Pop quiz: What's the difference between an economics professor and the rest of us?

Answer: When an economics professor gets screwed out of $650 by an airline , his reaction is that "United is perfectly rational to want fewer children in its business class."

There's been a lot of work in economics over the past couple decades on pricing theory. Probably the place where most people have seen the results is in the impenetrable pricing schemes offered by the major airlines. A lot of this research is a classic example of missing the forest for the trees.

To begin, let me offer a few definitions. Since I am most emphatically not an economics professor, my definitions may differ from those used in the literature, but I think they'll work for the educated lay person:

Price: What you pay for something (or what the seller is asking to be paid).

Value: The theoretical maximum price you could pay for something, before you've paid too much. In other words, the total benefit you expect to receive from a purchase, expressed in dollars.

Worth: The maximum amount you're willing to pay for a purchase, before you think you've paid too much. In other words, the perceived value.

The game, for a seller, is to set the price so as to maximize the total revenue. The problem is that, for any product, the value and the worth of a product will be different for every potential customer. You also don't know, in advance, what all your potential customers are willing to pay.

There are several strategies for solving the pricing problem. Traditionally, in western countries, a seller will set a price, and buyers will either choose to buy or not. In some other cultures, there is a strong tradition of haggling, where every price is negotiated for every buyer (needless to say, this doesn't scale for places like Wal-Mart). For one-of-a-kind items, an auction will often yield close to the highest price possible.

The newest strategy is to set different prices for different buyers, based on some criteria for discriminating between those willing to pay more and those not willing to pay as much. The airlines call this "yield management," and it is the reason why pricing for plane tickets is so bizarre (my favorite example: one-stop tickets are often cheaper than nonstop, even on the same airline, despite the fact that it is actually more expensive for the airline to provide the one-stop seat).

For trying to squeeze every last dollop of revenue out of an operation, these price discrimination strategies work well in theory. In practice, they have serious flaws:

Price Discrimination Ignores the Difference Between Value and Worth
"Value" (as I defined it) is how much benefit you get out of something, and can be (at least in the fuzzy world of economic theory) well-defined.

"Worth," on the other hand, is a much less precise measure. It involves not just the likely benefit (a calculation which few people make in any rigorous sense), but the answer to a host of other questions as well. Among these questions are: How much did someone else pay? What is the asking price? How much do I think it cost the seller to provide the product or service? What is a fair profit for the seller? Am I being treated fairly? What are my alternatives? What is my general impression of the seller?

As a result, customers will be less willing to pay the asking price if they perceive that the price being offered is unfair; if they're being gouged; if the seller is making too much profit (not overall, mind you, but on that particular sale); or if they have a negative impression of the seller. Setting different prices for the same product or service is almost universally viewed as unfair, gouging the customer, inflating the sellers profits, and only done by companies we love to hate.

Interestingly, a lot of these psychological negatives can be avoided by packaging the different prices as "discounts" off a single base price. Why the airlines don't do this is a complete mystery to me....but even then, sellers can get themselves into a trap by training customers to always look for a discount. Retailers, for example, have trained customers to wait for a sale before buying. Jewelers are notorious for having inflated "regular" prices just so they can have "50% off" sales. Customers will eventually figure out these games, and in many places, there are now laws defining what constitutes a "sale," and what is a "regular price."

Price Discrimination Only Works If Competition is Limited
Inherent in the idea of charging different customers different prices is that the seller will only barely cover expenses with some sales, and make most of its profit on other sales.

In a competitive market, though, someone else will undercut the high profit sales and cherry-pick the most profitable customers. This leaves the seller with only the low-margin sales, and a pricing strategy which no longer works. As a result, price discrimination only works if there is some barrier to prevent another seller from entering the market with lower prices for those most profitable customers.

In retail, this barrier is often just the nuisance factor of having to go to a different store. You may be willing to pay $0.50 for a single bolt at Home Depot (what a rip-off!) just because you were already in the store to buy a discounted snowblower, and it isn't worth making a trip elsewhere to pay a fair price for the bolt.

In the airlines, the barrier is the difficulty and expense for another airline to compete directly against an established incumbent in a given market.

But guess what: price discrimination in the airlines is already breaking down. The new crop of discount airlines generally offer the same low fare for all tickets, even last-minute purchases. At my company, we're already pretty far down the road of abandoning Northwest for airlines like Sun Country and ATA. Since we, as last-minute business travelers, would be paying the most inflated fares on Northwest, this is significant cost savings for us, and a big loss for Northwest. Keep in mind that Minneapolis is about as close to being a "fortress hub" for Northwest as you can get.

As an aside, the link between being able to maintain price discrimination and the lack of competition is so strong that the presence of price discrimination can be a useful indicator of the existence of a monopoly or de-facto price collusion. When sellers compete on price, prices tend to reflect the seller's underlying costs (because prices drop as far as they can). When prices are fixed, or sellers don't compete on price, then prices no longer reflect the seller's cost, and pricing strategies which allow for large profit margins on individual sales can flourish.

Is Price Discrimination Good or Bad?
Some economists argue that price discrimination is a good thing, since it can make it profitable for sellers to offer goods and services which might not otherwise be profitable. This is certainly true.

In addition, some level of differential pricing is inevitable, and part of the normal functioning of the marketplace. The polar opposite of having different prices for every buyer is having the same fixed price for everyone, which is essentially a command economy (i.e. communism or socialism). That doesn't work, either.

The reality is that price discrimination is neither good nor bad, but customers tend to dislike it unless they perceive that paying a higher price is worth more. Subtle forms of price discrimination (occasional discounts, packaging together multiple goods and services, value-added services, etc.) help sellers understand what customers really want to pay for a product or service, and are part of the give-and-take of a dynamic economy. More blatant price discrimination (like what the major airlines practice) can only survive when barriers to competition are high, and will collapse of its own weight when competition returns to a market.