Fair Treatment of Consumers at Any Price?

Many scholars and policymakers have suggested regulating firms’ ability to price discriminate between consumers when they operate in a market prone to inactive users, or users unwilling to switch to cheaper or higher quality services. In new research, Walter Beckert and Paolo Siciliani argue that interventions in these scenarios to reduce price discrimination to benefit inactive consumers may have the contrary effect of raising prices for all. However, induced competition may offset this negative impact on consumer welfare.

Everybody likes a bargain, but very few show the stamina to spend time looking for a better deal. This is especially true for utility-like services, such as checking accounts or credit cards that most consumers perceive as homogenous. It’s no fun trawling through a large number of often complex terms and conditions and tariff structures for something essentially seen as a commodity: As long as a minimum level of service quality and reliability is met, there is next to no apparent product differentiation and all consumers care about is finding the lowest price on offer. It is no coincidence that long-established large incumbent providers seem to be oblivious to market discipline: They can hold on to large and profitable customer bases with very low churn rate, notwithstanding lackluster quality of service and market contestability in the presence of smaller challenger entrants.  

This is why there are often calls for regulatory interventions. These aim at constraining the ability of dominant firms to discriminate against customers whom firms have identified as less likely to switch—the firms’ respective back-book—and to whom firms charge higher prices than they offer to those customers who are active switchers: the firms’ respective front-book. Customer inertia is often a consequence of economic illiteracy which, in turn, is more prevalent among vulnerable social groups that are exposed to various dimensions of deprivation. Regulatory interventions are therefore often justified on grounds of distributional fairness: Better-off customers should not benefit from the exploitation of poorer ones. 

Indeed, the underlying rationale is to let active consumers do the job on behalf of inactive ones, while at the same time constraining price dispersion, by tying prices targeted at inactive back-book customers to promotional prices aimed at poaching active front-book customers. To this end, intervening authorities would be willing to accept the fact that active consumers would be worse-off as a result—as firms react to the fact that the discount offered to attract active consumers would have to be at least partly extended to inactive ones—but the hope is that the reduction in the degree of exploitation of inactive consumers more than offsets in terms of consumer welfare the weakening of pricing rivalry for active ones. This balance can be quite difficult to ascertain. 

In our research, we argue that regulators shouldn’t miss the forest for the trees and that hopes of protecting inactive consumers may well be defeated. Regulatory interventions aimed at reducing price discrimination often induce equilibrium prices paid by inactive consumers that also end up being higher, thus making the intervention detrimental from a consumer perspective. On the other hand, higher equilibrium prices encourage entry. This suggests a potential tension between consumer protection and competition objectives.

We develop a model to better understand when this could be the case. We consider homogenous goods markets with asymmetric market structures: A large incumbent faces a smaller challenger entrant. We model demand-side frictions as consumers whose switching costs are heterogeneous, whereby the incumbent’s customer base has a switching-cost distribution that dominates that of the challenger’s customer base: The incumbent benefits from customers being relatively more locked-in. 

We compare four different pricing regimes, starting with the unrestrained baseline scenario where firms can set different prices between existing and new customers, labelled history-based price discrimination. We then assess the comparative impact of three types of pricing constraints that we are aware of having actually been taken into consideration by regulators. The most extreme among them is the complete ban of price discrimination, requiring prices to be uniform at the firm level. An intermediate price regime we consider is price discrimination with a disclosure requirement that facilitates customers of the firm switching from the higher back-book price to the lower front-book price. Another intermediate regime we look at is permissive of price discrimination, but with a constraint on the dispersion of prices, i.e., on the ratio of the back-book to front-book price. 

We find that price discrimination makes markets more competitive, benefiting consumers through lower prices: The firms segment the market into their respective customer base, and in equilibrium they find themselves in a prisoners’ dilemma when competing on price in each segment.  

With uniform prices, firms only compete for the incumbent’s front-book in equilibrium. Since the incumbent’s competitive reaction is unaltered relative to the situation with discriminatory prices, the challenger competes less vigorously and hence equilibrium prices are higher. 

Regulatory interventions that promote disclosure to facilitate internal switching and those that limit price dispersion dissipate consumer benefits arising from price discrimination. Disclosure requirements entail a profit sacrifice for both firms. In equilibrium, therefore, on the one hand firms compete with themselves, while on the other hand they also compete for the incumbent’s front-book. Therefore, front-book prices are lower than with uniform prices, but all prices are higher than with unconstrained discriminatory prices. 

Constraining the ratio of back-book to front-book prices similarly leads to equilibrium prices in excess of those that prevail absent the ratio constraint. In the limit, as the ratio constraint tends to price parity, these prices approach the uniform equilibrium prices. 

However, higher equilibrium prices as a consequence of the regulatory interventions we study do benefit the challenger entrant, thereby encouraging entry and enhancing market contestability. Indeed, our results suggest that a dominant incumbent may use price discrimination as a means to deter entry. This is why the case for entry (and expansion from a small customer base) is strongest when the imposition of the pricing constraint is targeted only at the incumbent firm. The challenger firm benefits from the ability to exploit its own back-book customers (however few they are), while being able to also take advantage of the “fat cat” stance asymmetrically imposed on the incumbent. 

While these types of interventions are often couched in terms of protecting vulnerable consumers from unfair exploitation by large established incumbents, we show that all consumers, active and inactive, might be harmed as a result. Given that consumer surplus is conventionally considered to be the guiding principle for this kind of intervention (as opposed to firms’ profits), it would appear that constraining the incumbent’s ability to exploit its back-book customers is ultimately ill-advised; unless, that is, the true aim is to facilitate the entry and expansion of a challenger firm. 

In this respect, it is worth emphasizing that our model is static, while entry is inherently a dynamic consideration. We do not assess the implications of facilitating entry/expansion over a longer period. However, it is a plausible conjecture that helping the challenger securing a solid foothold in a market dominated by the incumbent could in turn facilitate further inroads over time, which could ultimately benefit consumers as well if competition intensifies as a result. 

Articles represent the opinions of their writers, not necessarily those of the University of Chicago, the Booth School of Business, or its faculty.