Price Discrimination and the Illusion of Fairness

January 22, 2013 at 10:24 am 10 comments

In my previous article I pointed out that online price discrimination is suspiciously absent in directly observable form, even though covert price discrimination is everywhere. Now let’s talk about why that might be.

By “covert” I don’t mean that the firm is trying to keep price discrimination a secret. Rather, I mean that the differential treatment isn’t made explicit — e.g., by not basing it directly on a customer attribute — and thereby avoiding triggering the perception of unfairness or discrimination. A common example is selective distribution of coupons instead of listing different prices. Such discounting may be publicized, but it is still covert.

The perception of fairness

The perception of fairness or unfairness, then, is at the heart of what’s going on. Going back to the WSJ piece, I found it interesting to see the reaction of the customer to whom Staples quoted $1.50 more for a stapler based on her ZIP code: “How can they get away with that?” she asks. To which my initial reaction was, “Get away with what, exactly? Supply and demand? Econ 101?”

Even though some of us might not feel the same outrage, I think all of us share at least a vague sense of unease about overt price discrimination. So I decided to dig deeper into the literature in psychology, marketing, and behavioral economics on the topic of price fairness and understand where this perception comes from. What I found surprised me.

First, the fairness heuristic is quite elaborate and complex. In a vast literature spanning several decades, early work such as the “principle of dual entitlement” by Kahneman and coauthors established some basics. Quoting Anderson and Simester: “This theory argues that customers’ have perceived fairness levels for both firm profits and retail prices. Although firms are entitled to earn a fair profit, customers are also entitled to a fair price. Deviations from a fair price can be justified only by the firm’s need to maintain a fair profit. According to this argument, it is fair for retailers to raise the price of snow shovels if the wholesale price increases, but it is not fair to do so if a snowstorm leads to excess demand.”

Much later work has added to and refined that model. A particularly impressive and highly cited 2004 paper reviews the literature and proposes an elaborate framework with four different classes inputs to explain how people decide if pricing is fair or unfair in various situations. Some of the findings are quite surprising. For example: in case of differential pricing to the buyer’s disadvantage, “trust in the seller has a U-shaped effect on price fairness perceptions.”

The illusion of fairness

Sounds like we have a well-honed and sophisticated decision procedure, then? Quite the opposite, actually. The fairness heuristic seems to be rather fragile, even if complex.

Let’s start with an example. Andrew Odlyzko, in his brilliant essay on price discrimination — all the more for the fact that it was published back in 2003 [1] — has this to say about Coca Cola’s ill-fated plans for price-adjusting vending machines: “In retrospect, Coca Cola’s main problem was that news coverage always referred to its work as leading to vending machines that would raise prices in warm weather. Had it managed to control publicity and present its work as leading to machines that would lower prices in cold weather, it might have avoided the entire controversy.”

We know how to explain the public’s reaction to the Coca Cola announcement using behavioral economics — the way it was presented (or framed), customers take the lower price as the “reference price,” and the price increase seems unfair, whereas the Odlyzko’s suggested framing would anchor the higher price as the reference price. Of course, just because we can explain how the fairness heuristic works doesn’t make it logical or consistent, let alone properly grounded in social justice.

More generally, every aspect of our mental price fairness assessment heuristic seems similarly vulnerable to hijacking by tweaking the presentation of the transaction without changing the essence of price discrimination. Companies have of course gotten wise to this; there’s even academic literature on it. One of the techniques proposed in this paper is “reference group signaling” — getting a customer to change the set of other customers to whom they mentally compare themselves. [2]

The perception of fairness, then, can be more properly called the illusion of fairness.

The fragility of the fairness heuristic becomes less surprising considering that we apparently share it with other primates. This hilarious clip from a TED talk shows a capuchin monkey reacting poorly, to put it mildly, to differential treatment in a monkey-commerce setting (although the jury may still be out on the significance of this experiment). If our reaction to pricing schemes is partly or largely due to brain circuitry that evolved millions of years ago, we shouldn’t expect it to fare well when faced with the complexities of modern business.

Lose-lose

Given that the prime impediment to pervasive online price discrimination is a moral principle that is fickle and easily circumventable, one can expect that companies to do exactly that, since they can reap most of the benefits of price discrimination without the negative PR. Indeed, it is my belief that more covert price discrimination is going on than is generally recognized, and that it is accelerating due to some technological developments.

This is a problem because price discrimination does raise ethical concerns, and these concerns are every bit as significant when it is covert. [3] However, since it is much less transparent, there’s less of an opportunity for public debate.

There are two directions in which I want to take this series of articles from this point: first a look at how new technology is enabling powerful forms of tailoring and covert price discrimination, and second, a discussion of what can be done to make price discrimination more transparent and how to have an informed policy discussion about its benefits and dangers.

[1] I had the pleasure of sitting next to Professor Odlyzko at a conference dinner once, and I  expressed my admiration of the prescience of his article. He replied that he’d worked it all out in his head circa 1996 but took a few years to put it down on paper. I could only stare at him wordlessly.

[2] I’m struck by the similarities between price fairness perceptions and privacy perceptions. The aforementioned 2004 price fairness framework can be seen as serving a roughly analogous function to contextual integrity, which is (in part) a theory of consumer privacy expectations. Both these theories are the result of “reverse engineering,” if you will, of the complex mental models in their respective domains using empirical behavioral evidence. Continuing the analogy, privacy expectations are also fragile, highly susceptible to framing, and liable to be exploited by companies. Acquisti and Grossklags, among others, have done some excellent empirical work on this.

[3] In fact, crude ways of making customers reveal their price sensitivity lead to a much higher social cost than overt price discrimination. I will take this up in more detail in a future post.

Thanks to Alejandro Molnar, Joseph Bonneau, Solon Barocas, and many others for insightful conversations on this topic.

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Online price discrimination: Conspicuous by its absence The job talk is a performance

10 Comments Add your own

  • 1. Sasha Romanosky  |  January 23, 2013 at 6:18 am

    You statement, “This is a problem because price discrimination does raise ethical concerns, and these concerns are every bit as significant when it is covert.” is interesting. Why “ethical?” Leaving aside the consequences of any illegal practices (i.e. discrimination based on protected classes), I can see this reducing to a discussion of (consumer) fairness vs (economic) efficiency, or one of violating social norms, but why ethics?

    Reply
    • 2. Arvind Narayanan  |  January 24, 2013 at 10:53 am

      I’m not sure I understand the question. Maybe you’re using ethics in a narrower technical sense that I’m not familiar with. To me ethics subsumes fairness, as well as issues of social cost. For a concrete example, see the passage starting “It is not because of the few thousand francs” here.

      Reply
      • 3. Sasha Romanosky  |  January 29, 2013 at 7:19 am

        My only point was to question whether it was uniquely the covert behavior that made that form of PD unfair/unethical. That is, if the firm disclosed the practice, would it suddenly become fair?

        Reply
        • 4. Arvind Narayanan  |  January 29, 2013 at 12:46 pm

          Please see paragraph 2. My definition of covert isn’t about disclosure, and fairness is definitely not about disclosure to me.

          Reply
  • 5. Erin Jonaitis  |  January 23, 2013 at 9:33 am

    This may be a bit tangential, but it seems to me that online price discrimination really has to be covert, assuming I understand the term properly. If it weren’t — if it were easy to figure out who was getting offered what deal — then I would expect consumers to respond to that in some way: sharing or stealing logins, lying about identifying information when signing up for the site. It might be hard to fake a zip code — but you’d at least have people trying (“Hmm, my aunt lives in Cheaptown; maybe I can ship my textbooks to her and pick them up next week”).

    Reply
    • 6. Sasha Romanosky  |  January 23, 2013 at 10:53 am

      Great comment, Erin. A couple of points:
      1) remember that PD can be very good for consumers. Student discounts, loyalty cards, reduced pricing on paperback books are all examples. They work *because* people know about them.
      2) People claim that the practice is unfair when retailers don’t reveal it to consumers. However, what’s more deceptive, when firms base prices off of consumer characteristics, or when consumers lie about their information in order to enjoy a discount?

      Reply
    • 7. Arvind Narayanan  |  January 24, 2013 at 11:09 am

      Good point. Certainly the possibility of resale is one factor that limits overt price discrimination. That said, the search and transaction costs (finding someone to buy it instead of you, picking up the item from them) can be so high that it makes more sense to just pay the higher price.

      Reply
      • 8. Erin Jonaitis  |  January 24, 2013 at 11:29 am

        Right! I guess I didn’t make this explicit, but the costs are why I think the Internet is different when it comes to price discrimination — it is easier (=lower-cost) to fake many attributes online; “on the Internet nobody knows you’re a dog,” &c.

        Reply
  • 9. Robin Schuil (@schuilr)  |  January 23, 2013 at 1:26 pm

    Nice article. Check out MyPrice, a startup that does personalized pricing in brick-and-mortar stores: http://www.screenwerk.com/2013/01/18/spaaza-myprice-a-new-response-to-showrooming/

    Reply
  • 10. Robin Hanson  |  January 24, 2013 at 10:27 am

    I responded in this post: http://www.overcomingbias.com/2013/01/hypocritical-fairness.html

    Reply

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About 33bits.org

I'm an assistant professor of computer science at Princeton. I research (and teach) information privacy and security, and moonlight in technology policy.

This is a blog about my research on breaking data anonymization, and more broadly about information privacy, law and policy.

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