The Microeconomic Foundations

Orbitz, an online hotel search engine, has been criticised in this article for altering search results dependent on the computing equipment utilised by its consumers. Its pricing policies therefore can be evaluated in terms of the microeconomic foundations for such actions and so too can the sustainability of the policies as the firm moves forward. In this essay I shall attempt to define the model which I believe most closely matches that of Orbitz whilst bearing in mind that as it is a model it may not perfectly match the market in which Orbitz operates. Once this has been achieved I shall then identify and discuss the abilities of firms to sustain such pricing practices and whether or not these are sustainable in future. It is my believe that the nature of online markets mean they do not lend themselves kindly to standard economic models and as the online market grows, common practices that can be found on the high-street will become less and less common as competition grows and old issues of imperfect information become less of a problem for consumers.

The model which I believe most closely matches the scheme Orbitz use in the article is one of 'third-degree price discrimination in a monopoly environment'. A monopoly exists where there is one dominant firm in an industry which can set prices and makes supernormal profits above and beyond what would be produced were the firm existing in a perfectly/imperfectly competitive environment. (Begg, 2003: 110) Whilst Orbitz isn't itself a monopolist given the existence of many forms of online holiday/hotel room search engine, it acts as a monopolist in terms of the individual searches carried out by consumers. It is because of its ability to act like a monopolist that price discrimination is able to take place as price discrimination is not possible if there are other firms in the arena to compete with. Price discrimination in its simplest form exists where a firm identifies two markets within its customer base with differing Price Elasticities of Demand (PED) which identifies a consumers willingness to pay for x quantities of goods at price y. (Smith, 2009: 52-55) In this case, third degree price discrimination is at play because the firm utilises the information it gleans from "Predictive Analytics" (Mattioli,D. 2012) in its search results, and what it has identified as being differing willingness's to pay, depending on whether its customers are searching its site from Apple products or from a conventional PC. (Frank, 2010: 391-392) First and second degree price discrimination are not factors in the case put forward by the article but that is not to say that these are not used in online markets, in fact it is the opposite. First degree price discrimination requires a monopolist to understand and fully know what a consumer's maximum and minimum willingness to pay is and actively change prices in order to fully absorb the consumer surplus of the customer; The consumer surplus being the term used to define what a consumer was willing to pay above and beyond the price paid in the markets. (Begg, 2003: 249) By pricing in this way the monopolist producer will produce more of a good than it would if price discrimination wasn't used and in so doing removes all deadweight loss to society in the process. Second degree price discrimination is more prevalent in its relative ease to implement where discounts are offered based on the quantity of a good that is demanded. This is commonly seen on retailer websites where prices are reduced with 'bulk purchase'. This occurs mainly where the seller cannot accurately differentiate between its consumer groups themselves and therefore instead, consumers reveal their own grouping with their purchases known as self-selection. By pricing in this way, firms again attempt to recoup as much consumer surplus and producer surplus as possible. There is a final form of price discrimination; fourth degree price discrimination, whereby a good costs the same whichever customer purchases it, however there are options available to the consumer free of charge which may increase costs i.e. a vegetarian meal on a flight. These costs are not met by the consumer and instead are met by the producer, hence the term, reverse discrimination.

In the case of Orbitz we should now understand why it would wish to price discriminate in this way. As a profit maximising firm, Orbitz must exploit all the information it has available in order to effectively maximise profits as it sets out to. By reducing the consumer surplus the firm will increase its revenues and therefore its profits. This is particularly true of online retailers where the application of this form of analytics has a relatively small marginal cost and the benefits, therefore, can significantly outweigh the initial costs. (Begg, 2003: 209)

Graph 1: Demand and Marginal Revenue curves of the market and submarkets with price determinations

Having understood these two 'submarkets' to have differing PED's, inelastic and elastic, Orbitz continues to produce at its profit maximising point MC=MRt (Begg, 2003: 77-80). The inelastic group, shown in graph 1, is then charged a price, Pa, which produces a large supernormal profit whilst the elastic submarket is charged a price, Pb, awarding the seller with a smaller but still supernormal profit. In both cases the consumer surplus has been reduced causing the firm to receive greater profits from its customers. When combing the profit orchestrated by both the inelastic submarket and the elastic submarket we find that profits have in fact increased the supernormal profits which would have been derived from pricing at the whole market equilibrium and therefore exceeding what is show in the industry graph. Of course, the model of price discrimination does not totally match to our study of Orbitz as it is not the price that is changing but the results provided by searches from different computing equipment, however, the aim and way in which profit maximisation is achieved are closely comparative.

It is also important to analyse why this form of price discrimination is possible despite Orbitz not being a true monopolist. Here the model does not effectively take into account the market as a whole, whereby many firms exist offering a similar 'search' service and would therefore not qualify as a monopoly by the very fact that there is more than one large firm in the market and the 'goods' i.e. the search results are available elsewhere. (Smith, 2009: 36) Instead in order to understand the micro-economic principles we must narrow our definition of monopoly to focus solely on the individual searches of consumers. In this way Orbitz now 'controls' the products available to the consumer and can manipulate the result order so