Surge Pricing and the Ethics of Real-Time Markets

Is it fair to charge some consumers more than others?  This is a growing debate behind surge pricing, dynamic pricing, and real-time markets where prices adjust rapidly.  With modern technology, sellers no longer have to worry as much about menu costs.  Historically, one reason that prices and wages were not significantly flexible, despite being declared by classical economic theory, was the effort it took to manually adjust prices.  Menus and signs at restaurants had to physically be reprinted, making owners change prices infrequently.  

Today, most businesses use electronic signs or easily-printed stickers to label prices.  They can change these on a near-constant basis without paying significant costs.  Online prices, including on apps, can be changed for virtually zero cost.  They can even be programmed to change automatically based on various factors, such as time of day, number of orders incoming, or changes in economic indicators.

How Surge Pricing Works

In normal free market trade, price is set by flexible supply and demand.  Price rises or falls until it reaches a market-clearing amount, which is the price at which quantity demanded equals quantity supplied.  It is often assumed that, in the real world, prices change more gradually than the Demand curve shifts.  After all, sudden changes in society can cause sudden changes in the Determinants of Demand, especially consumer tastes and preferences and expectation of future prices.  We imagine that prices rise months, weeks, or days after widespread changes in Demand.

But, what if modern technology made prices more flexible and responsive to changes in demand?  Surge pricing occurs when firms are able to adjust prices in the short term, usually by the day or hour, to account for rapid changes in consumer demand.  This is effective when prices are shown electronically and can be changed instantly, at virtually zero cost to the firm.  A second requirement is that the firm is able to predictably and accurately gauge changes in demand on a real-time basis.  

Why Firms Pursue Surge Pricing

All consumers can purchase at this market-clearing price, which is also known as the equilibrium price.  However, many individual consumers are willing to pay more than the equilibrium price.  They are represented by the section of the Demand curve that is above this price.  These consumers enjoy consumer surplus, which is the difference between what they are asked to pay and what they are willing to pay.  If firms can engage in price discrimination to charge higher-demand consumers higher prices, they can make more revenue.

While it is difficult for firms to engage in true price discrimination and market segregation, a close substitute is adjusting prices to capture beneficial changes in demand.  There are known times and circumstances where consumer demand increases significantly.  For example, people grow hungrier around mealtimes, increasing their demand for restaurants and fast food.  People have an increased demand to travel around holidays, such as to see family.  During warm months, there is greater demand to spend time at beaches and lakes.  While seasonal changes are easy for most firms to adjust prices regarding, what about more rapid changes?  For example, what if a three-day cold front in autumn or winter raises consumer demand for warm, hearty food and hot chocolate?  

A firm that can raise its prices on warm, hearty food and hot chocolate during a brief cold snap can make more revenue, as consumers are likely to continue to purchase these things despite an increase in prices.  Even within a single day, such as during the dinner rush, firms can make more revenue by raising prices during periods of elevated demand.  If firms can raise prices quickly and keep most of their customers, meaning demand that is relatively price inelastic, they will try to do so.

Ethics of Surge Pricing

Not surprisingly, many consumers consider surge pricing to be undesirable because they have to pay more money.  Others defend the practice, at least if it involves lowering prices during periods of low demand to take advantage of low marginal cost and help cover fixed costs.  Dynamic pricing, a term with fewer negative connotations, allows some consumers to get financial deals by offering surplus goods or services for sale at low prices.  A common example of this involves travel: empty airplane seats and hotel rooms still cost firms money, so they will offer steep discounts to attract last-minute customers.

Benefits of Surge Pricing

Surge pricing is simply a reflection of supply and demand, and allows for a clearing of the market without causing a [lasting] shortage.  If prices did not rise quickly during spikes in demand, the first few customers might purchase all the available stock and deprive everyone else.  By raising prices and preventing hoarding during times of peak demand, more consumers have the ability to access the product.  It also reserves the product for consumers who will receive more utility (the economic term for satisfaction) from it, increasing the level of utility across society.

Knowing that prices will surge can also benefit society if it encourages consumers to spread out their activities and avoid creating shortages or bottlenecks.  For example, some consumers have the ability to adjust their daily schedules to not be hit with surge prices.  This would mean fewer consumers in stores, restaurants, and on the roads during rush hour, reducing congestion for the rest of us.  It would also encourage wiser consumer spending, perhaps reducing debt levels in the long term.

Harms of Surge Pricing

Many consider surge pricing unethical because many consumers lack the ability to avoid the surges.  Wealthier people are more likely to have flexible jobs and access to transportation and other resources that allow them to take advantage of non-peak price opportunities.  For example, low- and middle-income workers may have little ability to adjust their schedules, routes to work, and times for vacations.  High-income workers, retirees, and owners of capital may be able to pick and choose different options in life that allow them to enjoy lower-than-average prices, such as vacationing during the fall and spring rather than the summer.

Aside from dynamic pricing creating disadvantages for lower-income individuals, there is also the risk of stagnating productivity across society.  If firms can make substantially more revenue simply by engaging in surge pricing, rather than having to create better products, the incentive to invest in new capital and productivity enhancements is reduced.  In the long run, firms may focus on tailoring their surge pricing to increase revenue rather than investing in research and development.  This would result in reduced economic and technological growth.

Competing Technologies: Surge Pricing Versus Increased Access to Substitutes

Both firms and consumers can take advantage of new artificial intelligence (AI) technology to improve their ability to manage changes in demand.  Firms can use AI to improve the effectiveness of surge pricing, while consumers can use AI to find more substitutes to avoid surge pricing.  This could create a sort of technological arms race between buyers and sellers, with each trying to use perfect information - granted by AI - to maximize their own benefits.  In theory, both buyers and sellers having perfect information would increase economic efficiency by allowing everyone to only engage in transactions that were beneficial.