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Dynamic pricing and technology in different markets

February 10, 2012

Lynne Kiesling

Dynamic pricing has long been a topic of great interest here, in large part because digital technology is increasingly making it feasible to implement dynamic pricing in retail electricity markets in ways that can be acceptable to consumers. But dynamic pricing is fraught with challenges, and not just in retail electricity markets. Dynamic pricing is a form of price discrimination, and as such can improve efficiency; prices also are knowledge surrogates, communicating diffuse private knowledge about the relative scarcity of that good in that place at that time. Dynamic pricing is also most applicable in markets in which demand varies over time, and if you are going to implement dynamic pricing without annoying and aggravating consumers, consumers have to have access to the prices in advance.

These general principles showed up recently in a kerfuffle over dynamic pricing of taxi services by a new firm called Uber:

On New Year’s Eve, Uber, a start-up in the city, adopted a feature it called “surge pricing,” which increases the price of rides as more people request them.

Although New Year’s Eve was very profitable for Uber, customers were not happy. Many felt the pricing was exorbitant and they took to Twitter and the Web to complain. Some people said that at certain times in the evening, rides had spiked to as high as seven times the usual price, and they called it highway robbery. Uber’s goal is to make the experience as simple as possible, so customers are not shown their fare until the end of the ride, when it is automatically charged to their credit card. While the app does not show the total fare in dollars when customers book a ride, Uber did show a “surge pricing” multiple to customers booking rides for New Year’s Eve.

So what’s the underlying economics here? Jodi Beggs comments on the kerfuffle starting from first principles, pointing out that when demand increases, consumers are not likely to be able to get the quantity they want at the price to which they may have gotten habituated as “the price”. She also points out that the dynamic pricing is what keeps shortages from occurring — think about it: would you rather pay 7 times the base fare to have an immediate ride home after your New Year’s Eve party, or would you rather wait in line for the next available car? Either way, you pay; opportunity cost matters. In other words, as my colleague Jeff Ely observes, variable pricing means that prices go up and down, and generally will be higher when more people want the good (due both to higher and more inelastic demand at that time and to higher relative scarcity). Note that these observations also apply to retail electricity pricing — market demand varies over time, and prices can signal relative scarcity, if regulators allow them to.

The relative scarcity is another aspect of the economics here, because in the immediate run the firm can’t go out and scare up more cars and drivers; in other words, supply is not going to increase. Here we see the analogue to other industries that use dynamic pricing, such as airlines and hotels and car rentals — they have a pretty fixed supply, so as demand rises and falls the price to the consumer will rise and fall accordingly, because the supply response at the time is so limited. Over time profit signals will indicate to them whether or not to invest in more cars, planes, hotels, but if you’re trying to get home on that New Year’s Eve that’s not going to kick in that quickly. Thus prices adjust to communicate relative scarcity.

But notice another aspect of the story of Uber’s pricing: although they told the customer what the “surge multiple” was when they called the car, the customer doesn’t know the fare until after the transaction has occurred. Here I concur entirely with the NY Times blog post, Jodi, and Jeff, that not informing customers ex ante about at least an estimate of the fare is a bad way to implement dynamic pricing! Especially for flesh-and-blood humans who are more than calculating machines, and are likely to be royally ticked off when they are charged 7 times base fare for such a short ride. The NY Times blog post quotes Yale economist Dirk Bergemann, saying that consumers prefer price predictability, which is true as a very broad claim … but if I draw an analogy from regulated retail pricing in electricity (and using a rhetorical trope of Jeff’s), consider the equilibrium. If instead they kept their fares constant, it’s entirely possible that the average fare could be higher in the single fare market design than in the dynamic pricing market design. That’s one of the anxious concerns that regulated electricity firms have about dynamic pricing — what if our revenue falls because a large enough share of demand ends up happening in low price periods (i.e., more demand is more elastic)? In any case, not giving customers at least an estimated fare before they commit to the order is bad business, and it should be easy to communicate that estimate, because customers are all using smart phones to order the cars.

I’d like to suggest a couple of alternatives that my colleagues did not. The first alternative is inspired by time-of-use pricing as used in electricity, or by the types of dynamic pricing contracts used in car rentals. If I know well enough in advance that I want a car at 2AM on New Year’s Eve, why not offer me a contract in which I can make a reservation at a firm price, albeit one that is higher than the base price? Then Uber could, say, take reservations for 50% of their fleet, and leave the other 50% open for spot-market transactions. With that model, those customers who are risk averse and want to make sure to have a car at a particular time at a reasonable price will have an option. But if they can’t commit to a time for a pickup, then they suck it up and deal with the spot market.

The second alternative is less relevant to the Uber example, but in lots of markets that could have dynamic pricing, we can use technology to automate our responses to the price. I’ve gone on ad nauseam about the potential for transactive technology in retail electricity markets, and it’s applicable in other markets too — automated reservation bots for making a flight reservation if the price on your preferred itinerary on your dates goes below a trigger price that you set, or a device in your car or an app on your phone that receives the current toll level and tells you whether or not to take the toll road, wait to go home, etc. Transactive technolgies reduce the cognitive barriers associated with price uncertainty, as well as reducing the transaction costs of using dynamic pricing in the first place.

Posted in Economics | Tagged , | Leave a Comment »

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New paper: Knowledge Problem

February 9, 2012

Lynne Kiesling

I have a new paper that may be of interest to KP readers, since the subject of the paper is the same as the name of this site: Knowledge Problem. I am honored to have been invited to contribute this paper to the forthcoming Oxford Encyclopedia of Austrian Economics (Peter Boettke and Chris Coyne, eds.). Here’s the abstract:

Hayek’s (1945) elaboration of the difficulty of aggregating diffuse private knowledge is the best-known articulation of the knowledge problem, and is an example of the difficulty of coordinating individual plans and choices in the ubiquitous and unavoidable presence of dispersed, private, subjective knowledge; prices communicate some of this private knowledge and thus serve as knowledge surrogates. The knowledge problem has a deep provenance in economics and epistemology. Subsequent scholars have also developed the knowledge problem in various directions, and have applied it to areas such as robust political economy. In fact, the knowledge problem is a deep epistemological challenge, one with which several scholars in the Austrian tradition have grappled. This essay analyzes the development of the knowledge problem in its two main categories: the complexity knowledge problem (coordination in the face of diffuse private knowledge) and the contextual knowledge problem (some knowledge relevant to such coordination does not exist outside of the market context). It also provides an overview of the development of the knowledge problem as a concept that has both complexity and epistemic dimensions, the knowledge problemʼs relation to and differences from modern game theory and mechanism design, and its implications for institutional design and robust political economy.

In this paper I analyze the development of the two categories of the knowledge problem — the complexity knowledge problem and the contextual knowledge problem — and explore both the history of the development of these concepts and their application in robust political economy and new institutional economics. As is the hallmark of a good research project, I think on balance I learned more than I created in the process of writing this paper.

One other thing I made sure to include was a discussion of how the knowledge problem and its development relates to game theory and mechanism design, through the work of Oskar Morgenstern (and then through some of the work of Herb Simon and Vernon Smith, among others).

Tying together economics, institutional design, history of thought, and epistemology, I hope you find this paper informative and useful! I’ll also make sure to update when the full volume is available.


Posted in Complexity, Economics | Tagged , , , , | 1 Comment »

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How patents stifle innovation, Honeywell edition

February 7, 2012

Lynne Kiesling

In the comments on Mike’s post yesterday about the Honeywell patent lawsuit against Nest, Ed asks in the comments how it is that patents stifle innovation rather than promote it. The theoretical answer is that, as a government-granted monopoly, patents embed both incentives — at the margin they increase the incentive to create new patentable knowledge while also slowing or stifling the dissemination of that knowledge, and/or knowledge deemed too close to it. The fine balance of managing the tradeoff between those two effects is the objective of a “good” patent law, because to get net benefits the breadth and duration of the allowed patents has to be enough to be stimulative, but not so much that it deters other innovative activity. A good patent law allows differentiation of breadth and depth for different types of inventions in different areas/industries, and holds diligently to the “non-obvious” requirement that is written into U.S. patent law and is part of any economic theory of intellectual property.

It’s increasingly clear, particularly in technology, that the U.S. patent law is not striking that balance, and is instead doing more of what Michele Boldrin characterizes as using the political and patent process to protect monopoly rents (as per a post I wrote on the topic in 2009, with links worth pursuing). At least to me, some of Honeywell’s patents don’t pass the common sense/non-obvious test, such as their “natural language temperature range setting” patent.

In following up on their extensive reporting at Earth2Tech yesterday, which Mike linked to in his post, Katie Fehrenbacher today offers several reasons why she thinks this Honeywell lawsuit will in fact deter innovation. She agrees with me that the natural language patent does not pass the “non-obvious” test, and she also discusses the cost of a patent war, the David/Goliath nature of this lawsuit, and some other important reasons why this lawsuit may bode poorly for robust innovation in the home energy technology space.

Posted in Economics, Electricity, Technology | 2 Comments »

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Super Bowl price gouging complaints

February 5, 2012

Michael Giberson

If you follow price gouging headlines, you become accustomed to seeing price gouging stories around big sports events: the Rugby World Cup, NASCAR races, NCAA basketball finals, and always the Olympics (a selection: Barcelona 1992, Atlanta 1996, Sydney 2000, Salt Lake City 2002, Athens 2004, Vancouver 2010, London 2012, and finally this extreme example).

All of which serves as context to reports of Super Bowl price gouging.

Super Bowls usually produce price gouging complaints. But, as a story about today’s Super Bowl reports, rates in Indianapolis may have a particularly strong mark-up because of the relatively small host city. “This is what happens when the NFL books the nation’s largest sporting event in a city with only 6,000 hotel rooms. … By population, Indianapolis is the smallest Super Bowl city since Jacksonville, Fla., which hosted a disastrous game in 2005.”

Rooms are not in perfectly inelastic supply, non-traditional spaces from spare bedrooms to whole houses are being rented out for the week. Nonetheless, supply is relatively inelastic, and it is only the relatively high prices visitors are willing to pay that brings many of these spaces into the market. A surge in demand and relatively inelastic supply: elementary economics predicts a substantial increase in price.

Host city officials, league officials, and fans often lament price gouging, but it is easy enough to predict the effect of any law or custom that prevented it: more people renting rooms one, two, or more hours away, fewer people at game weekend events and pre-game events, and more people stuck in worse traffic before and after the game. (Or, perhaps in a language more relevant to host city officials, an effective anti-price gouging campaign would mean a smaller bump tax in local tax receipts from folks attending the game.)

The fundamental issue is the relative scarcity of rooms during the game weekend, and the question is how to match fans and rooms. Letting prices work earns price gouging complaints, but failing to let prices work would surely create worse problems.

Posted in Economics, Professional sports, Regulation | Tagged | 3 Comments »

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QOTD:Ron Bailey on cheap natural gas

February 3, 2012

Lynne Kiesling

Ron Bailey gets the quote of the day from this post about how cheap natural gas is roiling various energy markets, including renewables and nuclear:

Can an energy source be all that bad if it scares the two most heavily subsidized sectors of the electric power generation industry?

Posted in Economics, Energy markets | 2 Comments »

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Shale gas glut, but won’t last? The underlying model

January 31, 2012

Lynne Kiesling

Ken Silverstein has a good article in Forbes on the business prospects for shale gas developers (and I’m glad to see him there, having followed his work for a very long time). Since he asks in the title whether low shale gas prices are a mirage, I think it’s useful to go through the underlying economic analysis that’s embedded in his article. Note: if you are a principles student, this is a good exercise for you, because there will be a lot of shifting of supply and demand curves.

We start with the current boom in shale gas production, the consequence of technological change — horizontal drilling makes gas deposits available that were not with conventional technology. How do we model technological change? As an outward shift/increase in the supply of natural gas; at every price the quantity supplied is now greater, at every quantity the supplier’s marginal cost has fallen. For a given demand in the natural gas market, moving along the demand curve toward the new equilibrium means that price falls and quantity of gas sold and consumed rises. That’s a good model of where we are now.

But this equilibrium is unlikely to persist. Why? Because people don’t consume natural gas in isolation; we make decisions at the margin about when to substitute natural gas consumption for other fuel consumption, depending on the relative prices of those fuels. Even assuming all other things equal (a strong assumption), the falling price of natural gas will make the relative price of coal (Pcoal/Pnatgas) go up. Natural gas has become cheaper relative to coal, and at the margin consumers will substitute out of coal and into natural gas, even barring any other changes. We model this effect as a decrease in demand for coal, a leftward shift in the demand curve. For a given supply of coal, that means a lower price of coal (bringing their relative prices back into some balance that I won’t bore you with here) and lower quantities of coal consumed. In the short run that happens by substitution where it’s easiest, in industries using technologies (engines, turbines, smelters, etc.) where it’s relatively easier to switch between fuels.

Note also that regulatory changes, such as environmental regulations to reduce greenhouse gas emissions, will exacerbate the substitution out of coal, and shift the demand for coal even further to the left.

Another important factor in a dynamic economy is time, and the fact that over time, by adapting to these changes, people create new changes. One such change that Ken focuses on in his article is the extent to which electricity generators will, over time, retire coal generators and replace them with natural gas turbines. The longer-run effect of a low natural gas price (and low natural gas price relative to coal, so it’s in both absolute and relative terms) is the replacement of more durable, longer-lived technologies that use coal. Note the win-win here: not only is it cheaper (all other thing equal) to generate electricity with gas because of the shale gas, it’s also a cheaper way to meet environmental regulations because of the lower carbon footprint of natural gas. How do we model this effect? As an increase in the demand for natural gas, a rightward shift in the demand curve. So now in the natural gas market we have had an increase in supply and an increase in demand (yes, you should be jotting down graphs here!).

What do we learn about increases in supply and demand in the same market? The quantity transacted goes up, unambiguously. But price can go up or down relative to the initial price. That’s what we’ll see play out over the next several years, as electricity generators build more natural gas capacity and retire coal capacity. The empirical question will be whether or not the size of the increase in their demand outweighs the size of the increase in supply. That interaction will determine whether or not the current low prices are a mirage, although I admit that I object to that language in describing them; they aren’t a mirage, because they are real. But they are probably temporary. However, even if prices go up because of generator demand for natural gas for electricity, consumers benefit through controlling the economic and environmental costs of electricity generation. It’s just that their benefit will show up there instead of in the reduction in their home heating/stove bills. But don’t let the “mirage” framing of this point trick you into thinking that generator demand for natural gas is bad for consumers.

Posted in Economics, Electricity, Energy markets | 5 Comments »

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Soul searching in economics, Davos division

January 30, 2012

Lynne Kiesling

In Davos on Friday, the FT’s Martin Wolf chaired a panel discussion of economists including Peter Diamond, Joe Stiglitz, Robert Shiller, and Brian Arthur. His summary of the discussion is very well worth reading, because he highlights 10 important ideas that arose in the conversation. I’m going to summarize them here, which is no substitute for reading his description:

  1. First, orthodox economics had, in the years leading up to the crisis, become more a cult than a science, particularly with the assumption that what exists in competitive markets has to be the best possible outcome, since, if it were not, it could not exist.
  2. Second, let a thousand flowers of thought bloom.
  3. Third, the sociology of the profession – the need to define and defend a core discipline that can be taught to students and so determines what it means to be an economist – militates against such heterodoxy.
  4. Fourth, human beings are not rational calculating machines.
  5. Fifth, time matters in economic processes, which are, in general, not reversible and not characterised by any sort of equilibrium.
  6. Sixth, the world is not computable.
  7. Seventh, being a study of complex human behaviour, in which the world is created by human understand [sic] and motivations, economics is hard.
  8. Eighth, in theory it is right and proper to abstract in order to focus on a specific phenomenon. In addressing policy, this is irresponsible.
  9. Ninth, even though economists get much wrong, they still have much to offer to non-economists who tend to assume that economic problems are far more simple than they actually are.
  10. Tenth, there is a great danger that in rejected the most simplistic pro-market mantras, economists and policymakers will embrace even more dangerous and naïve statism.

This list is full of insights and healthy ideas to rediscover in economics, such as multi-disciplinary discourse and research, a dose of humility in applying theory that uses simplifying assumptions to real-world policy situations, and a meaningful recognition of the complexity of humans and the social systems we create and that emerge from our interactions. I say “rediscover” because several of the points above had been part of economics (even including Keynes, who cautioned people on #6) over the past two and a half centuries, but have been lost as our field has evolved toward more formalism, to the exclusion of other methods of analysis.

I think this soul searching is healthy, and that it’s valuable to have such an accomplished set of economists from a variety of sub-field backgrounds discussing them. How many economists, especially theorists at top research universities who “whisper in the ears of emperors”, will agree with these points, internalize them, and use these ideas to evolve their research in directions more consistent with them?

Posted in Economics | 4 Comments »

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A Friday flash

January 27, 2012

Lynne Kiesling

I found a lot of interesting and insightful thoughts in my morning reading today; here’s a synopsis:

  • Election year linguistics 1: The New York Times has an analysis of the language used by Obama and the four presidential candidates; at Cato at Liberty, David Boaz points out how different Ron Paul’s emphasis is from all of the others. He speaks about the fundamentals of both economics and the American small-l-liberal political tradition, while the others focus on topics that are more matters of expediency.
  • Election year linguistics 2: Newt Gingrich is currently getting his panties in a twist about people calling his ideas and his rhetoric “grandiose”, claiming that grandiosity is a defining American characteristic. I encourage Mr. Gingrich to consult his dictionary. According to dictionary.com, the first two definitions of “grandiose” are (1) affectedly grand or important; pompous and (2) more complicated or elaborate than necessary; overblown. I submit that while these meanings fit Mr. Gingrich, they are not defining characteristics of American culture, historically or at present.
  • Speaking of rhetoric and meaning, the Wall Street Journal has an interview, The New Theories of Moral Sentiments, with Deirdre McCloskey. She is doing more than any one person I know to return the perspectives of political economy and economics as transcending “Max U” to the professional and policy conversations.
  • Adam Thierer has a review of Liars and Outliers, the new book from security expert Bruce Schneier. Schneier analyzes the social institutions and mechanisms that enable trust to evolve in societies, and it sounds like it will be a great read; I’ve been looking forward to it, and Adam’s review whets my appetite even further. Schneier is the preeminent voice of reason in the debate over the surveillance state, so this book is self-recommending.
  • Also in technology, Steven Titch unpacks Google’s consolidation of its privacy policies across its suite of applications, and discusses what information Google does and does not capture, and what they will and won’t do with it. Very useful corrective to some of the anti-Google hyperbole, although I have some remaining skepticism.

Happy Friday!

Posted in Economics, Liberty, Technology | 1 Comment »

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Examining the “Masters Hypothesis” about the role of index funds in the 2007-2008 price spike

January 20, 2012

Michael Giberson

From the most recent (January 2012) edition of Energy Economics: “Testing the Masters Hypothesis in commodity futures markets” by Scott Irwin and Dwight Sander.

The “Masters Hypothesis” refers to claims by investment manager Michael Masters (in testimony before a Senate committee -included in this collection- and on the TV program 60 minutes, among other places) that significant flows of cash into commodity index funds drove the commodity price spike of 2007-08. Masters made a big splash with his claims, at least among the easily impressed (i.e. the TV program 60 minutes).

In brief, Irwin and Sander test the idea against market data and find no support for Masters’ claims. See a related discussion at the Big Picture Agriculture blog.

Here is the article abstract:

The ‘Masters Hypothesis’ is the claim that long-only index investment was a major driver of the 2007–2008 spike in commodity futures prices and energy futures prices in particular. Index position data compiled by the CFTC are carefully compared. In the energy markets, index position estimates based on agricultural markets are shown to contain considerable error relative to the CFTC’s Index Investment Data (IID). Fama–MacBeth tests using the CFTC’s quarterly IID find very little evidence that index positions influence returns or volatility in 19 commodity futures markets. Granger causality and long-horizon regression tests also show no causal links between daily returns or volatility in the crude oil and natural gas futures markets and the positions for two large energy exchange-traded index funds. Overall, the empirical results of this study offer no support for the Masters Hypothesis.

Posted in Economics, Energy markets | Tagged , | Comments Off

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SOPA/PIPA protests and the economics of content market power

January 19, 2012

Lynne Kiesling

I found some things striking in yesterday’s SOPA/PIPA protests. One was Jim Harper’s clear and cogent statement that the Internet is not a thing, it’s a set of protocols stipulating how computers communicate with each other. That set of protocols is a platform, and those protocols are not the government’s to regulate.

Jim’s Cato colleague, the ever-reliable Julian Sanchez, points out that if you estimate the profits/surplus at stake from piracy relative to the lost value all of the other Internet activities that would be stifled under SOPA/PIPA, the cost of piracy is just not that large. Sure, it’s concentrated in the hands of politically-powerful entertainment content companies, but relative to the rest of the vibrant, dynamic value creation that would “be disappeared” it’s small. Moreover, domestic and international legal institutions already exist to deal with piracy; like any other human institution they are imperfect, but as a consequence of them the losses from piracy are small relative to what would be lost if Congress imposed SOPA/PIPA. Here’s a good, short video from Julian covering some of the basics:

At Digitopoly, Joshua Gans makes an analogy near and dear to my heart: consider how SOPA/PIPA would make the Internet more like the arbitrary, intrusive, Constitution-free zone that is our airports:

But the notion that enforcement and prevention matters will be put in place that create massive harm to the lives of innocent individuals while being unlikely to really actually led to less of the activity targeted is not unprecedented. You can think about this every time you go through a US airport and think about who is winning there. …

So the scenario that US people should be concerned about is if publishing on the Internet becomes like airport security. That is, if copyright enforcers are able to automate enforcement without due process. That will raise the costs of publishing and will deter many. As is often the case with over-reaching laws, the problem is that it creates too few incentives for enforcers to enforce discriminately rather than indiscriminately.

These contributions to the discussion have all been outstanding, but the most useful one in my estimation is this TED video posted yesterday from Clay Shirky on the issues at stake in the SOPA/PIPA debate:

It really is a must-watch video, well worth 10 minutes of your time. Shirky describes the technological issues clearly for non-techies and delves helpfully into the legal history of copyright in media, but then makes the crucial economic point when he says “Time Warner wants us all back on the couch and not creating our own content”. In all of the justifiable furor about censorship, this is the economic point that gets a bit lost. For the past 70 years the entertainment companies have had a lot of market power, because entertainment was essentially an oligopoly. They profited handsomely from their market power over content. But with the decentralization and edge content generation now possible due to technology, and with the way that their content provides an input into that edge creation, we now have many more substitutes for their content. They are using the piracy red herring (which is not as large as they claim it is, as Julian points out above) to try to retain the viability of their decades-old business model and market power over content. That’s the real economic issue here — they want us back on the couch and in the movie theater.

This is a fight that is not new with SOPA/PIPA and the Internet, nor will it end with the Congressional retreat from these ill-designed pieces of proposed legislation. Yesterday raised a lot of awareness of the issues, but it’s going to have to happen over and over and over …

I’m going to give the last word to my friend Sarah, who makes a useful analysis of language and its use in the context of both SOPA/PIPA and the recently signed into law National Defense Authorization Act, complete with its provisions that allow extralegal detention of American citizens without due process on suspicion of terrorist activity. Sarah offers an analysis of Orwellian Newspeak language, and identifies disturbing parallels with our current environment:

It struck me today that the combination of SOPA/PIPA and the NDAA move us terrifyingly close to an Orwellian world where people, language, history, and information can disappear at any time. Forever. As if they never were. And worse than that, our primary way to discuss/protest/remedy that disappearance–the Web–will be taken from us as well. …

Newspeak as a language, then, mirrors the political system that creates it, and serves to support it and perpetuate it by creating an agreed upon reality where meanings are strictly limited, the possibility for unorthodox thought is all but eliminated, and an agreed upon “reality” allows Ingsoc to have been always in control. Winston’s friend Syme is correct that “Newspeak is Ingsoc and Ingsoc is Newspeak.”

I leave further connections to the contemporary political situation as an exercise for the reader.

Posted in Economics, Liberty, Politics, Regulation | Tagged , , , , | 2 Comments »

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