Sharper Tools forDiscriminatory Pricing

Expert Andrew Odlyzko explains how tech advances are making it much easier to charge one price for you and another for your neighbor

By Jane Black

Why do corporations want your personal data? The simple answer, according to Andrew Odlyzko, the director of the University of Minnesota's Digital Technology Center, is that such information is the key to a holy grail of capitalism: discriminatory pricing.

Economic theory posits that price discrimination -- where companies charge individuals based on their ability to pay and their value as a customer -- is desirable since it makes trade more efficient. Yet it rankles consumers, who perceive differential pricing as unfair. The fact that business travelers, whose corporations can arguably afford it, pay more for airline seats than a vacationer has made air travel more popular and routine. At the same time, the price discrimination that charges two people different prices for the same class of service infuriates those who pay more.

In a paper to be presented at the Fifth Annual Conference on E-Commerce this fall, Odlyzko, a Bell Labs researcher for 26 years, doesn't argue for or against discriminatory pricing. He focuses on how technology can bring it to new levels of sophistication and prevalence.

In 2000, Coca-Cola (COK ) tested a vending machine that would raise prices on a hot, humid day and lower them when temperatures fell. Today, (AMZ ) knows what, when, and how often customers buy and is experimenting with offering personalized bundles -- buy two books and get a discount, for example -- to induce people to buy more. Twenty years ago, neither experiment would have been possible.

Managers who invest in privacy-eroding data-collection technology aren't always conscious that they're moving toward a world of widespread discriminatory pricing, Odlyzko says. Rather, they're trying out ways to use information to increase profits. But as corporations become more sophisticated in collecting and parsing consumers' personal information, success will lead them to more pervasive price discrimination. On July 28, I talked to Odlyzko about how data is being used to usher in a more efficient -- and privacy-invasive -- economy. Edited excerpts follow:

Q: Your paper posits that private companies now have both greater incentive and ability to discriminate on pricing by collecting and analyzing customer data. How so?


The greater incentive comes from the fact that in an information economy, an increasing fraction of the costs is fixed. It costs a large amount to create and market a movie, but very little to distribute it to a theater and on-demand to a customer at home. But different customers are willing to pay different amounts for the privilege of seeing a movie.

In the last issue of BusinessWeek, there was a letter from a reader who advocated that Hollywood should start by charging $30 to see a new release at home, then reduce the price to $5 over time. He said he would happily pay $30 to see a new movie at home because it costs him $75 to see a movie in the cinema -- after he pays for the babysitter and popcorn and tickets.

So here's one guy who says he's willing to pay $30 because that's much less than what he's currently paying to see a new release. On the other hand, you've got teenagers and adults who like the social atmosphere of a movie theater, the wide screen, etc. For them, you have to induce them to stay in and watch the movie, rather than going out, by offering them very low prices, maybe $3. If you can do both without getting them upset, then society wins.

Q: So why does differential pricing upset customers?


There's this central issue of fairness that comes up. People are very concerned that they'll pay more than someone else and be played for a fool.

That's what we dislike about having to deal with the salesman in the car-buying process. That's why people got angry enough to file lawsuits when they observed that catalog companies had been offering different prices to different individuals. [The customers lost.] That's why people are sensitive to airline pricing -- and why they're concerned that it's spreading to other travel areas, such as hotels and rental cars.

Q: Is there a correlation between more powerful technology and consumer backlash?


Fear of discriminatory pricing isn't new: It was also a very big factor in the railroads at the end of the 19th century. Then, you had a huge industry -- even bigger than the information-technology industry today -- which was practicing price discrimination on a really gross scale. As with the Internet, railroads required huge investments up front, but the marginal costs were comparatively small.

Nineteenth-century railroads didn't have the information technologies to allow for "frequent-ride" programs. Nor did they have the "positive passenger identification" system, complete with government-issued ID cards, to allow them to sell nontransferable advance purchase tickets with Saturday-night stay restrictions like the airlines have today. But they did have a variety of other tools for price discrimination, such as "versioning." That's when for a lesser price you offer an inferior service, usually one so bad that people will feel it's worthwhile to pay more.

In the railroads' case, third-class carriages were uncovered and uncomfortable and in the front of the train, where passengers would be covered with cinders blowing from the engine. They also charged different prices for freight and gave preferential rates to powerful customers such as J. D. Rockefeller. U.S. customers revolted, and by 1887, railroad pricing was regulated.

Studying 19th-century railroads is important because it represents one of the first large-scale experiments with price discrimination. Technology changes rapidly but human nature doesn't.

Q: What types of price discrimination are common today?


Senior-citizen and student discounts are a well-known type of price discrimination. The airlines have used price discrimination since the industry was deregulated about 20 years ago.

You can also see price discrimination in scholarly journal publishing. As the journals move online, the incentive to price-discriminate and the ability to do so are both growing. Look at the JSTOR project -- a nonprofit that makes available electronic versions of archived issues of scholarly journals. The pricing for U.S. educational institutions varies because JSTOR prices the journals based on the value to the school, not the number of copies sold. So if you're a large institution that views an article many times, you pay more.

Such usage data was simply not available in the print world. Thus more information about customers -- less privacy -- provided by modern technologies leads to more price discrimination.

Q: Are there any benefits to eroding privacy and differential pricing?


Standard economic doctrine has always noted that first-degree price discrimination -- where the seller knows exactly how much each individual buyer is willing to pay -- is ideal since it induces maximum production.

But it has always been regarded as unattainable. Now, with improved technology, we can achieve it. It's important to note that it's not just the sellers who would benefit from higher revenues. There would be more intense competition, which would force lower average prices.

There would also be more access to goods and services. In some sense, McGraw-Hill would like everyone to read its books, magazines, etc. Society would benefit from wider access and McGraw-Hill benefits from more customers. But in order to make that profitable, it has to charge different customers different prices.

Q: Will people accept the price that comes with those benefits?


The big issue is how the information about you is used. When grocery-store loyalty programs first came to the area of New Jersey that I lived in about 15 years ago, we talked about what it would mean when the stores and potentially their suppliers would know in great detail what your consumption habits are (see BW Online, 6/20/02, "How Grocery Stores Are Feeding Fears").

One colleague said he welcomed this, because he was a diehard Coke fan, and he was looking forward to not having to discard the Pepsi ads and coupons. After all, Pepsi and the grocery stores would know that he wouldn't drink Pepsi under any circumstances. I then asked him how he would feel if everybody else was getting 50% off discounts on Coke, while he had to pay full price (which would be jacked up to exploit guys like him). He wasn't sure that would be such a good idea.

Q: When do you believe that differential pricing will become widespread?


We'll see dramatic growth over the next decade due to continued ability to find out just how much people are willing to pay and the desire to control how products and services are used. Since most consumers object in principle, it's likely that price discrimination will grow -- but in a concealed form.

The focus will be on tactics such as personalized bundling and loyalty programs, which tend to disguise the actual price that's charged. For example, online travel sites are also getting into dynamic packaging -- offering special discounts if you book a flight and hotel or hotel and a car. Bundling offers deliberately obscure the price of any one item. It's a small step from there to also take into account other information about the customer -- such as her wealth -- to adjust the price according to what the seller thinks can be extracted.

Black covers privacy issues for BusinessWeek Online in her twice-monthly Privacy Matters column

Edited by Patricia O'Connell

Before it's here, it's on the Bloomberg Terminal.