Since Hurricane Irma put Florida in its sights, there have been thousands of reports of price gouging on everything from water to gasoline.
That’s because it wasn’t actually hurricane-related price gouging. Airlines were charging similar fares to last-minute buyers two weeks ago – and have been for years – long before Irma became a threat.
The fact is that airlines have made it a routine practice to jack up prices at moments of peak demand, such as right before a flight, when Americans dealing with family or business emergencies are willing to pay almost anything to get on the next plane out of town.
By bringing desperation to so many, Hurricane Irma is revealing a sad fact about many American companies, and not just airlines: that they have come in recent years to embrace taking advantage of desperate consumers as a central part of their business models.
The practice, called dynamic pricing, is intended to ration scarce goods and services, yet, as I show in a recent paper, it primarily harms consumers by making it easier for companies to fleece them.
First come, first served
Until recently, American businesses rationed access to goods or services that are in limited supply on a first-come, first-served basis. A company would make a product and then choose a price that covers its costs, including a reasonable return for investors. The price wouldn’t change, even if that meant the product might sell out from time to time.
Apple, for one, follows this traditional approach. If demand for its new $999 iPhone X exceeds supply after the phone goes on sale in November, Apple likely won’t raise the price in response.
Instead, it’ll just tell consumers it’s temporarily sold out and increase production as quickly as it can.
How dynamic pricing rations differently
Dynamic pricing works differently, and more and more companies are doing it. Examples include Uber’s surge pricing, Disney World’s decision to increase prices when more kids show up to see Mickey and plans in the works at brick-and-mortar supermarkets to vary prices thousands of times per day, just like Amazon does online.
Some economists and company executives seem to believe that this approach to pricing, also known as “price discrimination,” is the best way to ration, because higher prices reduce the number of consumers who are willing to pay for a product or service, ensuring that the number of willing buyers is equal to available supply.
If Apple were to embrace dynamic pricing, instead of simply letting the iPhone X sell out, the company would keep raising the price as the supply dwindled: first to $1,050, then $1,100 and, who knows, perhaps $1,499 or more – to whatever price would be necessary to ensure that the number of consumers who can actually afford the phone equals the stock available.
Is it better?
Is dynamic pricing a better way to ration access than first come, first served?
Before the internet, the answer might have been yes. Back then, “first come, first served” meant wasting a lot of time standing on line. Die-hard Apple fans still do this (some were already lining up ahead of the iPhone X announcement).
But the internet is swiftly eliminating this problem. Every time you make a purchase online, or try but fail because the item is sold out, you have waited in an instantaneous virtual line. Indeed, Apple will allow enthusiasts to preorder the iPhone on Apple’s website without wasting time on a street corner. Buyers who take this route will use virtual lines.
So then why have companies been embracing dynamic pricing instead? The answer is just what you think: Raising prices is more profitable, and by making it easier for companies to change prices in real time, the internet has made dynamic pricing easier to execute as well.
The flip side of more profits for companies is less money in the pockets of consumers. But so what? Isn’t the economy healthy as long as supply meets demand, no matter how that is achieved?
In my paper, I argue that how we ration matters. An economy in which only consumers who are able to pay very high prices get access to products in scarce supply is not an economy worth living in, for two reasons.
First, dynamic pricing will tend to ration access to goods based on wealth. Of course, a company must charge enough to cover costs and make money, and, in market economies, that means that wealthier people, who can pay higher prices, get access to more stuff.
But dynamic pricing goes beyond this, giving priority to the wealthy even when their extra dollars aren’t needed to call forth production. Companies make enough to cover the costs of production – bringing forth the greatest possible supply – under both dynamic pricing and first come, first served – just look at Apple. When companies opt for dynamic pricing, they are choosing to raise prices above the price that is already high enough to cover those costs but at which the product would sell out.
Incidentally, that’s why the argument made by some companies, that dynamic pricing benefits consumers by creating incentives to increase supply, does not hold water.
Second, companies are not going to stop here. Their end goal is to be able to charge each individual consumer the highest price that consumer is willing to pay. Indeed, Uber is trying to do just that.
In such a world, the economy has little value to consumers. You might be willing to give up your life savings to flee Irma, but what a price to pay to simply get out of harm’s way.
That margin between what you get – safety, for a flight out of Irma – and what you pay is the entire value of the economy to you. The goal of dynamic pricing is to squeeze that value right down to zero.
The airlines responded to public pressure during Irma by temporarily reverting to first come, first served. But the problems with dynamic pricing won’t clear with the weather.