Pricing Experimentation & Broadband Usage-Based Pricing

by on October 19, 2012 · 11 comments

We spend a lot of time here defending the simple proposition that flexible free-market pricing is a good thing. You would think that in 2012 we wouldn’t need to do so, but there’s a growing movement afoot today by some academics, regulatory activists, and public policymakers to have government start asserting more authority over broadband pricing. In particular, they want Congress, the FCC, or state officials to investigate and possibly even regulate efforts by wireline and wireless broadband carriers to use usage-based pricing and data caps as a method of calibrating supply and demand. This was the focus of my last weekly Forbes column, “The Specter Of Broadband Price Controls.” In the piece I note that:

Data caps and usage-based pricing are forms of what economists refer to as price discrimination. Although viewed with suspicion by some policymakers and regulatory-minded academics and activists, price discrimination is widely recognized to improve consumer welfare. Price-differentiated and prioritized services are part of almost every industrial sector in our capitalist economy. Notable examples include airline and hotel reservations, prioritized shipping services, amusement park passes, and fuel and energy pricing. Economists agree that price discrimination represents a sensible way to calibrate supply and demand while ensuring the fixed costs of doing business get covered. Consumers benefit from such pricing experimentation by gaining more options while firms gain more certainty about investment and service decisions.

This is confirmed by an excellent new Mercatus Center working paper on “The Impact of Data Caps and Other Forms of Usage-Based Pricing for Broadband Access,” by Daniel A. Lyons, an assistant professor of law at Boston College Law School. Lyons explains why a return to price controls for communications would be monumentally misguided. Lyons notes that “data caps and other forms of metered consumption are not inherently anti-consumer or anticompetitive. Rather, they reflect different pricing strategies through which a broadband company may recover its costs from its customer base and fund future infrastructure investment.” He notes that “by aligning costs more closely with use, usage-based pricing may effectively shift more network costs onto those consumers who use the network the most.”

What I find most interesting about the debate over broadband pricing flexibility is the way some so-called “consumer advocates” cannot seemingly wrap their heads around the fact that price discrimination can actually benefit most consumers by creating more and better pricing options and service alternatives. As I noted in my Forbes essay, “if policymakers lock-in flat rate pricing or regulate pricing such that it is not allowed to fluctuate with demand or investment needs, then it is likely that light users (including many lower income users) will end up paying more than they need to for their overall share of network costs. If that is also disallowed through rate regulation, then network investment will suffer and further innovation will be discouraged. Something has to give because, again, there really is no free lunch.”

It remains to be seen whether true free market pricing will be allowed to continue in this context, but make no doubt about it, this is the most important aspect of the ongoing debate about modern information economics. If America returns to price and rate controls for communications, innovation and investment will suffer greatly.

Oh, and here’s a video featuring Eli Dourado, who can explain this much more eloquently than me! …

Additional Reading

  • Brett

    A few errors: First, you conflate price discrimination with cost-based differential pricing. Here and in the Forbes piece you say: “Data caps and usage-based pricing are forms of what economists refer to
    as price discrimination.” This is incorrect. Both pricing schemes are cost-based differential pricing, not what economists refer to
    as price discrimination. Second, you say: “Although viewed with suspicion by some
    policymakers and regulatory-minded academics and activists, price
    discrimination is widely recognized to improve consumer welfare.” This is incorrect as well. If you are referring to cost-based differential pricing, then you would be correct. But price discrimination may or may not improve consumer welfare. It depends very much on the context, the type of imperfect price discrimination being practiced (since perfect price discrimination is an unattainable pipe dream), and other things. Third, you suggest that network neutrality raises the specter of price regulation because “mandated ‘non-discriminatory access’ inevitably runs up against differential pricing methods that carriers might deploy.” Again, this is incorrect. Network neutrality or nondiscrimination rules do not conflict with most forms of cost-based differential pricing.

  • Eli Dourado

    Brett, I thought I’d chime in here since I’m an economist and you seem to be interested in what economists have to say.

    Your first alleged error is not an error. The pricing schemes Adam discusses may simply reflect differences in cost, but then again they may not. Often such schemes are used to charge higher markups to those with less elastic demand for the purpose of fixed cost recovery rather than congestion management.

    Your second claim is partially correct: the welfare effects of imperfect price discrimination are ambiguous at the highest level of generality. However, it can be rigorously proved that price discrimination schemes that increase output are welfare-improving. Since most price discrimination schemes charge a lower price to those with the most elastic demands, most price discrimination schemes do improve total welfare (which is what we should be talking about, not just consumer welfare).

    Thirdly, net neutrality does pose a significant threat to the actual welfare-enhancing price discrimination techniques that infrastructure providers might use. I know that you have recently written a book about infrastructure, but you should think more about price discrimination as a fixed cost recovery strategy. I don’t know how well you follow basic mathematical arguments, but I sketched one out here.

  • Brett

    On the first point, your observation doesn’t make Adam’s claim correct. Usage based pricing and data caps are generally cost-based; even when prices are differential, the schemes generally are designed to recover costs
    rather than convert consumer surplus to producer surplus, often the objective and consequence of price discrimination. Regardless, the fact that the pricing schemes may be one type or the other still means that it is incorrect to characterize the pricing schemes as “forms of what economists call price discrimination”. Often, they’re not. Conflating them obscures important differences. As an economist, you presumably know all of this. On the second point, my claim is correct. Adam completely overstated what is widely recognized. As an economist, I am surprised you don’t just admit it and move on. Adam’s claim is not even correct if you replaced consumer welfare with total welfare (as you did). Even then, you have to say what you carefully said which is that imperfect price discrimination is widely recognized to increase total welfare only when output increases, which most economists would say is a necessary but not sufficient condition. But you know that because again, you’re the economist. Third, my point was focused on cost-based differential pricing. Net neutrality does not preclude usage-based pricing, for example. But it does preclude certain forms of price discrimination and so Adam was partially correct (my bad, Adam!). There is room to disagree about the welfare effects. In fact, I say this in my book. I understand price discrimination as a fixed cost recovery strategy. It is not the only strategy, and I am not persuaded that it is necessary for cost recovery. Are you? What has persuaded you?

  • Eli Dourado

    The paper that I really like on price discrimination is Michael Levine’s “Price Discrimination Without Market Power.” It persuaded me that price discrimination is an indispensable fixed cost recovery mechanism even in some competitive markets. If price discrimination were banned in these markets, welfare would be unambiguously lower.

  • Brett

    Yes, I know the paper from reading it a few years ago. I don’t disagree that price discrimination can be indispensable to cost recovery in some markets/contexts. This has been pretty well known for a while (the hard part is determining when; it is certainly not the normal case that price discrimination is indispensable to cost recovery). Off the top of my head, I cannot recall the new angle that Levine adds, although for some reason the idea that comes to mind when I think about his paper is that price discrimination sometimes exists in competitive markets and thus should not serve as a proxy for market power. Of course, that is unrelated to our discussion. So I’ll have to read it again when I get a chance. Anyway, thanks for reminding me of the paper and the fun exchange.

  • Tiger Claw

    All usage based pricing will do is jack up the profit margins for all the greedy telecom companies. There’s no good to it other than more money for corporations. And it will further lessen any incentive they’ll have to improve their already failing networks.

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