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The Economics of Price Discrimination

Our next economics lesson is on “price discrimination.” This is economists’ label for the phenomenon of different customers being charged different prices for the same product or service. Familiar examples are airline trips, hotel rooms, and college tuitions (net of student-aid grants). In most circumstances, the motivation of sellers in introducing these differential prices is simple: some people are willing to pay more than others. So if you can charge more to those with greater willingness to pay, you make more money. Despite its suggestive name, this practice can also be good for society—allowing consumers who would otherwise be excluded to enjoy a good or service.

Any merchant of course would be happy to get extra cash from customers who are less sensitive to price. But doing so is a lot easier and a lot more significant for some products and services than others.

It’s not so important to a haberdasher as to an airline to move today’s inventory out of the “store” today. If you don’t sell a shirt today, you can sell it tomorrow.  But if you don’t sell a seat on today’s 5:30 flight to LA before it leaves, that seat will fly empty and you can’t sell that seat (a seat on today’s flight) tomorrow. It’s no problem if a hundred people come in to buy shirts Tuesday and 10 people come on Wednesday. But it’s a big problem if a plane with 75 seats has 100 people wanting to fly Tuesday and 10 on Wednesday. The same principle applies to places on campus. So suppliers in these industries have a particular incentive to operate at capacity in the short-term—even if it means lowering the price for marginal customers.

Because the marginal cost of supplying extra consumers is, in all of these cases, lower than the average cost—in fact in many cases the marginal cost is close to zero—selling those last units at a low price increases net revenues—but lowering the price so much for all consumers would result in big overall losses. (See our earlier post on marginal vs. average costs at http://chronicle.com/blogs/innovations/back-to-basics-ii-the-marginal-economist/29970.)

Fortunately for their financial prospects, services like transportation, lodging, and higher education have some big advantages in differentiating the prices they charge. One major one is that they generally know the names of their customers: I can’t buy an airplane ticket in my name in advance and then give it someone else to use (as I could with a shirt).  Often sellers know much more than the name. Airlines know, in particular, how far in advance you are buying and whether you are insistent on flying at a peak time of day when seats are scarce. Odds are that if you are booking one day in advance, you really have to get somewhere, and odds are also good that you’re on a business trip someone else is paying for. You’re a good candidate to be charged a high price. Hotels know those things too, and they also know whether you went to the trouble of going through a packager like hotels.com, implying a willingness to shop. These businesses employ sophisticated computer programs to “manage yield”—to set prices day by day or even minute by minute—to extract as much revenue as possible from customers for the slots that are available.

And colleges—well, colleges have a ton of information. Many colleges ask you where else you applied—i.e., with whom are they competing? They know, typically, your high-school grades and test scores, which is a good indicator of whether you will be an attractive prospect elsewhere. They also know whether or not you applied for financial aid and if so, how much money you have—information the average used-car dealer would die for.

Colleges thus have both the incentive and the information they need in order to price discriminate. Like airlines and hotels, many colleges would have a tough time staying in business if every customer paid the same average price. It’s in the nature of a business with high average and low marginal cost.

Despite that business logic, the practice of price discrimination makes people queasy. Nobody likes being played for a sucker, which is how you feel if you find out you paid 10 times as much for your seat as the person sitting next to you. Some price discrimination practices like ticket scalping are even put outside the law in some jurisdictions. Scalpers buy up tickets at retail, trading the risk of being stuck with unsold tickets to a flop in exchange for cleaning up on premium prices for a hit. Economists would call this a service, but many normal human beings would call it extortion. Meanwhile (and legally) the Half Price Tickets operation enables theaters to put a lower price on seats that are going begging without having to advertise that their show is having a tough time in the market, and they do it selectively by only offering the lower price to people who care enough about the bargain to wait in line in Times Square. (This TKTS operation, by the way, was invented by an economist named William Baumol.)

Much price discrimination in colleges takes the form of offering a bigger discount to those with less ability to pay. This makes economic sense for the colleges because, even with discounts in the form of need-based aid, those needier students are often still paying more than the marginal cost of their enrollment. This practice of charging less to those who can’t afford it also appeals to most people’s sense of fairness.  But are we okay with charging somebody more just because they are only applying to one place, or because we know they are really eager to come because they bought a logo cap while visiting? The very common practice of turning people down for admission because they have revealed to the college through the financial aid form that they would require a very large grant award if admitted also raises ethical questions.

Still, on the whole, the economic motivations for price discrimination and the moral motivation for need-based aid often point in the same direction in the realm of higher education (and often in that of airlines and hotels as well). If colleges charged a price high enough to cover costs and didn’t provide discounts, less-advantaged students would face much more limited options—and many colleges would go out of business. Offering special discounts to students with strong academic promise (“merit” scholarships) is a more ethically dubious practice—and one that may be economically wasteful if it leads to a price war across colleges for the same students. Yet there is also a case for colleges that are not in the top rank deploying merit aid (especially for students that also have need) in order to bring the educational advantages of having some “star” students come to their campuses.

The ethical issues that surround using price-discrimination strategies to increase the revenues colleges get from students need to be taken seriously. But the financial pressures colleges face imply that price discrimination, however it may be limited and constrained, is here to stay. We hope that understanding the economic forces at play will help colleges and the families who work with them think more clearly about the issues.

 

 

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