The Wacky World of Prices: Rental Cars, Hollywood, and HBO

Guest post by Gabriel Rossman -- Sociologist at UCLA. His work applies economic sociology to media industries. He blogs at Code and Culture and is the author of Climbing the Charts.

I study media markets and one of the interesting things about the entertainment industry is there's a lot of complex pricing. This includes both simple bundling (eg, basic cable) and two-part tariffs (eg, HBO). These pricing practices are forms of price discrimination, which is to say they are ways to customize the price point so the seller doesn't leave much money on the table relative to each particular consumer's willingness to pay. It's kind of like haggling but it works at scale over a large number of consumers.

Price discrimination is a mixed bag. On the downside it pushes consumer surplus close to zero, meaning you always feel like you're getting ripped off but not so much that you balk. On the upside it increases total revenues and quantity supplied. The effects can be pretty substantial. For instance, the record labels' main problem isn't decreased quantity supplied but the end of bundling with the switch from albums to singles. Likewise one of the most popular explanations for the decline of the Hollywood studio system is that the Paramount decision banned a form of bundling called block-booking and this decreased revenues sufficiently that the studios couldn't maintain a vertically-integrated production system.

The thing is, that price discrimination is only supposed to work under certain very narrow circumstances. Suppose we have a two-part tariff seller, say, a movie theater selling tickets for $10 and popcorn for $5. If a competing theater opens across the street charging $12 for tickets and $2 for popcorn, you'd expect to see everybody who doesn't like popcorn stay at the first theater and everybody who does like popcorn go to the second theater. That is, a price discrimination scheme should very quickly break down in the face of perfect competition and in fact this problem is so well understood that monopoly is understood to be a scope condition. For instance, the word "monopoly" is in the title of one of the major cites on two-part tariffs.

So what about when you don't have a monopoly or perfect competition, but something in between? In theory, you don't need a perfectly competitive market with innumerable infinitesimally small price-takers in order to get something that looks a lot like a Walrasian auction. This is why industrial-organizational econ loves game theory. Once you apply a prisoner's dilemma model to price competition in a market with two sellers (duopoly) or a handful of sellers (oligopoly), it looks a lot more like a market with an infinite number of sellers (perfect competition) than it does like a market with exactly one seller (monopoly).

The thing is though that we have lots of cases of price discrimination and most of these cases occur in reasonably competitive markets, with multiple sellers and no apparent price-fixing. For instance, I previously noted that movie theaters practice two-part tariffs but let's reflect on the fact that this is a competitive industry. This raises the puzzle of why we haven't seen a chain of movie theaters compete by giving up the two-part tariff business model, which would mean cheaper popcorn but higher ticket prices.

These kinds of issues are why I was so interested when a colleague recently sent me Xavier Gabaix and David Laibson's QJE paper "Shrouded Attributes, Consumer Myopia, and Information Suppression in Competitive Markets" (ungated version). The reason the paper is important is that last phrase about "competitive markets." It shows how all sorts of stuff we already knew could go on with monopolies can also occur under competition. "Shrouded attributes" refers to hidden costs like the marked-up component of the two-part tariff. The "consumer myopia" phrase explains that this works if you make the reasonable assumption that many consumers aren't reasonable.

The logic goes that we imagine two types of consumers, myopic and sophisticated, and two types of products, "no hidden fees" (but with a high base price) versus "low price" (but which nickel and dimes you to death). The myopic customers will flock to the low price provider because they don't realize that they'll wind up buying $10 peanuts from the minibar. The sophisticated customers will go to either the "no hidden fees" or the "low price" provider based on who gives a better deal when you tally up the total cost of the basket they expect to consume. What this means from the provider's perspective is there are no customers who will pay more for a given basket of goods under a "no hidden fees" plan than they would in a "low price" plan. As such, the "low price" plan can crowd out the "no hidden fees" plan.*

The upshot is that some of the things we thought could only exist given the rare scope condition of monopolies or collusion can also exist given the all too plausible assumption of bounded rationality. This is pretty cool in an empirical sense because when our theories told us this sort of thing could only exist with monopolies it was kind of anomalous to go through life constantly coming across $150 printers that take $100 toner cartridges, smart phones which cost $200 but which lock you into a two-year contract at $80/month, hotels that charge $100/night but add a mandatory $15 "resort fee," etc.

My favorite example of how consumer myopia works this way is how rental cars now offer you prepaid gas for about 10% less than the price you'd pay at the pump. The consumer may be thinking, wow, $3.90 a gallon is actually pretty cheap compared to $4.30 at the Exxon station, I should prepay for this full tank of gas. What doesn't occur to this consumer is that this is only cheap if you use the full tank. If you bring it back with half a tank you're effectively paying $7.80 a gallon. The consumers who appreciate this don't buy the plan but those who don't see the hitch may well buy it. As long as the base rental price isn't too low it makes sense for the rental company to more or less break even on people who pass up this offer and make an easy $20 or so profit on those who sign up for it.

There are also some big policy implications. Under the old model, as long as you have a modest antitrust policy in place, the market will sort things out so consumer protection can be limited to outright fraud. Adding bounded rationality into the mix suggests that consumers really can sign up for a bad deal. This then makes it somewhat facile to claim that by definition any freely entered exchange is mutually beneficial and from this we can imagine a variety of consumer protections. You may still have reasons to be skeptical of intervention, but it's not tenable to say "markets work just great, thank you very much."

* You may have seen the argument that even if individuals are irrational, markets can still be rational because irrationality gets arbitraged out. Let's accept this for the sake of argument and just note that it has scope conditions that basically mean it only works on Wall Street. With retail markets it's difficult to establish a secondary market and so you don't see the sophisticated people doing arbitrage that pushes us all back to predictions consistent with rational actors.