Wednesday, August 5, 2009

Econ 101: Price Discrimination and Arbitrage

On Craigslist just now, I found a 1995 Ford F150 truck advertised for $1000. I could buy this truck and immediately turn it in for a $4500 Cask for Clunkers rebate on a car that got at least 25 MPG. Or I could turn around and sell it to someone walking onto a new car lot who is ready to buy a car. In fact I am not sure why new car dealers are running around snapping up cars like this to offer to prospective customers so that they may take advantage of the Cash for Clunkers program (or perhaps they are). This example illustrates the difficulty of price discrimination.

Price discrimination is, among a few other things, charging different people different prices usually based on their willingness to pay (demand) for it. A classic example is the movie theater with its adult and child prices. Adults are generally willing (able) to pay more for a movie than children are. In the Cash for Clunkers program the government wants to essentially charge a lower price to people with cars that are not very fuel efficient. The challenge to such pricing schemes is that you have to be able to prevent arbitrage - the buying and selling of the same good for different prices. Otherwise you would have kids camped outside of theaters buying up tickets and reselling them to adults. Or people like me buying up old cars and reselling them to people without poor fuel efficiency cars so that they may enjoy the Cash for Clunkers rebate. In this case the program is temporary and the cost of searching for, re-titling the car and turning it in is probably enough to prevent this from happening too much - maybe. But the theater example is easy, which is why there are ticket takers at the door that check that adults are not entering with kids tickets.

Since businesses go for price discrimination it is probably pretty obvious that it is a profit maximizing strategy. In fact, in general, the more businesses are able to price discriminate the more profit they make. Interestingly, however, it is also generally true that more price discrimination leads to more sales which is good for market efficiency. Is it good for consumers? Well when it is done on the basis of group membership it usually depends on which group you are in. For example, when airlines charge more for business travelers and less for vacationers, the business travelers are paying more than they would in the absence of price discrimination, but leisure travelers pay less.

Another example of price discrimination that was brought to my attention is the reciprocal agreements that museums and zoos have. For example, a family membership in the Science Factory in Eugene costs $55, while a family membership in OMSI is almost twice that. This is a type of price discrimination as well - although the products aren't identical it is likely that the demand for science museums are different in the two cities. There is no restriction to becoming a member of the Science Factory as a Portlander and since the two museums have a reciprocity agreement, you could get into OMSI as much as you wanted on the Science Factory card. I almost didn't blog about this as I worried I would spark a surge of defecting OMSI patrons, until I scoured the OMSI website and found the link to the Association of Science - Technology centers which states this about the reciprocity agreement:

Please note—local restrictions apply

1. Based on your science center's/museum's location: Science centers and museums located within 90 miles of each other are excluded from the program unless that exclusion is lifted by mutual agreement. 90 miles is measured "as the crow flies" and not by driving distance. Science centers/museums may create their own local reciprocal program. ASTC does not require or participate in these agreements, or dictate their terms.

2. Based on your residence: To receive Travel Passport Program benefits, you must live more than 90 miles away from the center/museum you wish to visit. Admissions staff reserve the right to request proof of residence for benefits to apply.

So either they were smart at the outset or quickly learned about arbitrage the hard way (I hope OMSI staff are checking). The zoo association has only weak language about not offering to member of zoos that are too close but does not have the residency requirement. So here is a hint for you folks living in Seattle: the Oregon Zoo charges $69 for a family membership, while the Woodland Park Zoo charges $110. Why would you buy a membership up there when you can save $41 a year as an Oregon Zoo member? Oregon is much hipper anyway and this can give you the vicarious thrill of belonging, in some small way, to the state.


Dylan said...

I love price arbitrage, when I can find it.

However, it's my understanding that in order to take advantage of Cash for Clunkers that the buyer needs to have owned the clunker for more than 1 year (in order to prevent price arbitrage).

Patrick Emerson said...

Yes, a friend e-mailed the same thing. It is true that you cannot buy a car and immediately turn it in, but I can't tell from the FAQ if the person buying the new car has to be the same as the person owning the clunker. The other arbitrage opportunity is for owners of clunkers who don't want new cars to buy and re-sell them at a discount to those who do want new cars but do not have clunkers.

Dann Cutter said...

It turns out that the clunker owner must also be the titled owner of the new car. (I know, I examined this exact strategy to buy a new Charger).

vietmath said...

It turns out that the price arbitrage is quite complex and hard to manipulate properly. This article is really helpful, thanks a lot.

Gustavo Gorenstein said...

I know this is an old post, but since you are in Brazil and I'm from this lovely land as well, I decided to comment on it. I found very interesting that you did not mention online arbitrage, which is very common nowadays. Any particular reason? cheers!