Price Discrimination by Negotiation: a Field Experiment in Retail Electricity

Economist Cindy Nah authored a paper alongside David Byrne and Leslie Martin for the Quarterly Journal of Economics discussing the topic of price discrimination in the electricity market. In this paper, the authors use a field experiment to study price discrimination in a market with price posting and negotiation, motivated by concerns that low-income consumers do poorly in markets with privately negotiated prices. The authors built a call center staffed with actors armed with bargaining scripts to reveal negotiated prices and their determinants which generates sequences of price offers that allow the authors to identify price discrimination in negotiations based on retailer perceptions of consumers’ search and switching costs.

Abstract

We use a field experiment to study price discrimination in a market with price posting and negotiation. Motivated by concerns that low-income consumers do poorly in markets with privately negotiated prices, we built a call center staffed with actors armed with bargaining scripts to reveal negotiated prices and their determinants. Our actors implement sequential bargaining games under incomplete information in the field. By experimentally manipulating how information is revealed, we generate sequences of price offers that allow us to identify price discrimination in negotiations based on retailer perceptions of consumers’ search and switching costs. We also document differences in price distributions between entrants and incumbents, reflecting differences in captivity of their respective consumer bases. Finally, we show that higher prices paid by lower-income subsidy recipients in our market is not due to discriminatory targeting; they can be explained by variation in consumer willingness and ability to search and bargain.

Introduction

In many markets, firms post one set of prices publicly and negotiate discounts with customers privately. Prominent examples include automobiles, mortgages, health care, retirement savings, private schooling, telecommunications, and energy. In such settings, oligopolistic firms leverage their market power to price discriminate through posted and negotiated prices, segmenting customers based on their willingness and ability to search and negotiate. For public policy, this naturally raises the question of who searches and bargains and whether high- or low-income customers ultimately pay higher prices. These questions become even more policy relevant when the public sector intervenes to subsidize low-income households.

Despite the prevalence and policy relevance of price posting and negotiation, there is relatively little research on such pricing structures. This lack of research is in part because oligopolistic models of price discrimination are generally challenging to solve (Stole 2007), but also because data on negotiated prices are difficult to access.

In this article, we demonstrate the power of field experiments to recover negotiated price data, reveal how firms use price posting and negotiation to price discriminate, identify channels through which discrimination-based price dispersion arises (namely, search and switching costs), and discuss potential distributional consequences of public price posting and private negotiations. Our approach is based on audit studies, which have been used extensively in studying labor market discrimination but have been overlooked for their potential applications to oligopolistic industries until now.¹

We ran our audit study in a deregulated retail electricity market. We created fictitious customers with randomly allocated combinations of characteristics, including stated and revealed willingness and ability to search, while holding other characteristics related to demand and cost of service fixed. We hired actors to represent these customers and provided them with scripts, effectively creating a call center to negotiate with firms’ call centers. These calls yielded multiple price quotes that vary with perceived customer characteristics across and within calls, as our customers gradually revealed individual characteristics, recording sequences of price offers as they revealed new information. We describe the industry context in Section II and the experimental design in Section III.

Embedding this field experiment with sequential bargaining in an oligopoly yields two key innovations. The first relates to measurement: we uncover post-and-negotiate pricing structures that are otherwise unobservable due to limited availability of negotiated price data. Section IV examines the pricing structures at the market level. Established oligopoly models of price discrimination provide little guidance as to the form such pricing structures should take because they abstract from search frictions and private negotiation (Stole 2007). The market that we study contains both large incumbent retailers, the utilities that existed before retail market deregulation 10 years before, and entrants. We find that incumbent retailers post high prices and are willing to negotiate modest discounts. Entrants, in contrast, post lower prices and are heterogeneous in negotiations, with some aggressively discounting posted rates. Negotiated discounts represent a 27% reduction in retailers’ profit margins for a typical customer in the market.

We complement these findings with institutional evidence emphasizing that incumbents and entrants serve different customer segments, with incumbents serving a larger share of “captive” customers who are less willing to search and bargain. In this context, our novel empirical finding of asymmetric post-and-negotiate price distributions among incumbents and entrants supports theoretical results from Armstrong and Vickers (2019). Their model of oligopolistic price discrimination predicts that firms endowed with an exogenous larger share of captive customers who are uninformed about rival prices will, in equilibrium, offer price distributions with higher prices than rival firms with fewer captive customers. The incumbent and entrant price distributions that we uncover align with these predictions.

Section V turns to the second key advance of our IO audit study: it enables us to examine how incomplete information shapes bargaining at the individual level. Although theoretical research on bargaining with incomplete information dates back at least 40 years, few empirical studies on the topic exist. The difficulty in measuring negotiated prices has limited empirical research. Furthermore, even when price data from negotiations are available, real-world bargaining tends to be unstructured, making it challenging to use bargaining models to interpret data. Further, incomplete-information bargaining models are notoriously complex, with many equilibria that depend on assumptions about how the beliefs of buyers or sellers evolve on and off of the equilibrium path (Ausubel, Cramton, and Deneckere 2002). Such complexity and multiplicity limit these models’ ability to generate testable predictions to bring to bargaining data, even in settings where bargaining is structured.

Our field experiment overcomes these challenges to examine how incomplete information over sources of customer captivity—search and switching costs—affects negotiations. In particular, through our experimental design, we impose structure on a real-world high-stakes bargaining process that enables us to develop testable implications regarding information revelation and bargaining outcomes using Sobel and Takahashi’s (1983) incomplete-information bargaining model. In their model, a seller makes sequential price offers to a buyer. The buyer is privately informed about the utility of accepting an offer and makes accept/reject decisions. The model’s sequential equilibrium predicts that a seller initially offers high prices and gradually reduces them in later bargaining rounds as they update their beliefs about the buyer’s private utility, given previous offers and the buyer’s decisions to reject them.

We tailor their model to our experiment and research context and assume prospective electricity customers enter negotiations with retailers with two sources of private information: a reference price from the market and a utility value from switching to a given retailer. Incorporating institutional features into our experimental design, we examine how retailers’ sequences of price offers vary as a function of customers’ (i) awareness of reference prices; and (ii) switching costs that affect their utility value from switching. Our model predicts price discrimination in negotiations whereby customers who are more informed about reference prices or have lower switching costs are offered lower prices in equilibrium. These predictions are borne out in our data, with reference price awareness and switching costs having economically meaningful effects on negotiated prices.

Our results add to emerging empirical research on bargaining with incomplete information. This research ranges from descriptive analyses of price sequences from back-and-forth bargaining (Backus et al. 2020), to reduced-form studies of final negotiated prices that exploit shocks to buyer informedness of rival offers to estimate causal effects on negotiated price outcomes (Grennan and Swanson 2020), to structural analyses that study how incomplete information affect negotiations and measure associated market inefficiencies (Sieg 2000; Keniston 2011; Silveira 2017; Ambrus, Chaney, and Salitskiy 2018; Allen, Clark, and Houde 2019; Larsen 2021; Larsen and Zhang 2021).⁵ Our audit study approach overcomes the data availability problem and, through experimental design, can align the data-generating process for negotiated prices with a theory of bargaining to study how incomplete information shapes bargaining outcomes and underlying mechanisms.

In the latter part of Section V, we further use our experiment to study mechanisms that lead low-income households to pay higher electricity prices and to incomplete pass-through. In our setting, the government subsidizes a fraction of bills faced by low-income customers, and there is public concern that retailers fail to pass through subsidies to low-income customers. Again, market power and search frictions potentially shape these outcomes. It can be profitable for firms to charge subsidy recipients higher prices when they have market power and subsidies are targeted (Akerlof 1978), leading to a fraction of the low-income subsidy going to the supplier and not benefiting the intended customer. However, subsidy recipients could be more costly to serve or less likely to search for many reasons (including the subsidy itself reducing the expected gains from search (Gulati, McAusland, and Sallee 2017)), leading them to pay higher prices.

To overcome this identification problem, in the negotiations we randomize revealed subsidy status, separately from randomized revealed intensity of search. Despite public concern over this issue, we find no evidence that retailers engage in targeted discrimination against subsidy recipients. This result, together with results from Byrne and Martin (2021) showing that low-income customers in the market are far less likely to search and negotiate, point to differences in the rate of search and bargaining over the income distribution as the underlying driver of regressive price dispersion observed in the market. Our findings add to burgeoning research documenting incomplete pass-through of targeted government subsidies across many contexts: tuition (Turner 2017), hybrid electric vehicles (Gulati, McAusland, and Sallee 2017), childcare (Rodgers 2018), private Medicare Advantage plans (Cabral, Geruso, and Mahoney 2018), housing (Collinson and Ganong 2018), and ethanol-based fuel (Lade and Bushnell 2019). We introduce audit studies to test targeted discrimination as a potential mechanism for incomplete subsidy pass-through.

Section VI summarizes and concludes the article. We discuss how the search cost income gradient creates a potentially undesirable regressive form of price dispersion in markets with price posting and negotiation. We explore implications of search and switching frictions for energy market design, contributing to ongoing policy debates worldwide over the costs and benefits of deregulating retail electricity markets.

Read the full article here.

This paper was originally published for the Quarterly Journal of Economics here. The views expressed are those of the authors only and do not necessarily represent the views of Compass Lexecon, its management, its subsidiaries, its affiliates, its employees, or clients.