Variable prices, and what economists like about them

by Philip Brewer on 13 November 2007 5 comments
Photo: Philip Brewer

From the buyer's point of view, a "market price" is great. This is not only because he or she doesn't have to get a bunch of prices quotes to avoid being cheated, but also because the market price is almost always lower than the maximum amount the buyer would be willing to pay. The seller, though, much prefers variable prices--ideally, with each buyer paying his or her maximum price.

My discovery of the Consumer Surplus

One time, back when I was in college, I happened upon a book that I really wanted to read. I'd known it existed, because I'd seen it listed on an "other works by this author" page, but I hadn't been able to put my hands on a copy. There it was, though, on the shelf at the bookstore. I snatched it up and took it to the cash register without even looking at the price.

At the time, prices for paperback books were running around $1.95 to $2.25, but I would have cheerfully paid $3 for that particular book--and would probably have grudgingly paid even more than that.

When I got to the register, though, it turned out that book was only $1.75. What a bargain for me!

I was taking an economics class at the time. I described my experience to my professor, and was pleased to find that economists have a name for what I'd discovered: the difference between the market price and the maximum amount that a buyer would have paid is the "consumer surplus."

Practically everything you buy has a consumer surplus. Those items that you toss into your basket with barely a thought have a large consumer surplus. The ones that you stand in the aisle with the item in your hand, right on the cusp between putting the item in your basket, or put it back on the shelf--that's where the consumer surplus is close to zero.

What would a seller do?

Sellers, of course, hate to sell anything with a large consumer surplus--they're making less profit than they could. Oh, they're perfectly happy for there to be a consumer surplus on some items--cheap turkeys at Thanksgiving bring in shoppers who pay little attention to the price of all the other items they need for their feast. But they're not interested in there being a consumer surplus, except as a ploy to bring in other profitable business.

From the seller's point of view, the ideal situation would be one where you haggle over prices, and where the seller has a telepath reading your mind to figure out the most you're willing to pay. The seller has a rock-bottom price (where they make just enough profit to be worth the trouble to process the transaction), but almost every transaction is at a higher price, based on what the buyer is willing to pay.

Sellers don't actually do that, and not just because they can't find the telepaths. A buyer who is charged more than the next guy feels taken advantage of, and will take his business elsewhere, if the opportunity presents. There's also the standing-in-the-aisle problem mentioned early--get the consumer surplus close to zero on every item, and the buyer will end up taking forever to close the deal.

Without telepaths

Those issues aside, though, plenty of businesses charge variable prices. Airlines are the classic example. Ever checked the price of a ticket one day, and then tried to find the ticket for that price the next day? If you ever succeed at that, you should rush right out and buy a lottery ticket, as it is obviously your lucky day. But lots of businesses charge variable prices in the form of specials and coupons.

Where I live, there's a nearby pizza delivery place that has a special deal for a one-topping medium pizza ordered for pickup on a Monday. The price is about half what the pizza would be if you ordered it any other day of the week, or if you ordered it for delivery. I've gotten one of those pizzas several times. The place is walking distance (even carrying a pizza), the price is right, and the pizza is pretty good.

Unable to spot the people who'd pay top dollar for a pizza, the pizza place sets the price as high as they dare--any higher and too many potential customers would glance at the menu and then go somewhere cheaper. Then they offer deals calculated to bring in the people who won't pay that much, trying to configure them so that they don't end up cannibalizing their higher-priced sales.

Those darned economists

Economists think variable pricing is good. They especially like it in situations where you otherwise have lines forming. A toll bridge that charges higher tolls during rush hour, prompting drivers with flexibility in their schedule to come earlier or later to get the better price, is the classic example. They also like it when it makes sure the limited supply goes to the people who want it most. For example, they'd like a vending machine that started raising its prices as it approached empty, trying to stretch out its dwindling supply of soda until it gets restocked. (An empty vending machine in front of a guy with money in his pocket is a very sad sight to an economist.)

Economists are thwarted in their vision by consumers who get all bent out of shape when they feel cheated--as they usually do, when the other guy gets a better deal than they do.

Sellers do their best to work around this issue. The first thing is to never charge more than the base price--it's fine to offer a student discount, a senior discount, a coupon discount, and a Monday special, but it's never okay to offer a surcharge for affluent consumers. The next thing is to differentiate the sale--no delivery, no substitutions on today's special, etc. Historically, they would try to keep the better prices secret, but that never worked very well even before the internet made it easy to compare prices worldwide. (Related to all this is the trick of making it hard to compare prices--many appliances, for example, come in a dozen virtually identical configurations, specifically in order that each store be able to guarantee that you won't find the "same item" available at a lower price anywhere.)

Variable prices forever

There have always been variable prices, dating back to dawn of money. Even now, shops with fixed prices and no haggling are by no means universal.

Any source of information puts pressure on variable prices. If buyers learn that a seller has let an item go for some particular price, they're likely to hold out for that price, even if they'd otherwise have been willing to pay more. The internet, because it makes providing and finding the information so cheap, makes this all the more powerful.

We'll always have variable prices, but I don't see any end to the consumer surplus--which is great for consumers.

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MikeCinFLA's picture

How come this doesn't seem to work for gasolene or electricity?

Philip Brewer's picture

In a lot of states, electricity prices are still regulated, so the power companies charge whatever the state lets them charge. (In any case, consumers generally pay whatever the power company charges, because the alternative is getting your power turned off.) I haven't really looked at what effect electricity price deregulation has had so far.

Gasoline prices are posted on big signs, so there's no opportunity for the gas station to try to charge higher prices to consumers who would be willing to pay more. (Well, some gas stations charge more, hoping to capture the drivers who are willing to pay top dollar in order to get a name brand, shop at a station that's easier to get into/out of, and not to have to wait for a pump, but that's really around the edges of what I'm talking about.)

Guest's picture
Kelja

The definition of a fair price (at least mine) is what someone is willing to sell something for and what someone else is willing to buy that something for. Straightforward, simple.

When prices rise too high (an opinion), then people will either choose or be forced to buy less of that item. Perfect example: gasoline. The price keeps on rising because demand does not go down. Until people perceive they can't afford it anymore, the price stays high.

Best advice: quit complaining about being taken advantage - if something is priced too high, don't buy - or change your lifestyle to accommodate the price.

Philip Brewer's picture

I'm with you on what's a fair price.

On the other hand, if the guy in front of me buys a notebook for $9, and when I get to the register the price is $14, I might very well say, "Forget it--I'm keeping my money," even if I might very well have paid that much if I hadn't just seen someone get it cheaper. I think that's human nature, and it's why companies tend not to vary prices that way, even though I'm sure they would, if they thought they could get away with it.

As far as not complaining, I think it matters what you're complaining about. I don't complain about prices being too high (I just don't buy things if they're not worth the price). I do, on the other hand, complain about inscrutable pricing schemes (such as the airlines), where you can't actually get a reliable price quote. I also complain about deceptive schemes, where you think you've got an agreed-upon price, only to find some extra costs get added on later.

Guest's picture
Kelja

I do agree with you about deceptive pricing practices. One of the most egregious examples recently was the way certain gas stations price gas. Customarily the buttons on a pump for the different grades of gas from regular to premium, run left to right. This one station reversed the customary order so I found I had pumped myself a tank of premium at 20cents a gallon more than my regular. I purposely stay away from that gas station now.

And variable pricing without rationale is a turnoff as well. As a businessman the practice will quickly cost you in terms of customer base. Word does get around.

Variable pricing will work with the right rational. If someone gets a break on pricing because of being a regular customer or buying in volume, that is acceptable. If you use Ebay, the market sets the price dependent on interest in the particular product, and that is obviously acceptable.

As far a airline ticketing goes, check out Kayak.com.