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

Thursday, November 01, 2012

How Pricing Fairness Can Hurt You

Megan McArdle has a great piece up dealing with one of the things that often bothers people about price discrimination: finding out that other people are consistently paying less than you. Since we live one of the wealthiest and largest countries in the world, and since many of the companies we buy products from do business internationally, this often means that US consumers find out that the products they pay a lot for here in the US are being sold for much less overseas.

Case in point, the US Supreme Court is considering the case of Kirtsaeng v John Wiley and Sons which deals with whether companies can get into the business of buying US-made textbooks overseas and shipping them back to the US. Why would this be advantageous? Textbooks are fairly expensive to produce (as in, to get all the content put together and ready to print) but the cost of producing additional textbooks is low (the cost of printing and binding.) The result is that publishers sell textbooks for far, far more than the cost of printing a book -- that is, far above the marginal cost (the cost of producing one more product.) This isn't because it allows the publishing executives and their investors to lie on beds of gold coin like dragons, publishing companies are not actually massively profitable. It's because the revenue produced by selling the textbooks needs to cover the cost of producing the book content as well as the cost of producing the book itself. So they sell textbooks for what the market will bear, which with something as expensive as college is a heck of a lot.

However, since publishing companies are also constantly on the lookout for more revenue (again, to cover their production costs, as well as to produce profits for their dragons to lie on) after pricing college textbooks in the US at what the US market will bear, they'll go into other countries and sell the same textbooks there for what that country's local market can bear, so that as that price is still above the marginal cost of producing more books. The result: US textbooks can often be bought for much less in other countries. Thus creating the opportunity for some enterprising company to buy the books abroad and ship them back, if only they can get around the legal restrictions thereon. But will that save everyone money? McArdle describes why not:
It is possible for a firm to make money with some of its customers paying less than the average cost (but more than the marginal cost of producing an additional unit). It is not, however, possible for a firm to stay in business with all of its customers paying less than the average cost.

But we want to believe that it is possible. Indeed, no matter how often it is explained that we cannot all be the marginal cost consumer, someone will insist quite loudly that it is possible; that only greedy companies, incompetent bureaucrats, or bad laws stand between us and the joys of marginal cost pricing.
She draws out an example of how this situation would equalize out to the higher price with lower overall unit sales, taking as her example a situation in which ordinary US consumers are the beneficiaries of price discrimination: air travel.
If you're skeptical that this is true, consider an area where you're probably the beneficiary of price discrimination: business travel. The first class and business passengers provide the bulk of the profit on airline tickets; they pay for the extra amenities, and the ability to make last-minute arrangements for short stays during the week. Restricted economy travelers often generate very little revenue over and above the cost of transporting them--but since the seat is a wasting asset, you might as well sell it even if you'll only make a few bucks on it.

Let's say that businesses who travel a lot got a law passed to eliminate this sort of price discrimination, forcing airlines to set a single price for a given route, no matter what date or time the flight was. Such a law might well pass, since people hate confusing airline prices.

The result would not be that everyone got the tourist class price, however. Imagine that you've got 10 business class passengers paying $100 apiece, and 100 tourist class passengers paying $5 apiece. Assume that the marginal cost of taking on an extra business passenger is $2 and the marginal cost of a tourist passenger is $1. Assume your fixed cost of getting the plane off the ground is $1300, so you've got a total cost of $1420 and revenue of $1500.

Now say someone comes along and mandates that everyone has to be charged the same ticket price. What happens? Well, you charge all 110 passengers $13.50 and keep your margins about the same . . .

But wait! The tourist class passengers are very price sensitive. They're on average only willing to pay $5-$8 for a ticket. When you raise the price to $13.50, half drop out. Now you've got 60 passengers, which gives you revenue of $810. But your cost has only dropped by $50. Now you're losing a big hunk of money. You'll have to raise prices. $23 should cover it.

Gee, $23 is more than 4 times what the tourists were paying. They don't want to see Grandma that much. Another half of the tourists drop out. Now you've got 35 passengers. But your costs have only dropped by $25. You'll need to raise prices again. Maybe $40 would cover it?

You can see where this is going; pretty soon almost all you have left is business passengers, paying what they were paying before. In fact, depending on how many tourist class passengers drop out, the business class passengers might end up paying more.

someone has to pay for all those planes, and airline profit margins are far from reliably spectacular (which is why they keep ending up in bankruptcy). No, the tickets for your next vacation would probably cost three or four times as much. Obviously, this is a made-up example, with numbers chosen more for ease of calculation than versimilitude--in the real world, most people would snap up a $38 plane ticket. But empirical research bears this out; ending price discrimination doesn't necessarily mean consumers get a better deal. It can easily mean they get a worse deal.

But there's something deep within us that resists that insight. We hate the feeling that someone else is paying less than us, even if it's not costing us anything. So while a decision for the textbook importer might not make consumers any better off in the pocket, it may make them feel better about the high prices they're paying.


Anonymous said...

Price discrimination with airlines assumes benefit to the well-heeled customer.

Textbooks would probably be the same for everyone, except for the price.

This same discussion carries over into pharmaceuticals.

Andy said...

The government shouldn't ban such price discrimination, but should it enforce it either?

I think a better comparison with airlines would be if business passengers started, in bulk, buying their tickets in ways that get the "tourist" prices (weekend night stays, etc), but the airlines wanted the government to block them from doing so.