Price Discrimination

The World's Most Common and Effective Form of Economic Redistribution

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The Economics 101 model of supply and demand is that more of a product gets produced as the price rises, and less of it gets consumed as the price rises. That gives us two lines (or curves) with an intersection that tells us how much will be produced and at what price. The model isn’t meant to be accurate, it’s just meant to be a starting point for understanding all the ways the world doesn't quite conform to what the model says.

One of the ubiquitous instances of this is price discrimination, which covers both the practice of charging different amounts for exactly the same product and using tiny product differences to set very different prices. When you're on the receiving end of it—paying $4 for a bottle of water at a concert, buying a last-minute plane ticket for 5x the usual fare, upgrading some software from the free plan to the paid plan because your company is in a regulated industry and some of the logging you need is locked behind a paywall, taking an Uber in the rain, finally losing access to your ex's Netflix account—it's frustrating. But price discrimination is also a form of redistribution, where a given industry can support a larger capital base, and can sell more products, or when it can extract the maximum possible amount from the people most willing to pay.

You yourself engage in price discrimination any time you substitute for the cheaper-but-equivalent product because you know it's equivalent for your purposes. Booking your flight a month in advance is actually an aggressive negotiating tactic that knocks the price down substantially; eating at home before you go to a movie theater is a ruthless way to deprive the theater of their near-100% margin in popcorn, etc. And you benefit from it indirectly; there would be fewer theaters with fewer popcorn consumers, and the airline route map would be sparser without the subsidy from last-minute travelers. (There are darker versions of this, too; your local gym is partly paid for by someone whose only interaction with the gym is renewing their membership every January 1st but never showing up, while your local bar's rent is paid by the patrons who come too often and stay too long.)

One interesting form of price discrimination shows up in the provision of consumer credit. The most expensive loan you can get, even pricier than the typical 600% or so for unregulated payday loans, is paying 1.5% for an instant cashout with a product like Cash App. A 1.5% fee to save two days amounts to an annual interest rate of over 1,400%. Meanwhile, someone who borrows on a revolving credit line and pays off their statement balance every month is paying 0% interest for short-term credit, and probably earning money in the form of points.

This illustrates that price discrimination is about more than one dimension of relative demand. In some cases, it just means identifying people who have enough money that they're indifferent to losing a bit of it, especially if the process can be disguised a tad: waiters say "tap, sparkling, or still?" because it's more polite, and fewer syllables, than saying "Hey, care for a seltzer? And if not: I'm thinking of a number, and it's the amount you will have to add to your bill not to look slightly cheap."

Companies that have multiple interrelated lines of business can afford to engage in more elaborate forms of price discrimination. Airlines can monetize travelers through ticket sales, but can also monetize their traveller relationships with loyalty programs; high-end restaurants can capture a markup on a caviar or truffle surcharge, and can earn even more on drinks.

Amazon is a master of this (Disclosure: I'm a shareholder). They have digital goods, with an effective incremental margin close to 100%. And they have a retail business subject to real-world constraints, where the marginal cost of having enough deliveries to need another van, or another fulfillment center, is extremely high relative to the cost of getting a bit more throughput from their existing assets. They persistently trade off between these by offering customers credit for digital content if they accept slightly slower shipping. They're paying a small opportunity cost if their customers would have paid full price for the same digital goods, but what they're getting in return is smoother demand for their logistics network. Reducing the variance in the number of packages delivered per day on a given route means reducing the fixed cost of serving that route.

So even though streaming videos have nothing to do with next-day delivery for assorted physical products, the combination of these businesses lets Amazon engage in two-way price discrimination, charging impatient customers more for physical products and charging other customers less for the digital-plus-physical bundle.

Markets, too, engage in price discrimination. The product markets sell is liquidity, and the entire market-making ecosystem is built around ensuring that this liquidity is appropriate-priced, depending on:

  1. How much of a hurry you are in to convert your assets into dollars or your dollars into financial assets, and

  2. How likely it is that you are in such a big hurry for a good reason.

The mechanism for the first of these is that market-makers quote a spread between the price at which they buy and the price at which they sell. As of this writing, for example, Netflix shares can be bought for $340.17 or sold for $339.95. If you're doing a small trade as a retail investor, you will actually get a slightly better price than the quoted price, through a market-maker's arrangement with your broker. The market-maker wants to trade with you because when you sell, say, 25 shares of Netflix in your Robinhood account, it's probably not the first chunk of a 500,000-share order you'll be desperate to finish executing by the end of the day.

When market-makers see that order flow is moving in one direction, they adjust accordingly. They don't necessarily need to know why this is—whether it's because news happened intraday or because a portfolio manager got fired and their portfolio is being liquidated, or for some other reason. What they need to know is that the new equilibrium between supply and demand is at a different price than it used to be.

The world's biggest and most successful companies tend to simultaneously have a lot of pricing power and to offer lots of products for free, or to incorporate them as a low- or zero-cost add-on to an existing product. It's paradoxical but true that Google, a ruthless extractor of all possible economic surplus from its advertisers, has a bigger economic impact from the free usage of its search engine. But in the end it makes sense: these companies sit somewhere in a supply chain with lots of zero-marginal-cost outputs, and with perfect price discrimination and returns to scale, the optimal move is to make a large set of what they produce as cheap as possible and often free, in order to charge massive amounts to the comparatively small set of customers who have the ability to—and no choice not to—pay for them.

Read More in The Diff

Price discrimination shows up all the time in The Diff. Some greatest hits:

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