Because most philosophies that frown on reproduction don't survive.

Wednesday, May 30, 2012

The Ethics of Price Discrimination

To our modern ear the very term "discrimination" sounds bad. However, in the pricing discipline, "price discrimination" is not necessarily a bad thing. The term refers to creating a pricing and product structure which finds a way to charge customers with different willingness or ability to pay different amounts.

Examples include:

The price of clothes in a department store vs. in an "outlet" store.
The price of a newly released novel versus a backlist novel.
Name brands vs. store brands in grocery stores.

In most cases, price discrimination involves creating a situation in which customers can make a trade off between convenience and price or quality and price in order to get fairly similar products for very different prices. This ends up being good for both customers and companies. Companies are able to maximize their sales, allowing them to pay their employees, grow, and produce profits for their investors. They're able to do this by getting the most money from the customers most able to pay, and providing customers with the least ability to pay with the best deal.

However, some forms of price discrimination work more like an intelligence test. One of these I was reminded of recently when setting up travel arrangement for some upcoming trips. Most car rental companies now offer an option where the customer is offered the chance to pay for a tank of gas up front, usually at a rate $0.10 to $0.40 lower than the standard gas station price in the area. This seems like a great deal, until you remember that it only works out as a savings if you return the tank entirely empty. If you return the tank half full, you get no refund for that half tank, and you end up effectively giving the car rental company an extra $20 or so. By making money on the pre-sold tank of gas, the car rental companies are able to offer lower daily rates, allowing them to win more business, pushing other companies to lower their rates and make their money back in other less obvious ways like pre-paid gas, car rental insurance, etc.

This does offer customers who can think through all the offers they're given an opportunity to pay less, so it clearly benefits some customers. However, rather than doing so based on the willingness of customers to make small trade offs in convenience or quality, it does so based on their ability to problem solve. The pre-paid gas is particularly tricky, because at first pass the pre-pay at the lower price actually seems like a way to save money, but in most cases it will turn out to be an extra fee.

These kinds of price discrimination seem more ethically troubling, and yet it's very hard for companies to resist such approaches when they catch on, because "hiding" profits through this kind of pricing allows the companies that adopt such tactics to offer lower up-front prices.

11 comments:

mommyadventuresintx said...

Not necessarily price discrimination, but certainly ethically troubling is a new policy that some airlines are implementing. Apparently now you will be charged by some airlines to sit next to the person you are traveling with. So a family will be charged extra to sit together. This includes children. What is wrong with the world when a traveler has to pay extra to sit next to their 5 year old?!?!?!

RL said...

I agree with your ethical concerns, but I'm not so sure the gas thing is that troubling. There is another aspect of value that is being offered by the car company - that of not having to worry about filling the tank before you return it (a monetary and convenience cost) or paying an extra monetary cost for the rental companies per gallon price.

A consumer who figures he's sure to have less than half a tank of fuel left might consider his lost "monetary benefit" more of an insurance and convenience cost if he has a 6 AM flight to catch on departure date or some such thing.

Kate said...

I was thinking about this when I opened a Canadian bank account. I was at first kind of shocked by my monthly fee...I'd grown so accustomed to 'free' checking accounts while in the US! But after a few months I realized that there were NO hidden fees - the fee structure was very clear and upfront. Overall, I think the amount my Canadian bank is making off my account is probably about equivalent to what my US bank was making through various convenience fees, overdraft 'insurance', check fees, etc. And I find I prefer the up front fee structure because it is easy to understand and account for.

Darwin said...

RL,

Yeah, it's a pretty trivial example, it just struck me because I'd run into it recently. And as you say, looked at as a convenience fee (pay more to not worry about filling up the gas tank before you return it) it actually strikes me as more fair than the old practice of charging 3-5x the going rate for gas to fill up on return. It mostly just struck me because the rental guys always pitch it as, "For just $3.20 a gallon. That's $0.50 less than you'll find at gas stations around here."

Anonymous said...

Price structures that function as intelligence tests are easy to find. Credit cards, for example: People who carry a balance from month to month at 18% interest subsidize people who don't. Or groceries: People who clip coupons to buy brand-name items almost always still pay more than the store-brand items on the same shelf. Or fast food: I know that most chains make most of their profits from chips, fries, and sodas, not from burgers or subs - so I conclude that the sides are not cost-effective and it's better to just get the entrees. I could go on.

Joel

Darwin said...

Kate,

Bank fees are similar, though there's some variation. In some cases, avoiding fees is a matter of knowing arcane rules. For instance, banking regulations allow banks to charge and extra fee for looking up your account balance the ATM, so ATMs often ask you if you want to check your balance, then charge you. However, if you just hit "no", you'll get the balance on your receipt when you complete your transaction without paying any fee.

In other cases, the things they're charging for really do represent extra cost and hassle for the bank: for instance, overdrafting.

Darwin said...

Joel,

I'm not sure all of those necessarily count as intelligence tests.

For instance, it's true that credit cards charge a high interest rate, but if you need credit at short notice, credit cards actually represent a pretty cost effective way to get it. (Where it becomes an intelligence test is whether the credit card user realizes this or thinks it's just "free money" and racks up debt he has no ability to pay soon.)

Or on fast food: It's certainly true that the profit margin is much higher on a soft drink than it is on a hamburger. (Typically, the lowest margins are on the value menu, so if you really want to hurt your fast food chain, buy something off the dollar menu.) However, if the issue is that you're thirsty, the fact that the hamburger is a "better deal" doesn't really help you.

It'd tend to argue that side and drink pricing in fast food is more an example of trade-off-based price discrimination. They charge higher profit margins on the sides and drinks because typically a customer comes in order to get a whole meal, not just a side or just a drink, so the decision of which chain to go to is based on entree price. Once selecting an entree, most customers will get a side and/or a drink as well, but those who are especially price sensitive won't. By keeping lower prices on the entree and higher prices on the sides and drinks, the chains try to make the most money off the less price sensitive customers while leaving a cheap option for the customers who are watching their pennies. (The balance between the value menu and the core menu is a similar deal.)

Anonymous said...

Hmm, in my neck of the woods, you *have* to return the car with a full tank of gas, or face a hefty charge for them to refill it. I'm not sure how that policy would fit in with the "cheap tank of gas" policy you outline . . .

RL said...

Yeah, I get you Darwin. I still think it would be a raw deal even for convenience sake (I'm too cheap to throw away $30 for a convenience like that), but I could see how some people knowingly *might*.

Cathy said...

Just one quibble, which is that "intelligence" may not be the right word. I mean, it certainly is in some cases, but for me, the ethical concern has to do with when price or fee differentials are really preying on consumers' understandable but misguided assumptions, or on their lack of other options. Balloon mortgages, for example: sure, people could have done the math and seen how unsustainable their housing costs were going to become, but brokers went out of their way to obscure that fact in mountains of fine print and sought out customers who were unlikely to have either the experience to know better or the luxury of better options. To call that a failure of intelligence is, I think, ungenerous. Same goes for the folks who buy absurdly over-priced groceries at glorified convenience stores, because their neighborhoods have no real grocery stores in walking distance, or who buy cheap, poorly made goods that need replacing often because they can't afford to invest in higher-quality, longer-lasting things. Having money makes saving money much easier.

Not disagreeing with your post, just saying that I think the ethics are even more troubling than you suggest -- and that price discrimination often, in practice, ends up verging on other, more obviously immoral forms of discrimination.

Jennifer Fitz said...

Mommyadventures, I'm really quite pleased at the prospect of being paid not to have to sit next to my five year old. :-). Think an airline will actually let me?

Somehow I suspect that business guy in the aisle seat will suck it up and switch for a middle, in exchange for not having to have goldfish passed over his laptop every ten minutes.