The Economics of Priceline

The conventional wisdom debunked.
May 19 2000 9:30 PM

The Economics of Priceline

And what Priceline says about the American economy. 

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(This is the first in an occasional series, by different authors, about the economics of e-commerce.)

Priceline, the leading name-your-own-price Web site (the one with those William Shatner TV commercials), will be selling gasoline beginning May 20. You tell them how much you're willing to pay for a certain number of gallons—and give them your credit-card number in advance. If they accept your offer, they immediately charge your credit card. You then go to a nearby gas station and ignore the price at the pump.

Priceline's founder, Jay Walker, describes this new offering in the messianic language characteristic of Web hype. "It's the battle of the titans," he said recently. "The global Internet vs. global gas prices. OPEC was a force to increase the cost of gas. Now, the Internet is the new counterforce to lower it."

Well, maybe. But before you decide Priceline is the consumer's best friend, you ought to know a little about how it works. Start with Priceline's biggest selling point: You name your price. Priceline's conceit is that it has reversed the traditional balance of power. Usually, the seller sets the price, and the buyer must then decide whether to take it or leave it. At Priceline, supposedly, it's the other way around.

Only, it doesn't quite work that way. When you name your price, the seller has already told Priceline what minimum price he is willing to accept. The difference from traditional retailing is that you, the buyer, don't know what that price is. That's a breakthrough, all right. For sellers. Priceline offers them a clever way to charge different prices to different customers, based on their willingness to pay.

Economists call this price discrimination. To work, it has two requirements. One is a way to smoke out the different amounts different people are willing to pay. The second is a market that is at least somewhat uncompetitive. (Otherwise, competition inevitably will drive down the price, even for people who would be willing to pay more.)

Airlines are a classic example. On a typical flight, a big airline may charge dozens of different fares. The key task for the airlines' large staffs of pricing specialists is sorting the price-sensitive fliers from those who aren't. To do that, the airlines have come up with a maze of advance-purchase and stay-over requirements that keep business fliers from buying the cheap seats offered to leisure travelers. While this system of "yield management" has been a great success, it could still work better. About 30 percent of seats fly empty (never the seat next to you, of course). The extra cost of flying those seats with bodies in them is almost nothing, so a ticket sold at almost any price will be profitable—as long as other customers who are paying a lot more can be kept away.

Enter Priceline. It finds out how much each customer is willing to pay by the brilliant technique of asking. And it keeps the higher-paying customers away from the bargains by making the process such a pain in the ass. With Priceline, you have to give your credit-card information and agree to be charged before you know whether you've even got a deal. You don't get to choose the airline that you'll fly. You don't get to specify the time of day you'll leave or whether you'll make an intermediate stop. These hassles are not an unfortunate byproduct. The burdensome process is essential to making price discrimination work.

In a traditional market where everybody pays the same price, almost every buyer actually would have been willing to pay more, and almost every seller would have been willing to take less. Charging different prices to different people is a way for sellers to occupy more of this no man's land. Outlet malls and traditional discount ticket brokers are other methods of price discrimination. But Priceline's name-your-price allows price discrimination to be far more fine-tuned. An outlet mall separates those who'll pay $150 for a dress from those who'll drive 30 miles to get it for $119.96. The seller is still losing $4 from the outlet customer who would have paid $123.96, and losing entirely the customer who would have paid $118.96. Priceline has a different price tailor-made for each customer. (In the première issue of eCompany Now, Time Warner's new business magazine, a reporter tells of bidding—and prepaying—$75 for a room in a South Dakota hotel where the most expensive regular rate is $54.)

Priceline's system also improves on older methods of price discrimination by hiding the discount. There are no posted special rates that might spark a mutually defeating price war. The secrecy also permits forms of price discrimination that are positively baroque. Consumer Reports reported that when it first tried Priceline's grocery service, "We successfully bid the minimum for everything on our list, saving more than 40% overall. … Four days later, when our reporter again bid the minimum for the same items, the offers were uniformly rejected. At the same time another staffer, registering as a first-timer, got the entire market basket for the minimums."

The fact that Priceline is good for sellers doesn't make it bad for buyers. After all, the premise of capitalism is that voluntary transactions are good for both sides. But the fact that no one is forced to deal with Priceline doesn't prove that it's good for consumers or for society as a whole.

  • Some airline seats (and hotel rooms, etc.) that would otherwise go empty are sold to people who otherwise couldn't or didn't care to pay more. A plus for sellers, a plus for buyers, and therefore a plus for society.
  • Some people who would have bought seats through traditional methods buy from Priceline (and its rivals) instead. Most probably pay less as a result, but a few pay more. This is a zero-sum game: The buyers' gain is the sellers' loss. So call it a net plus for buyers, a net minus for sellers, and a wash for society.
  • Everyone who buys through Priceline pays a cost in time, inconvenience, and uncertainty. There is no equivalent gain to sellers. A minus for buyers, a wash for sellers, and a minus for society.
  • Those who don't use Priceline or other discount opportunities almost certainly pay more, since sellers know they're not looking for a bargain. This might be because they're well off. But it could also be because they're short of time, because they don't know lower prices are out there, or because they're unable—say, because they lack an Internet connection—to take advantage. This is a minus for buyers, a plus for sellers, and a wash for society.

Bottom line? Who knows. We can assume it nets out a plus for sellers, or they wouldn't be doing it. As for consumers, it's probably a net plus, but far from the pro-consumer revolution of Priceline propaganda.

One final economic question is raised by Priceline's latest move. If successful price discrimination depends on a lack of competition, how can it possibly work for gasoline? The retail gasoline business features thousands of sellers, often two or three at the same intersection; a homogeneous product (how many people care what brand of gas they get?); and prices are prominently displayed and easy to change. If this isn't a competitive market, you would think, nothing is.

And the answer may be, in fact, that nothing is. A study of Boston-area gas stations by Stanford economist Andrea Shepard found that price discrimination added at least 9 cents a gallon to the average price of full-service gas. In other words, 9 cents of the difference between full-service and self-service has nothing to do with the added cost but is simply a result of people self-selecting themselves for the privilege of paying more. And despite the seemingly competitive nature of the retail gasoline business, this 9-cent premium doesn't get competed away.

So if you can tolerate the hassle, go ahead and give Priceline gasoline a try. But don't think for a moment that you're actually in the driver's seat. 

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