing, Firm A's best response is to choose flat-rate pricing (since ++ is a better payoff than +) [we track the best responses with ticks, and not-best-responses with crosses; Note: I'm also tracking which payoffs I am comparing with numbers corresponding to the numbers in this list];
2. If Firm B chooses flat-rate pricing, Firm A's best response is to choose flat-rate pricing (since - is a better payoff than --);
3. If Firm A chooses usage-based pricing, Firm B's best response is to choose flat-rate pricing (since ++ is a better payoff than +); and
4. If Firm A chooses flat-rate pricing, Firm B's best response is to choose flat-rate pricing (since - is a better payoff than --).

Note that Firm A's best response is always to choose flat-rate pricing. This is their dominant strategy. Likewise, Firm B's best response is always to choose flat-rate pricing, which makes it their dominant strategy as well. The single Nash equilibrium occurs where both players are playing a best response (where there are two ticks), which is where both firms choose flat-rate pricing.

Notice that both players would be unambiguously better off if they chose usage-based pricing. However, both will choose flat-rate pricing, which makes them both worse off. This is a prisoners' dilemma game (it's a dilemma because, when both players act in their own best interests, both are made worse off).

Ding notes that this is a losing proposition for all generative AI firms, and is the position that they are all in right now. They could try to cooperate and shift to usage-based pricing, but there will always be a strong incentive for the firms to cheat on any agreement and instead offer flat-rate pricing. So, any agreement will not last. Especially since there are other strategies available, which Ding goes on to discuss. The one that caught my eye was this:

use ai as a loss leader to drive consumption of aws-competitive services. you're not selling inference. you're selling everything else, and inference is just marketing spend.

the genius is that code generation naturally creates demand for hosting. every app needs somewhere to run. every database needs management. every deployment needs monitoring. let openai and anthropic race inference to zero while you own everything else.

the companies still playing flat-rate-grow-at-all-costs? dead companies walking. they just have very expensive funerals scheduled for q4.

It makes sense to play the losing prisoners' dilemma strategy, if a firm can use it to be more profitable elsewhere. Using generative AI as a loss leader, and then making more profits by selling complementary services (hosting, data management, monitoring) may be more profitable overall for the generative AI firms.

For loss leading to be successful though, two conditions need to be met. First, the loss leading service should be price elastic. That means that when price is low, many consumers are attracted to the service. That seems likely to be the case for generative AI, because when the price increases, consumers can easily switch to one of the many other generative AI platforms. Second, there must be many other complementary services for the firm to sell. The three suggestions by Ding (hosting, data management, monitoring) are all complements to generative AI (or, at least, to the ways that generative AI is being used right now). So, it seems that loss leading with generative AI may be a profitable strategy for the generative AI firms, even though it means playing out the prisoners' dilemma on pricing.

[HT: Marginal Revolution]

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

Costco buttering up New Zealand consumers

Overseas, Costco uses a variety of products as loss leaders, including rotisserie chicken (see here). Right now in New Zealand, it appears to be butter. As the New Zealand Herald reported yesterday:

It was organised chaos this week at Costco when another delivery of butter arrived.

This butter is not just any butter – while the other supermarkets are selling a 500g slab for up to $10, Costco’s butter is $9.99 for a kg...

Chris Schulz, a senior investigative journalist at Consumer NZ, said it looked likely that the Costco butter was a loss leader.

“The retailer’s Facebook page is flooded with people speculating when the butter might be back on shelves, debating when to visit, and showing off when they do get it.

“With butter costing at least $17 per kilo elsewhere else, Costco’s pricing makes them look like the ‘good guys’ in contrast to our supermarket duopoly. Once they’re in store, I’m sure many people are picking up roast chickens, cheese, and giant tubs of biscuits too.”

As I note in my ECONS101 class, the ideal loss leading product is one that has a high price elasticity of demand, and lots of complementary goods. Elastic demand means that a decrease in price will increase the number of consumers by a lot. So, loss leading will get a lot more consumers in store. And complementary goods are goods where lowering the price of one good causes the consumer to buy more of the other good. Most supermarket staples that are regularly purchased will be complementary goods, because consumers tend to buy them together on the same shopping trip. So, lowering the price of one causes the consumer to buy more of the other goods on their shopping list.

In this case, by selling butter at a loss (and it must be at a loss, because there's no way that selling butter at half the price of other retailers is profitable), Costco is able to attract many more consumers, who then buy other things that Costco can profit from. The Herald article offers some examples, including this one:

Kaleb Halverson decided to start making the trip from New Plymouth to Auckland to deliver Costco’s 1kg blocks of butter at $9.99 to customers across the Taranaki region.

He only had a few orders at first, but they kept rolling in...

He brings back everything the store has to offer, but said butter is definitely top of the list. “It’s our hot item; at the moment, every order has butter.”

Other popular products are cleaning products and snacks.

Costco sells the butter at a loss, and makes up for it with greater sales of (and profits from) cleaning products and snacks. 

Black Mirror Season 7 illustrates the ultimate version of customer lock-in

[This post contains spoilers. You have been warned.]

I love the TV show Black Mirror. Charlie Brooker (the writer of almost all episodes of the show) is an evil genius. Nearly every episode depicts some dystopian near-future that is just plausible enough to make you both worry, and think. The first episode of the latest (seventh) season, titled Common People, is a perfect illustration of this. It is also a perfect illustration of customer lock-in, albeit at an extreme level. From the Wikipedia description of the episode:

Welder Mike Waters (Chris O'Dowd) and schoolteacher Amanda (Rashida Jones) have been married for three years and are trying to conceive a baby. One day while teaching, Amanda collapses, and doctors discover she has an inoperable brain tumor. Mike is introduced to Gaynor (Tracee Ellis Ross), a representative from tech startup Rivermind Technologies. Gaynor explains that Rivermind can remove the tumor and replace her excised brain tissue with synthetic tissue powered by their servers. While the surgery is free, the couple agree to pay a monthly subscription fee to give Amanda a chance at living a normal life again.

Initially the service seems to help Amanda, but as time passes they find that it has several limitations which can only be bypassed by subscribing to the costlier "Plus" tier, as opposed to their current "Common" tier. Unbeknownst to Amanda, she begins interjecting brief advertisements into her daily speech.

As I describe in my ECONS101 class, 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. High switching costs could also, in some cases, prevent consumers from stopping buying the good or service - that is, the switching cost causes the consumers to keep buying the good even if they would want to stop (if there was no switching cost). This is the case for subscriptions, for example (see here or here or here).

In this case, Rivermind appears to have discovered the ultimate form of customer lock-in. The switching cost that Mike and Amanda face if they try to cancel their Rivermind subscription is that Amanda dies (or becomes comatose - the episode is somewhat unclear on this point). That switching cost is obviously very high and provides a strong incentive for Mike and Amanda to keep their subscription going. They are locked into the subscription, which is quite expensive.

Rivermind doesn't just profit from Mike and Amanda through their subscription. Rivermind also engages in a form of multi-period pricing. Typically, firms engage in multi-period pricing by starting new consumers with a low price, and then raising the price once those consumers are locked in. This is what utility firms are trying to do when they offer a discounted rate for electricity or broadband for new customers (for a limited time!). The price is initially low, and then when the new customers are locked in, the price increases (because the discount ends).

Rivermind's approach is somewhat different to the standard case of multi-period pricing. Instead of directly raising the price of the service that Mike and Amanda receive, Rivermind degrades the quality of that service (by introducing advertising). Rivermind then introduces an advertising-free tier that is more expensive (which Mike and Amanda are invited to 'upgrade' to, even though tit is really just a more expensive price for the service they started with). Rivermind then also introduces more tiers of subscription with greater coverage and more perks (and even higher prices).

The Black Mirror episode focuses on the increasingly desperate ways in which Mike tries to keep the subscription going. However, my takeaway is that it illustrates how firms can lock consumers in with switching costs that are non-monetary, and then profit from those locked in consumers. Thanks Charlie Brooker - now you've given me something else to worry about in the dystopian near-future.

Read more:

• The subscription economy as price discrimination
• The switching costs of online subscriptions
• More on the switching costs of online subscriptions
• Cancelling subscriptions and customer lock-in

Qantas tries to execute a break-out of Air New Zealand's locked-in customers

As I noted in this post last week, customer lock-in occurs when consumers find it difficult (costly) to change once they have started purchasing a particular good or service. Having locked-in consumers is quite profitable for firms. They can raise their prices without fear of losing those consumers, or they can leverage their locked-in status to sell them other things.

Of course, if another firm wants to compete with a firm that has locked in its consumers, the competing firm may need to find some way of breaking those consumers out of being locked in. That usually involves trying to lower the switching costs that are keeping the consumers locked in. We saw an example of this late last year, when Qantas made a bid to lure away Air New Zealand's frequent flyers, as reported in the New Zealand Herald in November:

Qantas is targeting Air New Zealand’s upper-tier Airpoints members as it looks to grow its loyalty programme here beyond one million members.

As part of an aggressive push into New Zealand, Qantas will fast-track Gold members of other airline loyalty programmes into its scheme.

Those who hold Gold or higher equivalent status with other ‘‘select airlines’' can fast-track to Qantas Gold by earning 100 status credits in 90 days on flights with Qantas, Jetstar and partner airlines.

Gold status is usually obtained by earning 700 status credits in a membership year.

In addition, participating members will get access to the airline’s network of Qantas Club lounges and extra checked baggage during the 90-day fast-track offer...

Qantas is also targeting a wider range of New Zealanders to ensure they take advantage of points they already have.

Qantas Frequent Flyer will remove the $60 join fee on its website later this month.

Loyalty schemes, like frequent flyer programmes, lock consumers in because if they switch to a different programme, they lose the benefits that their current programme provides, and their frequent flyer points or airmiles will eventually expire (those are the switching costs). Qantas is trying to reduce those switching costs by fast-tracking Air New Zealand Gold Airpoints members to Qantas Gold, meaning that consumers who switch wouldn't lose their frequent flyer benefits (or wouldn't lose them for long). The switching costs aren't eliminated, because their Air New Zealand frequent flyer points will eventually expire, but they are substantially reduced. The lower cost of switching would probably attract at least some Air New Zealand frequent flyers to make the switch. As the article notes:

Qantas made a similar offer to Air NZ Gold members in 2020 which [Qantas Loyalty chief executive Andrew] Glance said had been successful.

Taking advantage of switching costs and customer lock-in is an important way that firms use to increase their profitability. It isn't surprising that firms have discovered countermeasures to restrict their competitors' ability to lock-in customers. What might be more surprising is that Air New Zealand didn't appear to retaliate by offering a similar deal for Qantas frequent flyers!

Mobile phone providers and the repeated switching costs game

This week, my ECONS101 class covered pricing and business strategy, and one aspect of that is switching costs and customer lock-in. Switching costs are the costs of switching from one good or service to another (or from one provider to another). Customer lock-in occurs when customers find it difficult (costly) to change once they have started purchasing a particular good or service. The main cause of customer lock-in is, unsurprisingly, high switching costs.

As one example, consider this article from the New Zealand Herald last month:

A new Commerce Commission study has found the switching process between telecommunications providers is not working as well as it should for consumers...

The study found 50% of mobile switchers and 45% of broadband switchers ran into at least one issue when switching.

The experience was so bad that 29% of mobile switchers and 27% of broadband switchers said they wouldn’t want to switch again in future...

The commission’s latest consumer satisfaction report found that 31% of mobile consumers and 29% of broadband consumers have not switched because it requires ‘too much effort to change providers’...

Gilbertson said a lack of comprehensive protocols between the “gaining” service provider and the “losing” service provider was a central issue with the current switching process.

This led to a number of problems, including double billing, unexpected charges, and delays.

The difficulty of changing from one mobile phone provider to another is a form of switching cost. It's not a monetary cost, but the time, effort, and frustration experienced by consumers wanting to switch makes the process of switching costly. And because the process is costly, mobile phone consumers are locked into their current provider.

It is clear why a mobile phone provider would want to make it difficult (costly) for its consumers to switch away from it and use some other provider. However, why don't mobile phone providers try to make it easier to switch to using their service instead? Maybe they could have staff whose role is to help consumers to navigate the process of switching to their service. That would allow the mobile phone provider to attract consumers and capture a greater market share. The answer is provided by considering a little bit of game theory.

Consider the game below, with two mobile phone providers (A and B), each with two strategies ('Easy' to switch to, and 'Hard' to switch to). The payoffs are made-up numbers that might represent profits to the two providers.

To find the Nash equilibrium in this game, we use the 'best response method'. To do this, we track: for each player, for each strategy, what is the best response of the other player. Where both players are selecting a best response, they are doing the best they can, given the choice of the other player (this is the definition of Nash equilibrium). In this game, the best responses are:

1. If Provider B chooses to make switching easy, Provider A's best response is to make switching easy (since 3 is a better payoff than 2) [we track the best responses with ticks, and not-best-responses with crosses; Note: I'm also tracking which payoffs I am comparing with numbers corresponding to the numbers in this list];
2. If Provider B chooses to make switching hard, Provider A's best response is to make switching easy (since 8 is a better payoff than 6);
3. If Provider A chooses to make switching easy, Provider B's best response is to make switching easy (since 3 is a better payoff than 2); and
4. If Provider A chooses to make switching hard, Provider B's best response is to make switching easy (since 8 is a better payoff than 6).

Note that Provider A's best response is always to choose to make switching easy. This is their dominant strategy. Likewise, Provider B's best response is always to make switching easy, which makes it their dominant strategy as well. The single Nash equilibrium occurs where both players are playing a best response (where there are two ticks), which is where both providers make switching easy.

So, that seems to suggest that the mobile phone providers should be making switching to them easier. However, notice that both providers would be unambiguously better off if they chose to make switching hard (they would both receive a payoff of 6, instead of both receiving a payoff of 3). By both choosing to make switching easy, it makes both providers worse off. This is a prisoners' dilemma game (it's a dilemma because, when both players act in their own best interests, both are made worse off).

That's not the end of this story though, because the simple example above assumes that this is a non-repeated game. A non-repeated game is played once only, after which the two players go their separate ways, never to interact again. Most games in the real world are not like that - they are repeated games. In a repeated game, the outcome may differ from the equilibrium of the non-repeated game, because the players can learn to work together to obtain the best outcome.

So, given that this is a repeated game (because the providers are constantly deciding whether to make switching easier or not), both providers will realise that they are better off making switching harder, and receiving a higher payoff as a result. And unsurprisingly, that is what happens, and it doesn't require an explicit agreement between the players - the agreement is 'tacit' (it is understood by the providers without needing to be explicit). Each provider just needs to trust that the other providers will make switching hard (because there is an incentive for each provider to 'cheat' on this outcome). Any instance of cheating (by making switching easier) would be immediately known by the other providers, and the agreement would break down, making them all worse off. So, there is an incentive for all providers to keep switching hard for the consumers. Even a new entrant firm into the market, which might initially make it easy for consumers to switch to them in order to capture market share, would soon realise that they are then better off making switching more difficult (it is not so long ago (2009) that 2degrees was a new entrant in this market).

The Commerce Commission is correct that the difficulty of switching mobile phone providers (the switching cost) keeps consumers with their current provider (customer lock-in). The result is that the mobile phone providers can profit from increasing prices for their lock-in consumers. The only solution to this situation would be to find some way to force a breakdown of the tacit arrangement. Then the market would settle at the equilibrium of all providers making it easy to switch to them. This may be an instance where some regulation is necessary.

Pricing like Ferrari

This week my ECONS101 class is covering pricing strategy. Essentially, this topic is about a lot of situations (supported by real-world examples) where firms may choose not to price at the single profit-maximising price. Most of the time, deviations from the profit-maximising price involve the firm pricing at a lower price than the profit-maximising price. The firm might set a lower price in order to generate goodwill and a long-term relationship with consumers, or to sell a greater quantity so that it can take advantage of moving down the learning curve (and achieving lower costs quicker), or to keep competitors out of the market (what economists refer to as limit pricing). The thing about all of those situations is that, by setting a lower price now, the firm earns more profits in the long run. It seems to me to be less clear that firms would want to set a higher price than the profit-maximising price now. Unless they face consumers like this:

Perhaps some consumers are simply willing to buy a good because it has a higher price. That is the basis of conspicuous consumption (which I have written about before here). However, I want to take this in a different direction, because firms can set a high price without needing to rely on conspicuous consumption, even when it seems like a possible explanation for what the firm is doing. Consider this example from the Wall Street Journal last month (ungated version here):

With a list price of $3.7 million, Ferrari’s new “hypercar” was revealed to the public in October with a twist: It wasn’t available for sale.

All 799 units of the low-slung, high-haunched F80 model—the most expensive production vehicle in Ferrari’s history—had been promised to top customers like Luc Poirier.

The Montreal real estate entrepreneur already owns 42 Ferraris. He said he felt “lucky” to be allowed to buy yet another.

“To be chosen by Ferrari for one of their hypercars is a true milestone for any collector,” he said.

Money isn’t enough to buy a top-of-the-range Ferrari. You need to be in a long-term relationship with the company.

By leveraging the rabid fandom of its customers through a business model based on uber-scarcity, the storied Italian company is enjoying a new golden age.

When goods are scarcer, the marginal consumer is willing to pay more for them. This is the 'Law of Demand' working in reverse. If the firm restricts the quantity it sells, then it moves up the demand curve and can sell at a higher price. However, by definition, setting a higher price than the profit-maximising price decreases profits. And, there doesn't seem to be a mechanism where over-pricing their cars gives Ferrari a long-term increase in profits. So, let's consider what they are actually doing.

Consider the market for regular, run-of-the-mill Ferraris. Because there are lots of substitutes for a regular, run-of-the-mill Ferrari, the demand for Ferraris is relatively elastic (shown by the flat demand curve D1). When Ferrari prices its cars, it sets the price so that it will sell the quantity where marginal revenue is exactly equal to marginal cost. That is the quantity Q*, and the price P1. The mark-up for Ferrari is the difference between P1 and marginal cost (MC). 

Ferrari could try setting the price higher than P1, but as noted above, this would decrease the quantity sold below the profit-maximising quantity Q*, and by definition this would decrease Ferrari's profits. So, how could Ferrari increase its profits from selling run-of-the-mill Ferraris? One way is to make demand less elastic (making the demand curve steeper). If the demand curve was steeper, like D0, then the profit maximising price would be P0 rather than P1, and the mark-up on run-of-the-mill Ferraris would be much higher. Selling run-of-the-mill Ferraris would be much more profitable.

If you are a seller, how can a firm make demand for its good less elastic? One of the factors that affects the price elasticity of demand is the number of close substitutes. If the firm can decrease the number of substitutes, or make its good less substitutable by other goods (reducing the number of close substitutes), then demand will be less elastic.

This is what Ferrari is doing by selling its most premium cars only to consumers "in a long-term relationship with the company". If you really want a Ferrari hypercar (or whatever the latest release Ferrari is), then you need to be buying run-of-the-mill Ferraris. That makes other luxury cars less close substitutes for a run-of-the-mill Ferrari, making demand for run-of-the-mill Ferraris less elastic, and allowing Ferrari to set a higher price for run-of-the-mill Ferraris. Since Ferrari sells a lot more run-of-the-mill Ferraris than hypercars, this is likely to be much more profitable for Ferrari overall:

Anyone with a few hundred thousand dollars to spare can buy a regular Ferrari as long as they are willing to wait a couple of years. While the standard models aren’t subject to strictly limited runs, the company still lives by Enzo Ferrari’s scarcity dictum: “Ferrari will always deliver one car less than the market demands.”

Limited-edition Ferraris are even scarcer, and you can’t just walk into your local showroom and buy one. These range from special versions of regular models to the design-oriented “Icona” and, most exclusively, once-in-a-decade hypercars like LaFerrari and the F80.

Such models help keep orders flowing for the company’s entire product range even though they account for a fraction of deliveries—just 7% last year. Collectors had on average bought 10 new Ferraris before qualifying to buy LaFerrari or an Icona, which means icon in Italian, according to Hagerty.

Maybe buying a premium Ferrari is conspicuous consumption, and maybe Ferrari is taking advantage of that. However, it is also using its premium Ferraris to increase the price and profitability of a run-of-the-mill Ferrari.

[HT: Marginal Revolution]

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

Tourist levies and tourist spending

The New Zealand Herald reported earlier this month:

An international tourism levy charged to visitors to New Zealand will increase to $100 – a jump of almost 200% – in a decision the Government believes will help boost economic growth and support conservation.

But it has some in the sector concerned the increase will be a barrier to visitors coming to New Zealand.

The International Visitor Conservation and Tourism Levy (IVL) is currently set at $35 and is charged to most tourists, people on working holidays, some students and some workers coming to New Zealand.

The IVL acts as a form of two-part pricing (which you can read about here). A firm uses two-part pricing when it splits the price into two parts: (1) an up-front fee for the right to purchase; and (2) a price per unit. If the consumer wants to buy any of the product, they must first pay the up-front fee. In the case of the IVL, it isn't a firm that's using two-part pricing, it is New Zealand as a whole. Tourists to New Zealand, if they want to buy any tourism experiences in New Zealand, must first pay the IVL.

The effect of the IVL on tourist spending is shown in the consumer choice model diagram below. In this case, the consumer is a tourist. They can spend their income (M) on either of two goods: NZ goods (as a tourist) with price Px, or overseas goods with price Py. The tourist's budget constraint with no IVL is the black line. The highest indifference curve that they can reach is I0, and they will buy the bundle of goods E0, which includes X0 NZ goods, and Y0 overseas goods. Now consider the impact of the IVL. The IVL takes income away from the tourist, but they don't receive any NZ goods in exchange for it (they just receive the right to buy NZ goods, as they can enter the country). That shifts the tourist's budget constraint inwards to the blue line (note that the end points on the budget constraint now have income (M-F), where F is the amount of the IVL). The tourist cannot buy the bundle of goods E0 anymore, as it is outside their budget constraint (it is outside the feasible set). The highest indifference curve that they can reach is now I1, and they will buy the bundle of goods E1, which includes X1 NZ goods, and Y1 overseas goods.

Now consider what this means for the government and for tourism operators in New Zealand. Overall, the tourist is spending more money in New Zealand now. We know this because they are buying fewer overseas goods (Y1 instead of Y0), and since they are still spending all of their income, they must be spending less on overseas goods (because the price of overseas goods is still Py), and more in New Zealand (made up of the IVL and what the tourist spends on NZ goods). The government might see that as a good thing.

On the other hand, the tourist is now buying fewer NZ goods (X1 instead of X0). That clearly isn't a good thing for New Zealand tourism operators, because tourists are spending less on NZ goods. It is little wonder that tourism operators are not happy about the IVL increasing. [*]

It gets worse for NZ tourism operators though, when we consider heterogeneous tourists. The diagram below shows two different consumers - a high-demand tourist (who spends a lot on NZ goods) shown in blue, and a low-demand tourist (who spends very little on NZ goods) shown in red. After the IVL is introduced, the high-demand tourist moves from buying bundle EH0 to bundle EH1. This means that they buy fewer NZ goods (XH1 instead of XH0), but spend more in NZ in total (just like the previous diagram, because they are buying less overseas goods - YH1 instead of YH0). However, the low-demand tourist's best affordable choice after the IVL is introduced is to stop buying any NZ goods at all, and not pay the IVL at all. They would consume the bundle EL1, spending all of their income on overseas goods (and buying no NZ goods at all instead of XL0).

Tourism operators might console themselves that while there will be fewer tourists, the remaining tourists are those that buy a lot of NZ goods. However, high-demand tourists could even end up spending less in NZ overall, as shown in the diagram below. In this diagram, I only show the high-demand tourists (for simplicity). Notice that in this case, once the IVL is introduced the high-demand consumers move from buying bundle EH0 to buying bundle EH1, and they end up buying less NZ goods (XH1 instead of XH0), but more overseas goods (YH1 instead of YH1). Since they are buying more overseas goods, they must be spending more on overseas goods (because the price of overseas goods is still Py), and therefore spending less in NZ overall (even when you add the IVL plus their spending on NZ goods).

Which of these scenarios will play out? Will consumers end up spending more overall (combining the IVL and spending on NZ goods)? Low-demand tourists will stop visiting, but how many will do so? Will high-demand tourists spend more overall, or less? These are all relevant questions that it would be worthwhile to answer. And the New Zealand tourism industry really needs some answers, because it will be really consequential for their revenue and profits.

*****

[*] Note that the diagram doesn't show the effect of increasing the IVL. However, comparing IVL with no-IVL is qualitatively the same as comparing smaller-IVL with larger-IVL.

Cancelling subscriptions and customer lock-in

I posted last week about customer lock-in, and briefly discussed subscription services as an example. Then on Monday, The Conversation published this article by Katharine Kemp (UNSW):

Subscription business models have become common – many products are now provided in the form of software, an app or access to a website. Some of these would once have been a physical book, newspaper, CD or exercise class.

Most people who use online services have experienced the frustration of finding a credit card charge for an unwanted, unused subscription or spending excessive time trying to cancel a subscription.

Businesses can make it difficult for consumers to stop paying for unwanted subscriptions. Some do this by allowing consumers to start a subscription with a single click, but creating multiple obstacles if you want to end the subscription.

This can include obscuring cancellation options in the app, requiring consumers to phone during business hours or making them navigate through multiple steps and offers before terminating. The report points out many of the last-ditch discounts offered in this process are only short term. One survey respondent said:

I wasn’t able to cancel without having to call up and speak to someone. Their business hours meant I had to call up during my work day and it took some time to action.

Other businesses badger consumers with frequent emails or messages after they cancel. One respondent said a business made “the cancellation process impossible by making you call and then judging your reason for cancellation”.

Let me reiterate some points from last week's post (as well as posts here and here about online subscriptions). Making it difficult to unsubscribe creates a form of switching cost. Switching costs provide sellers with a lot of opportunity to extract additional profits from consumers. That's because high switching costs create customer lock-in - customers are unwilling to change provider, or stop buying, because they would then face the costs of switching.

We often think about switching costs in monetary terms, like the contract termination fee on a mobile phone contract, or a break fee on a fixed mortgage. However, switching costs can be highly effective even if they are not monetary. In fact, they could even be more effective. Take the example from Kemp's article - in order to unsubscribe, you have to call up and speak to someone. That takes time and effort (a switching cost). Add to that the fact that the call has to be made during business hours (increasing the switching cost). Being bombarded with emails or messages after cancelling adds a switching cost (although one that can be easily avoided by automatically sending all those emails to the junk folder).

Part of Kemp's article highlights these switching costs, and raises some justifiable concerns (at least, justifiable from a consumer's perspective). As a solution, she highlights firms that try to make it 'easy' to unsubscribe, noting that:

Businesses focused on a short-sighted cash grab fail to realise that consumers might cancel but later return if treated well.

However, consumers don't all return, regardless of how well they are treated. Because of that, it is more profitable for many firms to try and lock consumers in (if it wasn't profitable to do this, the firms wouldn't bother).

That brings us to the second aspect of Kemp's article, which is about how firms profit from their locked-in customers. In my ECONS101 class, I talk about two main ways that firms profit from these customers. First, firms may engage in multi-period pricing. This involves selling at a low price initially (sometimes an artificially low price, like a free trial), and then raising the price once a customer is locked in. This is why drug dealers may give away their highest-quality product for free! Second, firms may profit by selling complementary goods and services. This is how the manufacturers of coffee pod machines make their money - not from selling the machines, but from selling the pods. These firms can afford to give quite generous bonuses to their sales staff because each sale is going to generate a lot of coffee pod profits.

Kemp argues that 'unfair practices' should be legislated against. It is hard to argue against preventing unfairness. However, in practical terms, it may not be as simple as Kemp makes it out to be. Some ways that firms lock customers in can easily be re-framed in terms of customer privacy. Why does Firm XYZ make customers call during business hours to cancel their subscription? Because they want to be sure that the request to cancel is genuinely coming from the subscribed customer, and not from some identity thief. It would be difficult to legislate against a firm making customers who want to unsubscribe prove their identity.

On the other hand, some (but not all) of the ways that businesses profit from locked-in customers are clearly unfair and could be legislated against. Kemp discusses free trials that automatically transition to a paid subscription, or subscriptions that auto-renew. There is little justification that firms can provide for the former, and for the latter they would have to rely on 'customer convenience'. Neither is a particularly good justification, when set aside the costs that consumers face when firms engage in those practices. Certainly, subscription services are something that governments should be taking a closer look at.

Read more:

• The subscription economy as price discrimination
• The switching costs of online subscriptions
• More on the switching costs of online subscriptions