Congestion Pricing Works... Sometimes.

Wednesday, February 4, 2015

Businesses have discovered many useful techniques for keeping their profits high. One is as follows: When demand is high, raise prices. When demand falls, reduce prices. Amazing!

In many cases, the strategy I outlined is sufficient for firms to ensure large profits. As readers of my software pricing book are aware, profit maximization isn't always the goal of a pricing strategy. Sometimes organizations (especially governments and regulated monopolies) select pricing strategies to flatten out demand for their wares over time.

For instance, a government might want to keep a bridge free for commercial travel and thus want to dissuade some drivers from using it at times of peak usage through the use of congestion pricing. By charging premium prices during times of peak use, an organization is able to reduce usage at peak times to manageable levels.

Congestion pricing is relatively straightforward - charge more when demand is plentiful and charge less when demand is reduced. Though many wonder whether the harm it inflicts on poorer users is worth the societal benefit, few can deny that raising prices can affect consumer behavior.

At least, that's what most economic textbooks will lead you to believe. There's just one problem: congestion pricing only works in a world in which the congestion pricing is obvious to consumers. If customers can't make a mental association between the time an item is used and its relative cost, the price differential will fail to change customer behavior.

Let's take a simple example: the electric company. Almost everyone uses some quantity of electricity, but there are certain times of the day when more electricity is demanded than others. Unfortunately, as a specialist in software economics (and not energy economics), I have no idea what those peak usage times are. I also have no idea what the differential is between on-peak and off-peak rates. If some feedback mechanism existed to alert me when I use electricity at a peak time and make the increase in costs obvious to me, congestion pricing might influence my usage habits. As it stands, I simply use energy whenever I want, because it never occurs to me to do otherwise.

That's right! I'm telling you that economics works differently in the real world than it does in textbooks... Well, textbooks other than my book on the economics of software engineering. Fortunately you can contact me for a private pricing consultation, and I'll set you straight.