Online pricing algorithms game the system and could mean you pay more
If you’ve shopped online recently, you may have had this experience: you find an item, add it to your cart, and then when you’re about to pay, the price has gone up.
You can thank the pricing algorithms.
These are computer programs that examine factors such as supply, demand, and competitor prices, then adjust the price in real time. Now there are calls for greater regulation at a time when these tactics are expected to become more common.
“A key part of the algorithm is that given different inputs, like, for example, the time of day or the weather or the number of customers likely to show up, it can decide on a different price” , said Alexander MacKay, professor of economics at Harvard.
Theoretically, these algorithms could be good for concurrency. For example, if a company sets a price, the algorithm could automatically reduce it, which would result in a lower price for the consumer.
But it doesn’t quite work that way, MacKay said. In an article he co-authored in the National Bureau of Economic Research, he studied how algorithms compete with each other. He found that when multiple companies used pricing algorithms, both knew that dropping their price would cause their rival to drop in price, which could trigger an endless chain of price drops.
This, MacKay said, eliminates price competition.
“Why try to start a price war against a company whose algorithm will see my price change and immediately reduce it,” he said.
The impact of algorithms can be more than a few extra dollars at checkout. During the 2017 terrorist attack on London Bridge, Uber’s pricing algorithm detected the increase in demand and the price of a ride jumped in the area. Uber later manually stopped surge pricing and refunded users.
Price fluctuations due to algorithms have also been found to increase customers’ feelings of betrayal.
A study published in the Frontiers in Psychology found that price discrimination leads to a diminished sense of fairness and leads to “disastrous consequences both for the vulnerable party and for the performance of the business relationship as a whole”.
This is a point taken up by Professors Marco Bertini and Oded Koenigsberg in the harvard business review. They wrote that the pricing algorithms lack “the empathy needed to anticipate and understand the behavioral and psychological effects that price changes have on customers”, and that, “By focusing solely on price fluctuations ‘real-time supply and demand algorithm works against marketing teams’ goals for longer-term relationships and loyalty.’
MacKay said a few regulations could help avoid some of these consequences and move competition toward a more standard model. The first would be to prevent algorithms from taking competitors’ price into account, which he said was the key factor weakening price competition. The second was to reduce the frequency with which companies could update their prices, which he said would mitigate or prevent a company from undercutting a competitor’s price.
Yet ultimately, MacKay said, pricing algorithms will only become more mainstream.
“Companies try to maximize their profits and they try to do it in a legal and competitive way,” he said. “It’s kind of in your best interest to adopt an algorithm so you can constantly undermine your rivals to maintain a market share advantage.”