Friday, October 5, 2012

How to make a profit through price obfuscation

The standard model of competition with a homogeneous good tells us that every supplier will apply the same, low price. This situation of perfect competition arises because there is no good differentiation and suppliers cannot exploit any market power, because they have none. They end up with little profit.

Suppose they can now artificially differentiate the good. Ioana Chioveanu and Jidong Zhou say this could happen in the way the price information is presented, for example by omitting taxes, or slicing the price in pieces for various components of the service, like for some flights, hotel nights or shipping fees. All this leads to price obfuscation. firms then start to compete on price and price "frame." Just look on how participating resellers can offer very different prices by adding wildly different shipping pricing. Or how sellers may add coupons for future purchases. And there are plenty of other examples.

Chioveanu and Zhou that within such a framework various competitive equilibria can result because consumer may get confused and fail to buy the best deal. This is equivalent to saying consumers are irrational, and of course anything can then happen. What is more interesting is that there is still competitive pressure, as suppliers may converge to more transparent pricing. Equilibria are such that firm randomize both price and price frames. If more firms enter the market (as it supports more profits), it becomes more difficult to obfuscate prices using price frames, so firms make those even more complex, resulting paradoxically in more profits.

I think it has been very welcome that in the US airline ticket prices now need to include all taxes and fees. It would not hurt if other prices could also include all taxes, but as this model shows, this needs to be initiated by the government, as the industry will not do it voluntarily. And this also shows that there is some good to say about the European Union's efforts into standardizing goods and price frames.

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