Saturday, 1 June 2013

Last minute deals and price discrimination

I was flicking through a magazine yesterday when I saw an advert for the travel company Great Railway Journeys. The advert caught my eye because it guaranteed that 'you'll never pay more than last-minute bookers. If we reduce a holiday price for any reason, we'll give the same saving to anyone who has already booked'. To someone brought up on the microeconomics textbook this can sound a bit weird. The textbook tells us that price discrimination - charging different people a different price for the same good - is one of the main ways a company can increase profit. So, why would a company guarantee that it will not discriminate?
     Last minute deals are an example of second-degree price discrimination. This is where a company knows there are different types of buyer but cannot tell them apart. By offering a menu of packages the company can potentially get customers to reveal their type and charge them accordingly. To illustrate: Holiday makers may differ in their willingness to pay for comfort. Hotels with standard rooms, executive rooms, junior suites, and presidential suites are offering a menu of packages for holiday makers to choose amongst. And anyone staying in a presidential suite can expect to pay a lot more than someone staying in a standard room. The hotel can profit from discriminating in this way.
   The main hope of last minute deals is to discriminate between customers willing to pay a lot for a holiday - who will book early - and those willing to pay less for the holiday - who will book at the last minute. Many travel companies clearly use this strategy. But, there is a basic flaw - a time-inconsistency problem. If customers expect the price to drop at the last minute then why book early? Customers have an incentive to delay purchase and pick up the bargains. Unfortunately, this is the exact opposite of what the company wants: it creates uncertainty about the level of demand and means the company has failed to discriminate between customers.
     To understand why last minute deals can fail to work, its worth mentioning that most examples of second-degree price discrimination also come by the name of hurdle pricing. The idea being that to get a cheap price the customer has to overcome some hurdle. This will only work if the hurdle is high enough. For a traveler who values their comfort and has money to burn, staying in a standard room is a big hurdle; to get a cheap price, they have to sacrifice the comfort of the presidential suite for the cramped standard room. Booking late, however, is not much of a hurdle, particularly when there are lots of companies with holidays on offer. To get a cheap price, the customer merely has to wait a bit. And given people's present bias propensity to delay, waiting a bit is not a big hurdle!
    The time-inconsistency problem means that last minute deals can be more of a curse than opportunity for profit making companies. So, an ability to price discriminate is not always advantageous. Which explains why a company like Great Rail Journeys would want to 'tie their hands' and rule out last minute bargains. The guarantee 'if we reduce a holiday price for any reason, we'll give the same saving to anyone who has already booked' does this in a seemingly credible way. With a guarantee like that they have no incentive to drop the price. Moreover it should reassure customers that the list prices are not too high.    

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