Radiohead Did What Economists Didn't Think Was Possible

In my first microeconomics lecture of the spring term a student asked for an example of what first degree price discrimination is. Maybe you don't know what that is (I'll get that to that in a minute) but don't worry: neither did my professor. He said that first degree price discrimination is more of a theoretical concept.

But Thom Yorke might beg to differ.

Price discrimination is the idea that companies charge different customers different prices. There are three types. Microeconomic theory usually teaches that only two of them occur in the real world.        

So-called second degree price discrimination is basically about buying in bulk. The more you buy, the cheaper the company will see each good. Think of it as the Costco model: If you’re willing to carry home 44 rolls of toilet paper at once, the seller will let you do it at a lower price than 4 trips with 11 rolls.

Third degree price discrimination is charging different groups of customers different prices, like clubs giving free cover to ladies on a busy night. It’s also the reason Uber got so much bad press during December’s east coast snowstorm: surge pricing. They knew lots of people wanted to catch a ride, so Uber charged more than at other times.

First-degree price discrimination is the crown jewel of price discrimination. Second- and third-degree price discrimination only even exist as ways to get close to first-degree price discrimination without being able to read customers’ minds. In first-degree price discrimination, companies charge exactly what each customer is willing to pay. The problems in putting that into practice are (nearly) insurmountable. For one thing, it’s not feasible to change the price tag each time a new customer looks at the shelf. Even more daunting, though, is that companies have no idea how much each customer values their product.

To think about why this is so important, think about buying tickets to see a movie in the theaters. For fun, say the movie is Anchorman 2 and the tickets are $10. Who would pay that price? Certainly some of the people in the theater would have paid $15 to see the movie and some others wouldn’t have paid anything more than $10. But the movie theater doesn’t know that! All they know is that these people will pay $10. They may test different prices and analyze what single price gives them the most profit, but they still don’t know the highest price each customer would have paid (economists call this the reserve price).

If companies knew each person’s reserve price, they could make more money. In the movie theater’s case, it is essentially giving away $5 to the guy who would pay $15 for the show. More seats would be filled and the movie theater would be making as much money as it could from each customer.

That’s why my professor said first-degree price discrimination is just a theoretical concept: Companies can’t know the reserve price of each customer.

Radiohead's Pay What You Want as 1st Degree Price Discrimination

This is where Thom Yorke comes in. In 2007 his band, Radiohead did something that was considered revolutionary. The price of their new album In Rainbows was whatever the customer wanted it to be, whether that was $0 or $500. The pay-what-you-want model has been adopted by other artists and companies since then, notably the Panera Bread store in Clayton, MO.

By giving the customer the choice of what they will pay, Radiohead started using first-degree price discrimination. Each customer had a different price, which was revealed when they purchased the album (economists call this revealed preferences). With the help of the internet, Radiohead got around the limits that kept Costco and Uber from using first-degree price discrimination.

The big question was why everybody wouldn’t take the album without paying anything. After all, they would get all the benefits with none of the costs. In the cold, hard, mathematical world of economics they would. But there is something to be said for the sense of trust and respect that flows between the artist and the fans. Without it, fans wouldn’t feel bad downloading the album without paying anything. But because there is a relationship there, however abstract, it feels much less justifiable to not pay at all. It breaks some sort of social norm of morality because it feels like you’re taking advantage of a person (the members of Radiohead) instead of a big, faceless company. If Wal-Mart had tried a pay-what-you-want model on, say, paper towels, I doubt the same result would occur.

When all was said and done, Radiohead took home quite a bit of money. Sure, some people took the album for free but the average customer paid $6 for the download. When considering that Radiohead went around the traditional record company structure, they probably ended up making more money per download than they would have otherwise. Still, the average price was lower.

But I’m not sure if it really matters what the average price was, at least without considering how many people purchased the album. Part of the idea behind price discrimination is that each customer pays his or her reserve price. The consumers who bought the album for less than what it would have been sold for on iTunes (probably $10) wouldn’t have purchased it otherwise. Radiohead greatly increased the number of people willing to buy their album. Since allowing one more digital download costs nothing to Radiohead, any price above $0 makes a profit. 

What Radiohead did was realize that their product was a great candidate for first-price discrimination, and it worked. They did something that most economists didn’t think was possible in the ‘classical’ economics world but, based on what we’re learning about behavioral economics, is totally possible. It's also at the heart of why I think it's a travesty that economics seems to ignore the indie and alternative world. There are some truly innovative models being tried out, and some of them end up working.

So when you are trying to remember the types of price discrimination (which I’m sure you will be soon), just remember that there are three types: Radiohead, Costco, and Uber.