CONVOY (Part 2)
Feb 20, 2001
Consider the violent reaction to Amazon.com’s "dynamic pricing" experiment with its DVD customers. The flap began when some of them noticed that, by turning cookies off, or coming in through another computer or a new account, they got better discounts. They also discovered that they could get any difference between the best price and what they had paid refunded to them – if they would only complain to Amazon. In response to the furor, the company reversed course by announcing a policy of automatically refunding any dynamic pricing difference in the future, even if the customer doesn’t complain. No wonder. Some complained strenuously not only about the prices, but also about the practice of price discrimination itself, and the fact that they were not told by the company about it.
The episode highlights the importance of knowing your niche and, perhaps, the utility to that end of listening to your customers before your professional "business method" consultants. These DVD fans were way ahead of those economists touting the potential to capture consumer surplus through hidden price discrimination on the anonymous Internet. And, although Amazon stumbled in pushing this particular envelope, the company demonstrated an ability to make quick changes in response to evident consumer preferences.
Among the things they learned:
1) Their customers trust them well enough to pay a premium price for the service they expect.
2) They do not want to see others getting better prices by strategizing their purchases (turning cookies off, clearing caches, checking out the prices others are getting, asking Amazon for a better discount, etc.).
3) They don’t want to have to strategize their own purchases.
4) The trust of their customers depends on Amazon not surreptitiously engaging in price discrimination. While Amazon never said it wouldn’t discriminate, the clear sense of its DVD customers was that there was an implicit understanding not to.
Big Brother to the Rescue
As one of Amazon’s DVD customers quoted in note three implies, a major feature of the landscape upon which price discrimination does or does not occur is antitrust law. Although Amazon’s customers clearly needed no Government help making their choice, the Robinson-Patman Act is often invoked (if seldom by name) to contest perceived or real discrimination. This is not at all irrational: the very existence of any Government interest in price discrimination implies that you may have a cause of action if you have been discriminated against. And the more imprecise and obscure the law, and this one is both, the more likely you are to imagine you might have a case. In fact, you generally don’t, because most antitrust actions regarding price discrimination are at the wholesale level, and applied in service of such esoteric goals that often the only thing consumers notice is that regulators are preventing them from getting discounts. Naturally, they are confused – and they aren’t the only ones. Experts often disagree strenuously over whether price discrimination is an appropriate target of antitrust, and, if so, to what end or ends the various overlapping and conflicting statutes should be applied.
Unlike the consumer protection regulations discussed earlier, which only accidentally affect price discrimination, antitrust deliberately involves itself in the issue, with even more disastrous results. This is not a case of intervention causing more harm than good. Here, the harm is immense, and there are no benefits whatsoever (unless one counts the greater employment of bureaucrats as a benefit). The very fact of Government involvement implies many things, among them that intervention is needed, that consumers can’t effectively make the right decisions on their own, that there is always something wrong, even sleazy, about price discrimination, and that Government is on the case and can stop and punish discriminators. None of these implications is correct. But the detailed involvement is distorting the formation of commercial structures on a grand scale across the economy, because whether or not to accept price discrimination is perhaps the most fundamental choice that consumers need to be free to make if those structures are to evolve to their liking.
The paternalistic approach not only denies consumers those crucial choices, but probably over time destroys their ability to make them. This, of course, makes them even more dependent on Government to choose for them, however misguided and confused the bureaucrats may be. To the average consumer, his Government’s involvement in the price discrimination issue looks something like this: first you think antitrust’s price discrimination law is there to defend you from discrimination, but then you learn it’s not. Then you find that the discriminators they do go after were actually giving you discounts. And finally you find that the main effect of antitrust’s most important effort, to bust monopolies under the Sherman Act, is anticonsumer with respect to price discrimination in two important ways: while one hand prevents discrimination that benefits you, the other causes discrimination that harms you.
Trustbusters actually block or retard pricing standards you may want, such as Saturn’s no-dicker sticker. And they promote discrimination that endlessly confuses and frustrates you by fragmenting every industry into so many competitors and, thereby, so many permutations and combinations of products and vendors, that you can’t possibly compare prices effectively, much less collectively decide on the right price for a standard product.
Having retarded the natural formation of standard single-price processes, regulators then set about designing and providing their own versions of the standards they have blocked. That’s when things really get ugly.
Best Execution
An example of this pattern is found in today’s stock market. Having busted the exchanges for fixed commissions, fixed increments and fixed spreads, regulators have now set about making sure all investors always get "best execution." The result is that investors have been forcibly moved from a situation where they paid relatively known, common and explicit costs for execution (a beneficial side effect of fixing their key components), to one in which the target is moving too fast to trust. They were thereby moved from an environment in which they were able to allow rational ignorance to operate safely, to one in which they must monitor the markets second-by-second to see if someone else gets a better deal. As University of Memphis Professor Robert Wood put it to the Wall Street Journal in an article about his preliminary study of the effects of decimalization:
We’re undergoing a sea change in the way that trading is going to be conducted. There are opportunities and perils. Those traders who are fast on their feet are going to have some opportunities, and those who are not are going to be financing those opportunities.
Decimalization is only the latest initiative in a three-decade long effort to create a "National Market System" (NMS), all of them in service of the goal of providing everyone with best execution. Every one of these initiatives has had the effect of increasing the number of possible trade prices and, thus, the risk and burden of price discrimination. The result is that your "best execution" today often looks bad within seconds compared to someone else’s "best execution." How could the single term "best execution" apply to so many different prices at or nearly at the same time? Good question. But don’t imagine that regulators are asking – much less answering – it. They have adopted a policy of leaving the concept of best execution undefined and vague.
Now let’s have another look at what is meant by the term "auction." Specifically, what are those academics and regulators talking about when they call the evolving NMS an "electronic order-driven auction"? Is each fleeting price the result of a separate auction? Or is the whole grab-bag of prices an auction? Obviously, you can’t have a sale to the highest bidder when there are multiple sales to multiple bidders at different prices only "sub-seconds" apart. So where did the idea come from that these continuous "flicker markets," as they are sometimes called, are auctions?
The most common use of the term "auction" in modern times is no doubt the ubiquitous reference to The New York Stock Exchange as a "continuous agency auction." Sometimes the words "continuous" or "agency" are left out, but one never hears the NYSE’s trading process spoken of as anything other than an auction. But is it? The usual purpose of the reference is to distinguish the Big Board’s structure from Nasdaq’s "dealer market." And it is certainly true that the NYSE’s specialists have traditionally enabled many more customer-to-customer transactions than Nasdaq’s dealers did. But why does the fact that the Exchange’s process is not a dealer market automatically mean that it is an auction? Why do we assume that an agency matching service, however fair and cost-effective it may be, is an auction?
As for the dealer market, Nasdaq never really had a shot at calling itself an auction, if only because of NYSE’s success at defining non-Nasdaqness as, per se, an auction. But if one ignores that argument, it is not at all clear that Nasdaq’s continuous trading is any less auction-like than the Big Board’s. In the first place, the "customer" on the other side of your Big Board trade is often as professional as the specialist or a Nasdaq dealer, so the presumed lack of intermediation is often bogus. Thus, even by its own chief criterion, the Big Board is really just another dealer market with a spread to pay. But that does not mean that either of them – the NYSE or Nasdaq – are bad markets. In terms of their abilities to charge customers a reasonable and standard price for liquidity such that they can deal on those markets safely in rational ignorance of their operating details, both markets have historically been quite effective – or were until the reforms kicked in.
Prior to Christie-Schultz, the 1994 study that ignited an antitrust investigation, the price of a Nasdaq stock would bounce regularly between the bid and offer of an easily visible spread of a quarter point, or twenty-five cents. While some thought that egregiously wide, and instigated antitrust proceedings to block the "tacit collusion" that produced it, the fact was that Nasdaq customers were more likely to get the same price in the old days than they are today. Not that buyers got the same price as sellers; that seldom happens on any continuous market. But buyers got the same price as other buyers trading at around the same time, and so did sellers relative to each other. Like no-dicker stickers or price tags, the comparatively stable and visible spreads allowed customers to trade comfortably without strategizing, to let the process handle their trades, because they couldn’t do any better with any strategizing techniques that were reasonably available to them.
Now, post the "order handling" reforms of 1997, and halfway into the radical increase in the number of possible prices known as decimalization, customers are getting very wary. Strictly in terms of whether they can allow rational ignorance to operate safely, they were better off before. Now the tape spews out so many different prices within seconds of their executions that they must worry that their counterparty made better strategic use of the available information, such as CNBC, Level II, etc. And, now that the Big Board has fully decimalized, another worry – that their limit orders are much more likely to be front-run by specialists or other insiders – has emerged. Thus, even though spreads and apparent average costs have shrunk, the burden is now on the investor, just as it was for a while on the Amazon DVD customer, to be on his toes, to strategize. While the average per share trading cost in the old days may have been a quarter, give or take a nickel, the average cost today might be a dime, give or take a dollar. And the hypothetical fifteen-cent improvement for the average investor could be cold comfort if the average investor disappears. That could happen, if professional traders wake up to the opportunity, as they are certain to do. Once that fully happens, average investors will be hard-pressed to prevent the most expensive outcomes possible (i.e., a dollar in our hypothetical), unless they take the time to become professionals themselves. So much for rational ignorance and being able to trust yourself to a safe process.
Whatever the effect of the reforms on investors, this is not what they think of when they hear the term "auction." The greater number of prices and prints around any potential execution time would probably lead most investors to say that both the Big Board and Nasdaq felt more auction-like in the old days than they do today. And when Nasdaq joins the Big Board in full decimalization in April, the potential for price discrimination will explode again there, too, and with it the implied burden to micromanage your execution strategies, to protect yourself against professional front-running, etc. Furthermore, it must be remembered that reforms are forcing all these markets to become more automated and anonymous, which separates the investor from any previous comfort he may have gotten from the branded execution quality of his broker-dealer. With all executions commoditized by best execution, customers are facing the fact that, "democratized" as they may be, every trade is now suspect. And it is hardly reassuring that one of the fastest growing brokers in the fastest growing category (semi-professionals, once called day-traders) invites its customers to avail themselves of its lightening-quick execution capabilities, as if they were Bruce Lee at a keyboard. What are the rest of us supposed to do?
The dissatisfied customers of Priceline, after learning that the hidden potential for price discrimination was much greater than they expected, even in a "reverse auction," bid less aggressively, bailed or sued. Optimark never really got off the ground, arguably because word spread as it was trying to get going that the thing had a fearsome winner’s curse built into its multi-price "auction" algorithm. Either system may make a comeback, since the markets within which they operate are so fraught with either natural or regulator-induced price discrimination that, if honestly presented, the systems could fit right in. Honest presentation probably means dropping the word "auction," or at least explaining to their customers how far from what they normally expect of auctions their results could be.
A larger question than the prospects for those private systems is how consumers of air travel and stock trading services will feel about the pricing of products generally in those industries going forward. Although both have been subject to "deregulation" for some time, one effect of which has been to dismantle or prevent efforts to standardize pricing, I suspect that air travel has a head start. If it does, the example is ominous. That industry is in a constant state of crisis, characterized by poor profits, deteriorating service and the "rage" of its customers. Although it is difficult to quantify the degree to which such rage is exacerbated by discriminatory pricing, it is hard to imagine that the sense of unfairness that inevitably accompanies discrimination helps. In any case, the rapid ratcheting up of price discrimination in the stock market as a result of decimals and such anonymous electronic systems as SuperMontage is potentially explosive.
Like the Priceline convoy, each of these reforms has been sold as the best thing since sliced bread; in the case of decimals, the benefits seemed so obvious that even Congress got on the bandwagon. The coming consumer letdown is likely to have far reaching and long lasting effects on their willingness to support capital formation through equity investing.
-S. Wunch |
