CONVOY (Part 1)
Feb 20, 2001
Price discrimination – the practice of selling the same product to different people at different prices – is widespread, sometimes illegal, and always controversial.
Lost in the crossfire is any sense that consumers may want both discriminatory pricing structures and unitary pricing structures and, in any case, should be able to decide between them on their own. With the choice increasingly made for them by paternalistic bureaucrats, consumers may be losing their ability to tell the difference. This may explain why they seem increasingly vulnerable to hidden discriminatory pricing schemes masquerading as auctions. The unfolding decimalization of the stock market is one such scheme.
Few television viewers in the last couple years have escaped Star Trek hero William Shatner touting Priceline.com’s "name-your-own-price" service. In the commercials, Mr. Shatner plays a nightclub performer with relentless anguish over not being able to name his own price for airline tickets, hotel rooms, etc. In one spot, the former Captain Kirk fervently shouts "convoy" in revolutionary solidarity with the presumed masses who, like him, are sick and tired of being told what to pay for the products they buy. They are apparently freed from such tyranny when they join Priceline’s patented "reverse auction" convoy.
In the last couple years a revolutionary stock trading system called Optimark promised to optimize the satisfaction of all investors who would state in the form of a complex set of limit orders the trade prices they would be happy with. Every few minutes, Optimark’s supercomputer solved for the price or prices that would optimize satisfaction. The patented "multi-attribute preference-based matching engine" was promoted as a futuristic "auction" that would soon replace all other stock trading systems.
The reform-driven transformation of traditional stock trading into continuous electronic "auctions" has been accompanied by rising volatility in the last couple years. Concerned over the rising number of complaints about bad executions in the fast-paced environment, regulators have been urging investors to protect themselves by putting price limits on their orders. The advice applies in all the popular trading venues, from the NYSE’s continuous agency auction, to Nasdaq’s forthcoming SuperMontage.
The above initiatives share an implicit assumption that a strategy of using limit orders to participate in what are believed to be auctions will benefit the consumer. This Auction Countdown explores why all three strategies are bound to disappoint their users, as Priceline and Optimark already have. The disappointment in the case of SuperMontage and similar electronic book proposals is likely to be especially galling. Not only are they promoted, as were Priceline and Optimark, as the latest in electronic efficiency, but they also carry the implicit imprimatur of official regulatory reform. The truth is, however, that none of these are really auctions. Rather, they are price discrimination machines, and price discrimination, as we will see, is incompatible with what people expect from auctions. To make a bad situation far worse, the collapse of the trading tick – the primary intended effect of decimalization – will greatly magnify the potential for price discrimination.
The basic problem here is that, even though you name your own price, chances are you won’t be happy with it, because others can get better prices at the same time. These systems share a built-in version of what game theorists call the "winner’s curse." It is a fatal flaw, because it makes you feel foolish twice: once for naming the wrong price, and again for believing the hype about a fair auction. Having been made a fool of, you won’t come back or, if you do, won’t bid aggressively. In academic parlance, you will "shave your bids." This is a problem for these systems because, once the word spreads, the supply of fools will dry up, and there may be no one to trade with or, in the case of Priceline, there will be insufficient bids for services at prices that their vendors will accept. In theory, price discrimination can enhance profits by enabling the capture of "consumer surplus," and enhance "efficiency" by enabling more consumers to trade at prices that satisfy them. But, these benefits will remain theoretical if consumers feel scammed. And they will, as long as there remains a large gap between expectation and reality, such as inevitably follows from touting these systems as auctions. No one has yet figured out how to make sitting ducks remain seated after the shooting starts.
In the case of SuperMontage and other visible limit order book systems, one effect of lessened aggressiveness is less transparency, as bid (and offer) shaving moves orders out of the range of tradability, cuts down on their size, or moves them out of the book altogether. The loss of transparency is a particularly ironic result in that the most common reason put forward by reformers for both such books and decimals is the need to improve transparency. The theoretical errors behind such seemingly trivial technicalities are not merely academic, nor are these examples unique. Consumers, regulators, business method consultants and entrepreneurs all seem to be falling en masse for the most improbable snake oil. Both the embrace by experts of these auctions that are not really auctions, and the inarticulate consumer revulsion they cause, are signs of a collective analytical breakdown, which I believe may be the result of excessive Government intervention in the formation of commercial structures. To get a handle on where these errors are coming from, let’s start with some background on auctions.
What Is an Auction?
Behind all their high-tech terms, the "auctions" in question are hiding a crude and actually somewhat old-fashioned merchandising mechanism, a throwback to watch-your-wallet dealing bazaars, or to shopping in 19th century American stores, where bargaining and price discrimination were the norm. But just as the price tag unified prices for most shoppers in the 20th century, true auctions provide a more civilized alternative for many consumers to such primitive multi-price structures. And, more to the point here, they provide a result that is consistent with what is expected from any mechanism that calls itself an auction; consistent, that is, with what is implied, but cannot be delivered, by Priceline, Optimark and SuperMontage. A true auction, as discussed below, is one in which you not only name your own price, but – if competition produces a better one – you get the better price paid by all. Such competition is an expected feature of an auction, as is a single-price result. Because consumers reasonably assume that the act of bidding brings all these features into play, they understandably feel scammed when – without warning – the competition and single-price features are left out.
Before looking at specific situations, let’s first acknowledge that there is today no common or popularly accepted definition of what an auction is. The standard dictionary definition is at best only a distant and loosely suggestive relative of the systems that today claim auction status. Consequently, the use of "auction" to describe them invites so much play with the concept that, in the end, the term elicits only vague notions of a mechanism that somehow involves other vague but positive-sounding concepts. Among these are: public openness, officially licensed and regulated status, vigorous and unhindered competition, efficiency and fairness. But, while use of the term implies the presence of at least some of these benefits, the lack of definitional certainty means that today’s "auctions" may leave some or all of them out. So egregious can these omissions be, that often even the core auction concept of the sale going "to the highest bidder" is more honored in the breach than the observance. Nonetheless, it is clear that auctions have a positive image, and that any confusion over what is meant by the term usually works in their favor, as it allows both speakers and listeners to assume the best if in doubt. While each individual may have a specific meaning in mind when someone utters the word "auction," it is almost impossible to pin down that meaning, and – for that reason – almost impossible to discredit a sham auction.
Let’s also acknowledge that some newer auction structures are mind-numbingly complex. This, too, works in favor of their image in the public eye. If the people who hear an auction pitch can’t figure out precisely how it works, but assume that the experts who designed it have, they can easily maintain their positive expectations of it. All of us are used to giving the benefit of the doubt to experts who design the many high-tech miracles we use daily. So we should not be surprised when the complexity that prevents personal comprehension of an auction process may actually move us to be very positive, even messianic, about it.
Now let’s move away from auctions for a moment to see why certain features of some common merchandising methods are attractive or not. We will then apply what we learn to make some educated guesses at what people really mean when they use the term "auction."
Rational Ignorance
Economists sometimes refer to giving-the-benefit-of-the-doubt-to-experts as "rational ignorance." In spite of its negative sound, rational ignorance is a very useful tool. It allows us to maneuver successfully through life without being expert at everything, so that we may focus on what we do best. But for rational ignorance to work effectively, we must be able to trust the experts not to take advantage of us. Every honestly represented commercial structure meets this test, whether it is safe enough to use in rational ignorance of its details, or whether it clearly requires us to be wary. Examples of the latter are buying a car from a traditional car dealer or an antique from an antique dealer, both of which are understood to require consumers to be knowledgeable and willing to negotiate. While such requirements make many of us uncomfortable, we are generally aware of the need to be wary, and so will have our rational ignorance mechanism turned off.
In contrast, one example of a structure in which we can let our rational ignorance operate safely is buying a car under the new one-price selling method (i.e., "haggle free" dealing, which was introduced in this country in the mid-‘Nineties by Saturn’s "no-dicker sticker"). As long as we know that bargaining – by us or anyone else – will not result in a changed deal, we are relieved of the need to engage in it. We can then focus on comparing the haggle free car to those available from other companies, whether or not offered through haggle free selling methods. We know that it is safe to allow rational ignorance to operate because, at least in the haggle free showroom, the salesman is not our adversary. The key feature that makes this situation safe is that the same cars are sold to everyone at the same price. Of course another, and better-known, example of this concept is buying merchandise marked with non-negotiable price tags.
These methods of one-price dealing do not visibly display the competition that makes them fair in the showroom or store, itself. However, the very act of giving everyone the same price correctly implies the existence of effective competition between the products’ provider and the providers of alternative products the consumer could buy. In effect, the vendor’s reputation as an honest competitor is implied – and is on the line – when setting the price that all consumers can scrutinize and evaluate en masse. And to restate for emphasis what is probably its most attractive feature from the consumer’s perspective, one-price selling relieves the buyer of much or all of the need to engage in purchase strategies, such as soliciting competing offers, bargaining for discounts, or asking other shoppers if they got discounts. Relieved of the need to bargain, the consumer can safely allow rational ignorance to operate.
Now let’s look at some key differences between how one-price and multiple-price (negotiated) selling methods affect consumers, middlemen and producers, respectively. Understanding these differences can help us gain perspective on what might be called the political dimension of how industries choose one method over another. First, consumers: many, perhaps most of us, consider bargaining an unwanted and often intimidating chore, and are generally willing, therefore, to pay a higher price for an item if it is sold at a single price that everyone pays. Middlemen, in contrast, are the customary beneficiaries of haggling, because they become expert at distinguishing the naïve and/or bargaining-challenged consumers from the ones that need discounts to open their wallets. Consequently, middlemen are generally opposed to one-price selling methods, because their intermediation role diminishes or disappears under such methods.
Finally, producers, although often dependent on middlemen for sales, may prefer one-price selling methods for two major reasons: 1) the middleman’s slice of sales revenues is cut out, and 2) sales revenues themselves are higher, because the customer will pay a higher price if he doesn’t have to haggle. Although producers might, in theory, gain some "consumer surplus" if they could sell to different people at different prices, such discrimination opportunities generally go to middlemen who become expert at mining them. Producers sell to everyone, rather than to only the few reached by any one dealer in their products. As a result, they usually cannot afford the reputational problems they encounter when trying to discriminate. Thus, because they benefit from higher single-price selling revenues, and because any potential discrimination benefits are usually available only to middlemen anyway, producers often find common cause with consumers in support of switching to single-price methods when circumstances or new technologies, such as the Internet, will allow it.
To effect such changes, producers must first wean themselves off of their need for dealers as distributors. Second, and always far more difficult, official Government protection of the dealer’s role must be removed. Such protection is pervasive in many industries, including car sales and stock trading. Although invariably characterized by middlemen and regulators as consumer protection, Government oversight of sales processes invariably turns into protection from competition for middlemen. Such protection is maintained by a combination of the raw political power of dealer associations, and the inherent inertia of long-standing regulatory processes. The argument in support of such arrangements generally boils down to the following sophistry: dealers sometimes rip off customers. Therefore, strong oversight of the dealing process is necessary. To maintain strong oversight, all other sales processes are declared illegal, especially those that don’t use dealers.
Such "logic" has so far blocked the wide adoption of Internet car sales at single prices, since only producers have the economic incentive to offer haggle free buying. It has also blocked the adoption by Nasdaq of a single-price open. Politically active dealers in support of their positions characterize both industries. Car dealers often demand and get political support for their position that only dealers can be relied upon to honestly sell and service a car to the consumer’s satisfaction. This is clearly absurd. While many dealers have no doubt made progress in reversing their industry’s poor reputation among consumers, it is ridiculous to say that manufacturers could not sell an honest product without the help of dealers. The case of the Nasdaq open is particularly demonstrative of the regulatory inertia problem. Not only has SEC Chairman Arthur Levitt repeatedly recommended a single-price open over the past two years, but so have several prominent and progressive dealers. Nevertheless, Nasdaq itself has so far ignored these recommendations, after conducting a "study" which purportedly demonstrated that a single-price open was both difficult to implement and unnecessary. Instead, they claimed, SuperMontage will address all perceived problems with their market, including the raucous opening, in which a handful of "wholesale" dealers have all the information about the all-important overnight orders to be executed at the open.
Coming back to our rational ignorance concept, the key difference between a commercial structure in which we can safely allow it to operate and one where we can’t is that, in the former, there is little or no price discrimination while, in the latter, multiple prices are the norm. In spite of the advantages mentioned above for one-price selling, neither structure is necessarily good or bad; there are plenty of examples of each, and each has many consumers that prefer it to the other. Surveys show that nearly two thirds of Americans dislike the dominant dealer-negotiated method for buying cars, which implies that there are also many buyers – more than one third of them – who are quite happy with haggling. Apparently, they consider themselves better than average bargainers who will get better than average deals. Not only is there a constituency for each method, but there is abundant evidence that consumers can safely make the choice on their own, even in the new and often confusing world of e-commerce. |
