Price discrimination with consumer misperception

ABSTRACT

The rise of big data and sophisticated, machine learning algorithms is increasing the prevalence of price discrimination and even personalized pricing. In traditional models, where consumers’ willingness-to-pay (WTP) is a function of preferences (and budget constraints), price discrimination is often celebrated for increasing efficiency albeit while reducing consumer surplus. This favourable view of price discrimination should be re-evaluated when WTP is a function of both preferences and misperceptions. With demand-inflating misperceptions, price discrimination is even more harmful to consumers and might reduce efficiency. These results are derived using a simple, linear demand model with different levels of price discrimination (or segmentation). In the many consumer markets where misperception is common, more careful scrutiny of price discrimination is warranted.

KEYWORDS:

• Price discrimination
• segmentation
• consumer misperceptions
• behavioural economics
• big data

JEL CLASSIFICATION:

• L11
• L12
• L40

Acknowledgments

For helpful comments and suggestions, I would like to thank Omri Ben-Shahar, Yochai Benkler, Ryan Bubb, Howell Jackson, Louis Kaplow, Alon Klement, Michael Meurer, Ariel Porat, Mark Ramseyer, Steve Shavell, Holger Spamann, Kathy Spier, Cass Sunstein, Rory Van Loo, David Walker, Kathy Zeiler, and workshop and conference participants at BU, Harvard and Tel-Aviv University, as well as the Editor and an anonymous referee. Haggai Porat and Emily Feldstein provided outstanding research assistance.

Disclosure statement

No potential conflict of interest was reported by the author.

Correction Statement

This article has been republished with minor changes. These changes do not impact the academic content of the article.

Notes

¹ With a per-unit cost of $c>0$, the analysis would be largely unchanged. We would define $\stackrel{⌣}{P}=\bar{P}-c$ and let $\stackrel{⌣}{Q}=\stackrel{⌣}{P}/\alpha$ denote the maximal quantity, obtained when $P=c$. For present purposes, a market with a demand curve $P(Q)=\bar{P}-\alpha Q$ and positive per-unit cost, c, is equivalent to a market with a demand curve $P(Q)=\stackrel{⌣}{P}-\alpha Q$ and zero per-unit cost. The analysis below would remain unaffected, except that we would need to replace $\bar{P}$ and $\bar{Q}$ with $\stackrel{⌣}{P}$ and $\stackrel{⌣}{Q}$ respectively. (And when considering misperceptions, we would add the misperception to the demand curve $P(Q)=\stackrel{⌣}{P}-\alpha Q$.) Of course, a higher cost reduces overall welfare and consumer surplus (as the monopolist increases the price), but the relative effects of price discrimination and of misperception remain the same.