Price Discrimination and Cross-Subsidy in Financial Services
46 Pages Posted: 9 Mar 2017
Date Written: September 5, 2016
Charging different prices to different individuals for the same product or service has been a common practice since Ancient Greece. We experience it so commonly that it rarely attracts comment and is seen as a normal part of life, such as when we see a film at the cinema or catch a flight. Contrast this with concerns about such pricing (also known as price discrimination) expressed in courts and by consumer groups and we have a conundrum. Why is it that a practice that barely merits any notice in some contexts provokes calls for, and in some cases initiates, regulatory intervention in other contexts?
Let us initially define terms. Price discrimination occurs where firms charge prices to different consumer groups, with different mark-ups on the costs of supplying the product to these groups; for example, prices differ while the costs of supplying the consumer groups are the same. In other cases, prices to groups of consumers may be the same but the cost of supplying varies between them. This includes cost differences which arise because consumers have different risk profiles. Price discrimination is therefore distinct from purely cost-reflective pricing.
Cross-subsidy is commonly used to refer to the distributional consequences of price discrimination. Consumers who are charged high mark-ups may be considered to ‘subsidise’ those who are paying lower mark-ups (for reasons other than costs/risk). Economists usually use it more narrowly, to refer to situations where certain consumer groups or products are priced below economic cost, while sales to other consumer groups or sales of other products are profitable. In this paper, we focus on cross-subsidy in the narrow, economic sense.
This paper uses an economic lens to examine price discrimination and cross-subsidy in financial services. It sets out how economists analyse such pricing practices and how that analysis addresses concerns about fairness, efficiency and distribution. It also examines the link between the pricing practices and competition – recognising that price discrimination and cross-subsidy can be products of a normal and maybe very intense competitive process, but that the same practices can also be an indicator of weak competition in some segments of the market. Competition can be weakened by such pricing and may be strengthened by appropriately designed policy interventions.
The focus on these questions reflects the widespread use of this pricing in financial services. This is in part due to the nature of contracts, of costs and of consumer behaviour in financial services. This pricing may become more prevalent as Big Data use increases and as firms become more sophisticated in their understanding of, and ability to react to, consumer behaviour.
Pricing practices take many different forms and evolve over time. However, the form of the pricing practice is less important than its effects (though both are linked). Economics provides us with the conceptual tools to explore the consequences of product and pricing strategies that firms use. As set out in this paper, these concepts improve our understanding of when firms’ strategies may give rise to regulatory concerns.
What lessons are to be learned?
Economic analyses show that there can be no presumption that these practices are either harmful or beneficial. First, the relative lack of concern about price discrimination in some cases is well justified. Price discrimination can occur in markets where firms compete for consumers. Such pricing may encourage competing firms to charge lower prices to win customers and may make all consumers better off than uniform pricing. Moreover, price discrimination can be an efficient way for firms to cover their fixed and common costs and it can expand the market, allowing some previously priced-out customers to access the market.
However, concerns about price discrimination can also be well founded. Such pricing can signal weak or distorted competition. Some forms of price discrimination and cross-subsidy, especially when used by firms with substantial market power, can drive out actual and exclude potential rivals, further reducing competition in the market. A firm’s ability to identify a consumer group and charge them high mark-ups may indicate those consumers have few available competing options – or that barriers stop those consumers from accessing these options. This is clearly a concern for a regulator with a competition objective, such as the FCA.
Further, these pricing practices usually have distributional consequences – some consumers benefit from lower prices, while others face higher prices and may even stop buying. For example, sophisticated consumers (the ‘savvy’) could secure good deals while others (the ‘non-savvy’) face higher prices. These distributional effects may persist even if firms compete vigorously. In other cases consumers can choose whether or not to become informed (‘savvy’) and high prices may incentivise them to check the details of a firm’s offer. In these cases, the challenge for the FCA in terms of its consumer protection objective is to decide when the characteristics of the ‘non-savvy’ warrant intervention, given the characteristics of the ‘savvy’. In addition, a regulator will consider whether the interests of consumers who are considered vulnerable for policy reasons are being damaged.
Regarding policy, the mere presence of price discrimination or cross-subsidy does not necessarily warrant an intervention. Whether an intervention is appropriate depends on the identification of harm resulting from the practice, as well as the expected material improvement in welfare from the intervention.
Assessing whether pricing practices are harmful to consumers and competition requires a case-by-case assessment based on detailed data. This requires considerable resources but is important for judging whether an intervention is required to protect consumers or to improve competition in the market.
To reduce any harm from such pricing, a regulator may directly intervene on pricing practices, or may intervene to address underlying market failures, such as market power. Some regulatory interventions that stop short of banning price discrimination or direct price capping appear to have had positive impacts in addressing problems arising from price discrimination. However, badly designed or inappropriate regulatory interventions to address such pricing’s effects can lead to undesirable consequences for consumers and competition. Such interventions might, for example, reduce consumers’ incentives to shop around and switch and hence lessen pressure on firms to compete. The Competition and Market Authority (CMA), for example, found that Ofgem’s policy package, which limits price discrimination by energy providers, adversely affected competition ‘by reducing retail suppliers’ ability and incentives to compete and innovate in designing tariff structures, and by softening competition between PCWs’ (price comparison websites) and recommended removing those restrictions (CMA, 2016b, para. 12.356/7).
Keywords: pricing, price discrimination, cross subsidy, efficiency, fairness, distribution, competition, regulation, financial services
JEL Classification: D21, D31, D42, D43, L12, L13, D61, L51
Suggested Citation: Suggested Citation