Wednesday, October 7, 2015

How digital disruption allows higher prices

Do you think much about the process involved when you decide to buy something some seller is offering you? If you're like most consumers, probably not. But the businesses doing the selling do, which ought to be a warning.

And the study of exchange – the buying and selling of goods and services – is the central element of economics. Economists long ago concluded they had it all figured.

Trouble is, the digital revolution is changing the way sellers behave when we buy things online or use the internet to check out the choice before deciding what to buy.

These hidden changes are revealed in the eye-opening book, All You Can Pay, by former Fairfax Media journalist Anna Bernasek and her husband, D. T. Mongan.

None of us wants to pay more than we have to to buy the things we decide we need. But the great insight of economists is that we'd often be prepared to pay more for something we want than we're required to.

The difference between what we're willing to pay and what we actually have to is known to economists as the "consumer surplus". It's a measure of how much better off the purchase has left us.
The more successful competition is in holding down the market price, the greater is our consumer surplus and thus the more we've gained from living in a market economy.

By the same token, sellers are often able to sell their wares for a higher price than the minimum at which they'd be willing to sell. This difference is the "producer surplus". The smaller the producer surplus, the more competition in the market is advancing the interests of consumers.

It's obvious that producers would like their surplus to be as great as possible. The history of the modern market economy is the story of how businesses have discovered ways of increasing that surplus even while competition between them has been working to keep it small.

For most of the past century we lived in the era of mass-produced consumer goods, as epitomised by Henry Ford. He invented the production line as a way of more fully exploiting economies of scale and keeping the price of his cars as low as possible.

The lower the price, he reasoned, the more people who could afford a car. And the more cars he sold, the higher his profits. To keep costs and prices low he produced just one kind of car, in one colour, black.

But, as Bernasek and Mongan record, Ford was eventually overtaken by General Motors, pursuing a different strategy of selling a range of models at differing prices, aimed at different segments of the market. GM even started changing each model slightly every year.

This "product differentiation" involved selling more than just a car: style, fashionability, social status, even self-expression. From an economist's perspective, however, it was about gaining the freedom to charge a higher price, making the "market price" harder to discern, reducing consumer surplus and increasing producer surplus.

If each consumer has their own price they're willing to pay, the ideal from a profit-maximising producer's perspective is to charge each individual a price that matches their willingness to pay. That some people would pay a price much lower than others are paying won't matter provided you're getting as much as you can out of each of them.

Trouble is, how do you know how much a person is willing to pay? You don't. But for years many businesses have practiced various forms of "price discrimination" involving charging broad categories of customers higher prices than others.

Cinemas, for instance, charge adults more than children. Airlines charge business travellers more than holidaying families. They do this not out of the goodness of their hearts, but to maximise their producer surplus.

But this is where the online revolution is making it a lot easier for sellers to assess the willingness to pay of particular customers. The more information they have on file about you – your age, sex, address, occupation and record of previous purchases – the more accurately they can estimate how much they can get away with charging you.

The authors explain that the trend to "customisation" is actually a way of asking you to disclose more about what you're looking for, giving the seller greater control over what you're offered and at what price.

Chain stores' loyalty cards are primarily a way of gathering information about your buying habits and preferences. If I know you invariably buy brand X, I know I don't need to offer you a lower price.

These days, prices are often framed as discount off what's purported to be the usual price. But how do you know the price wasn't bumped up before it was discounted? And how do you know the discount you're being offered isn't lower than others are getting?

Most of us still do only some of our shopping online rather than in stores, so it's early days for the trends Bernasek and Mongan see emerging.

But it's not hard to believe it's getting ever easier for businesses to convert consumer surplus to producer surplus by charging us more than they used to.

The more prices become personalised, the harder it becomes to know the actual market price – even the average price – customers are paying. If that day dawns, the benefits of living in a market economy will be greatly reduced.