Authors: David Reinstein and Owen Southam, University of Essex, 15 Sep 2015.
Four people get on a bus (this is not the opening line of a joke): a student, a pensioner, a dishwasher (who earns minimum wage), and a lawyer.
Who pays the most? Usually the dishwasher and the lawyer will pay the full price, say £4. The pensioner (in the UK and many countries) can ride for free for most of the day, even if he retired from an investment bank with a gold-plated annuity, because his fare is subsidised by the government. The student (rich or poor) gets a discount bus pass for a different reason: the bus company knows that students will tend not ride the bus unless it is cheap, so they can make more money by offering discounts.
Is this efficient?
Suppose the dishwasher ‘Dave’ finds the £4 fare too dear, and decides to walk instead. The bus company now has lost income and the dishwasher has lost time. As long as the bus was not overcrowded and the dishwasher was boarding and departing at required stops, no one has gained from this. Offering lower prices to students made them want to take the bus. Similarly, the company could offer discounts to low income consumers like the dishwasher. If Dave was willing to pay £2, and the increased cost to the bus company was £1 (in terms of having to make another stop), then if they charged any fare in between £1 and £2, both would be better off.
In general, when a firm has ‘market power’ and can only charge a single price, there is a loss of efficiency: the firm reduces the quantity and keeps prices high. The bus company could reduce the fare to £2 (or even £1) but it makes more money charging £4. Although it loses Dave’s fare, the £4 it gets from the lawyer makes up for this.
On the other hand, if the firm could perfectly price-discriminate -- charging everyone his or her maximum willingness-to-pay -- there is no efficiency loss. If Dave’s fare is £2 and the lawyer’s is £4, both ride, and the bus company profits. (Remember, economists think of efficiency in terms of the total size of the pie, not on how it is divided). However, an intermediate amount of price discrimination may either make things better or worse; we return to this below.
Offering different prices for different prices for the same or similar good to different consumers is known as ‘price discrimination.’ Companies spend vast sums hiring marketers and ‘big data’ consultants to find the best way to divide consumers into segments and charge them different prices; through targeted discounts and coupons, cross-store variations, internet cookies, etc. The firm wants to identify the maximum amount you would be willing to pay for a product, and then charge you a penny less than that. The conventional wisdom, (echoed in standard textbook discussions) is that the strongest determinant of the amount a consumer is willing to pay is likely to be her income and wealth. Existing empirical work typically finds that price sensitivity decreases in income. If firms knew everyone’s income they would likely charge less to the poor and more to the rich. They would do this not to be a kind-hearted Robin Hood, but to make as much profit as possible.
So why does Dave the dishwasher pay the full price? While the pensioner and the student have government and university-issued ID’s, the bus company has no easy way of identifying the low-income consumer.
How can income-based price discrimination be made possible?
While firms cannot observe your income directly, the government does. Thus they could give consumers who request it a card that offers proof of their income. (Japan’s ‘My Number identity system’ already encapsulates this information, but its use is strictly limited.) Consumers could show merchants this “OpportunityCard” (OC) to companies to get discounts, i.e., to enable income-based price discrimination.
How could this help reduce inequality?
The OpportunityCard will reduce inequality in terms of purchasing power. Poorer consumers will tend to get OC discounts while the default prices, for the wealthier consumers, will tend to increase. E.g., the standard bus fare may rise from £4 to £5, while those whose OC shows they are earning minimum wage may be charged £1.50. Dave the dishwasher, who was willing to pay up to a £2 fare will now ride the bus. Molly the maid, who was already willing to ride the bus for £4 will continue to do so, and will have £2.50 more in her pocket to spend on other things. Both Dave and Molly are now better off. On the other hand, Larry the lawyer who was willing to pay up to £4.50 will no longer ride the bus, and Bob the banker who is willing to pay up to £6 will continue to ride but will have £2 less to spend on other things -- both Larry and Bob are made worse off.
Potential obstacles and limitations: FAQ
OK, so the OpportunityCard would reduce inequality. But would it work? Would people use it? If it were so great, why doesn’t it already exist?
There are foreseeable obstacles that can be dealt with, and it will not be used everywhere.
Would stores really want to serve poor people?
Some status-conscious firms want to be known for appealing to wealthier clientele; others prefer to avoid serving poor customers, seeing them as troublesome or unlikely to pay standing charges. These ‘snobbish’ firms will not offer OC discounts. But many more will do.
Would poor people be willing to use this, or would it be stigmatised?
We cannot know in advance how widely the OC will be accepted. However, it could be ‘mainstreamed’ – made available to people across a range of incomes (‘the 99%’), and even those who are comfortably middle-class may get some discounts. It may be used rather discretely, like loyalty cards in supermarkets. There is also some precedent – over 40 million low-income Americans regularly use ‘Food Stamp’ cards, and across the UK people take advantage of subsidised council housing.
Wouldn’t rich people just get poor people to buy on their behalf?
This is called ‘arbitrage’: sellers will anticipate this, and will tend to give discounts only where they do not expect this to occur. However, for many goods and services – like bus passes with photo ID and airline tickets – arbitrage is difficult or impossible. We do not typically see large groups of people standing outside of supermarkets buying and selling from one another, or re-selling mayonnaise on EBay.
If this is profitable and practical, why is it not already being done?
Several obstacles may have limited its use; some of these may be removed by government. The rules and regulations for price discrimination are often complicated and misunderstood. Verifying income may be too cumbersome for individual smaller transactions; a centralised OC could solve this problem.
So, would the OpportunityCard improve the efficiency of the market or worsen it?
Not everyone is made better off by price discrimination, as seen above. In general, groups that tend to value the product more will be charged more, but not every individual within this group will be charged her valuation. Thus, with the OC, the poor will get discounts, and the rich will be charged more, particularly for luxuries like gourmet food and hotels. As in the above example, because of these discounts, some poor people may buy a product even though they value it less than some rich people who don’t buy that product. This is an inefficiency from a ‘misallocation’ -- the ‘wrong’ person consumes the product. In the above example, we know there is room for improvement: e.g., if Molly could sell her bus ticket to Larry for £4.25 then both would be better off. (However, price discrimination is only used when this ‘arbitrage’ is impossible).
For price discrimination to increase market efficiency in spite of this misallocation problem, it must increase output. In the above example, the number of low-income riders who start using the bus (like Dave) must exceed the number of wealthy people (like Larry) who stop.
Given these uncertainties, is it worth trying?
You may be thinking ‘there is no such thing as a free lunch’ (although with price discrimination there may be discounted lunches.) As noted above, the efficiency -- in terms of the production and allocation of goods and services -- is uncertain. As with means-tested benefits, there will also be an impact on the labour market. This means that the traditional way for governments to play Robin Hood – taxes and benefits – may be less costly, or more costly. We simply do not know. We can only learn this by experience, testing, and measurement. The chief benefit of the OpportunityCard may be as a politically-palatable way to stem inequality – an issue that resonates with voters both on the left and on the right in the UK and the USA.
Politics of the OpportunityCard
Left-of-centre politicians see income inequality as a chief social ill. Jeremy Corbyn has argued that ‘Labour has traditionally ironed out the inequalities in society.’ On the right, Milton Friedman typifies the belief that a ‘government solution to a problem is usually as bad as the problem.’ The OpportunityCard can make both sides happy -- reducing inequality through using market forces, strengthening rather than hindering the ‘invisible hand’. By allowing information to be shared, it will increase both company profits and the purchasing power of the poor.
How to move forward
As noted above, there are unresolved theoretical and practical issues. While we can be fairly sure that an OpportunityCard will help the poor while boosting firm profits, we do not know for certain whether it will be an efficient way to do this. We also don’t know how whether issues like stigma, fraud and arbitrage will prove serious impediments. This can be tested through controlled field experiments and policy trials. The OC could be gradually introduced to a random selection of consumers, towns, or regions, or to one area or industry at a time. Distinct administration and marketing techniques could be tested, and focus groups and surveys can gage attitudes. A controlled trial could provide valuable ‘difference-in-difference’ comparisons. Relative to the control groups, where the OC is introduced, where are discounts offered and how do ‘base’ prices change, how does demand respond, and what is the relative change in total output? Economists and policymakers could use this information to make inferences about whether, where, and how to expand the programme and encourage price discrimination by income.
If we do not test this out, we will never know: we may be missing out on a crucial tool for improving both equity and efficiency.
 David Reinstein is a lecturer in Economics at the University of Essex. Owen Southam is a student in Economics at the University of Essex. Note: Some material overlaps ‘The Government May Want to Encourage Price Discrimination by Income’, University of Essex Economics Discussion Paper No. 771.
 Wealthy people may get a greater relative value on certain products, like caviar and fine champagne. This could be either because their tastes differ, or because these products bring little benefit unless you already have a comfortable house and eat otherwise tasty nutritious meals.
 One possibility is that at the margin, people may choose to work sightly less hard in order to qualify for more benefits or discounts.