Privacy, Exposure and Price Discrimination

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1 Privacy, Exposure and Price Discriination Luc Wathieu 1 Harvard usiness School, Soldiers Field, oston, M (eail) (Tel) Subitted for presentation at the first QME conference This paper explores the deand for privacy that arises fro the loss of consuer surplus when firs gain the ability to treat different consuers differently. It is shown that firs in quest of a copetitive advantage ay have an incentive to acquire consuer inforation and use it to gain exclusive access to finer consuer segents, even when the costs of custoized arketing are exceedingly high. When such is the case, the opportunity arises for an interediary to coarsen arket access in order to protect consuer surplus and to bar firs fro exercising price discriination. This interediary could be a ass retailer, a ass edia or a diverse counity. Forally, the paper analyzes the situation of an interediary who owns a finer arket access syste, i.e., the capability to separately access two types of consuers who previously reained undistinguishable. The syste could be ade available to one fir in exclusivity, or to several firs (two instances of exposure ), or to no fir at all ( privacy ). The best-bidding agent (fro aong firs, arginal-type consuers, and ainstrea-type consuers) is buying the right to coand the equilibriu access allocation. The solution involves either privacy (coanded by ainstrea consuers) or exclusive exposure (coanded by a fir), depending intuitively on factors such as consuer involveent, hoogeneity and adaptability, as well as the size of returns to scale in arketing and the extent of copetition. Keywords: Segentation, price discriination, privacy, exposure, interediary, involveent, hoogeneity, adaptability, returns to scale, copetition, arketing. JEL classification nubers: D0, D4, D6, D8, L1, L2, M2, M3 1 Thanks are due to seinar audiences at NYU, HS, Dartouth, Wharton, the Infors/Cornell Pricing Conference, and to David ell, Teck Ho, Rajiv Lal, and Marketing Science reviewers and associate editor. 1

2 1. INTRODUCTION Technological advances allow firs to collect increasing aounts of inforation about consuer behavior, both online and offline. ased on that inforation, firs can expect to achieve greater precision in segentation, and to create finely targeted value propositions. This evolution generates both positive and negative reactions on the consuer side. Consuers generally value targeted products and the convenience associated with ore efficient arketing techniques. However, constant onitoring inevitably raises privacy concerns that appear to be rooted in strong feelings and in deeply held principles such as the right to be left alone. s recently predicted in an article fro The Econoist (2003) appropriately titled No Hiding Place, there will be constant arguents about what trade-offs to ake between privacy on the one hand, and security, econoic efficiency and convenience on the other. This paper will focus on clarifying the relationship between privacy and econoic efficiency. For a sound debate on privacy to take place, a nuber of questions need to be addressed: eyond the eotions and the principles, what are the ore substantial causes of the privacy concern? Should this concern doinate the alleged econoic benefits associated with the diffusion of consuer inforation? Finally, can there be a arket solution to address the deand for privacy? The purpose of this paper is to provide a partial but consistent set of answers to each of these three questions. The proposed answer to the first question is relatively straightforward. When various types of consuers are hit with undifferentiated products and undifferentiated prices as is custoary under ass arketing, ost consuers perceive a significant rent or surplus, caused by the fact that firs need to lower their price in order to appeal to the arginal consuers. In contrast, finer consuer inforation and access creates opportunities for price discriination (targeted products and prices), which in turns jeopardizes consuer surplus for a fraction of consuers. This loss of consuer surplus is the proposed substantial cause of the deand for privacy (or arket coarsening). The second question is the ost critical: re there circustances under which the lost surplus is so significant a force that it could override the benefits that firs derive fro greater consuer discriination? If there were no such circustances, deands for privacy could arguably be viewed as uniportant resistance. In fact, firs are interested to seek finer consuer inforation and access only to the extent that it gives the a copetitive advantage, resulting in a greater ability to extract profit. This paper will argue that, due to the increased ability to extract profit, firs have an incentive to acquire and use exclusive consuer inforation even when the cost of channeling their targeted offers is exceedingly high, as copared to the added value created for consuers through product custoization. In other words, profit axiization through increased consuer targetability ay result in the industry creating less value overall, which legitiizes consuer deands for privacy. In particular, this will occur when arketing costs are subjects to strong returns to scale, aking efficient custoization harder to achieve. Finally, what would a arket for privacy look like in this context? One needs to iagine suppliers of privacy, gatekeepers who effectively conceal finer consuer access, on behalf of 2

3 consuers, for the sake of fostering copetition on the arkets for products. Consuers would share with the part of the protected surplus. Such interediaries would consistently and credibly resist the deands of downstrea firs to allow for exclusive consuer access and price discriination. The popular literature on online infoediaries (Hagel and Singer 1999) envisioned such entities, while questioning the conditions under which their pledge to protect privacy could be trusted (Scott Morton, Zetteleyer and Silva-Risso 2001). In reality, one can readily acknowledge the existence of several types of interediaries whose pledge to enforce copetition aong supplying firs and to aintain a high degree of access coarsening is ordinarily viewed as a credible departure fro the secular trend towards finer segentations and increased custoization: Retailers. Retailers soeties sell exclusive access to their shelves based on consuer characteristics they have anaged to isolate (e.g., club discounters appealing to certain consuer segents). However, other types of retailers foster product copetition while aintaining coarse access to a variety of consuers who are all treated indiscriinately (e.g., large everyday low price departent stores). The latter kind of retailers is an illustration of the eergence of a arket-coarsening interediary in the presence of returns to scale in arketing and relative consuer hoogeneity. Media. Fans of cultural products (e.g., usic, TV series) gain a lot of surplus fro being addressed in a way that does not distinguish the fro less involved consuers. Thus, it is not surprising to see interediaries in these doains pledging strong and usually believable privacy guarantees. For instance, a leading provider of digital video recording services finds that consuers would siply not buy the service if they believed that their individual preferences ight be exposed. Counities. One iportant function of counities (e.g., towns, aluni and professional associations) is to negotiate exclusive access with suppliers. However, counities also hold back fro providing suppliers with finer inforation (e.g., inforation that could be relevant for policy custoization and price discriination in an insurance contract) when they know that the ajority of their ebers want to reain hidden behind the counity s overall plural identity. There sees to be two distinct trends in the existing literature on the econoics of privacy. Soe authors ai to deonstrate the econoic efficiencies resulting fro increased consuer exposure (e.g., Posner 1981, Cate 2002, Calzolari and Pavan 2001). Other authors, siilar to this paper, ai to uncover substantial causes behind privacy concerns. In Taylor (2002), consuers anticipate that their current behavior can be used at a later tie for price discriination purpose. Taylor finds that the strategic behavior of consuers (who ay reject offers in order to bias the perception of firs) would be so costly that both firs and consuers should welcoe a privacy protection regie. In Taylor (2003), firs under copetitive pressure acquire excessive aounts of inforation about consuers, in a context where consuers have to qualify to enter the arket (as in an insurance arket). This leads to inefficient levels of consuer disqualification, justifying a privacy rule. This arguent is soewhat related to this paper s proposition 1 (part (2)), where a onopolist ay abusively want to select arginal consuer groups out of the arket in order to profitably focus arketing efforts on the ost involved consuers. However, 3

4 for the ost part, the present paper focuses on inefficient degrees of custoization, whereby firs have an incentive to ake several distinct targeted offers despite the presence of exceedingly high costs of custoization. In their study of the value of online inforation privacy, Hann et al. (2002) ake the interesting observation (consistent with this paper) that not all consuers have the sae interest in privacy protection, suggesting antagoniss aong consuer groups (e.g., groups that Hann et al. call privacy guardians and inforation sellers ) with respect to their preferences over arketing systes. This point was also illustrated in an ethnographic study by Holt (2002) that explores the resistance of arginal consuers confronted with brands that better atch the preferences of the ainstrea. Overall, this paper copleents other research in arketing that explored the profitability potential of increased consuer targetability. It has already been coented that copetition aong firs ay ruin the profitability of finer segentations (e.g., Villas-oas 1999, Chen, Narasihan, and Zhang 2001). Iyer and Soberan (2000) also explored how the strategic interests of a vendor of consuer inforation ight interfere with the ability for copeting firs to profit fro that inforation. dding another perspective, the present paper exaines the influence that consuer surplus-seeking behavior can have (via an interediary) on the ability of firs to coand a copetitive advantage based on privileged consuer access. Forally, this paper assues a profit-axiizing interediary who owns a syste capable of separately accessing consuer segents that were previously undistinguishable. The interediary has to choose an optial access allocation: should finer access be ade public, or should it be negotiated with one fir in exclusivity? Or should privacy be preserved? To ake that choice, the interediary has to figure out which econoic actor (consuer group or fir) is ost willing to pay in order to influence the access allocation decision. In the spirit of the literature on technological copetition (Dasgupta 1986), the actor with the greatest stakes in the access allocation process will win the right to coand the interediary. It results fro this analysis that finer access systes should either be allocated to one supplying fir in exclusivity (i.e., exclusive exposure), or to no fir at all (i.e., privacy or arket coarsening). Whether exposure or privacy prevails depends on deand-side paraeters of consuer involveent, hoogeneity and adaptability, and supply-side paraeters of copetitive intensity (onopoly versus copetition), econoies of scale in arketing. Siply put, exposure should only result if it truly creates value, which requires contexts with less econoies of scale, higher involveent, sufficient consuer heterogeneity and a relative lack of adaptability. In undane product categories characterized by econoies of scale, consuer hoogeneity and adaptability, ainstrea consuers should be able to successfully spend resources to protect unifor access. One iplication of this analysis is that nondiscriinant access devices (e.g., ass retailers, diverse counities and ass edia) should soeties be expected to give privileged treatent to their arginal ebers who need to be copensated for staying unexposed. The next section presents the odel, including the characteristics of the consuers, the firs, and of the interediary, as well as a definition of the equilibriu concept. Then, section 3 analyses the onopoly case, highlighting the fact that privacy contracts can correct for an 4

5 abusive use of finer arket access by the onopolist. Section 4 analyses the copetitive case and describes the conditions and features of privacy and exposure equilibriu. Section 5 concludes. 2. MODEL The odel involves three categories of agents: (1) two types of consuers (type- and type-), (2) a supply-side ade of one fir (onopoly case) or ore than one copeting firs (copetitive case) who can t distinguish between the two types of consuers, and (3) an interediary who owns a finer access syste that allows firs to access type- and type- consuers separately. This section describes these three categories of agents and introduces the equilibriu concept. The key decision of interest concerns the allocation of the finer arket access syste: how any firs will be allowed to use it, and who will pay the interediary Consuers Consider a arket for two substitute goods, denoted by and. There are N consuers, who are on the arket for one unit of good at ost. Soe consuers (called type- consuers) prefer to : good for the is worth v, while good is worth γ v. For clarity, the analysis focuses on cases with 0. 5 < γ < 1. The other consuers (called type- consuers) prefer to : good for the is worth v, while good is worth γ v. Thus, each consuer is willing to pay up to v to get the good she wants ore, or γ v for the good she wants less. In that sense, γ is a easure of consuer adaptability. 2 Paraeter v will occasionally be interpreted as a easure of consuer involveent. There are N type- consuers and ( 1 )N type- consuers. Without loss of generality, 1 2 is assued, so that type- consuers are in ajority. Type- consuers will soetie be called ainstrea and type- consuers will soetie be called arginal consuers. Paraeter is a easure of consuer hoogeneity in the population Firs On the supply-side of the arket, both onopoly and copetitive situations will be considered. The cost to produce or is assued to be zero for any fir. However, firs face an access cost (or, siply, arketing cost) incurred to present a consuer with a good. This cost includes activities related to aking a good known and physically accessible to the consuer. In the baseline case, firs are assued to know but they are unable to access type- and type- individuals separately. The baseline access cost is denoted by, so that addressing all consuers 2 The analysis will always result in supplying type- consuers with what they want, and thus γ as it applies to the ay appear to be soewhat irrelevant. However, the paraeter is kept to ake clear that the only source of asyetry between type- and type- consuers is their nuber. 5

6 with either good only or good only will cost a total of N, and addressing all consuers with both and iplies a total arketing cost of 2N (this analysis oits the possible ipact of econoies of scope). In order to focus on non-trivial solutions, it is assued that 1 2 v. Collectively, these assuptions describe the baseline arket access syste M. ecause it cannot distinguish between type- and type- consuers, M will soeties be described as a coarse access syste Interediary The interediary owns a finer arket access syste, denoted by M, that allows firs to access type- and type- consuers separately. The iplied access costs are denoted by ' (average cost to access a type- consuer) and ' (average cost to access a type- consuer). Thus, the total cost of accessing -type consuers is ' N (versus N under M) and the cost of addressing -type consuers is ' ( 1 )N (versus N under M). The average access cost under M is denoted ' = ' + 1 '. ( ) finer access syste could result, e.g., fro a new store s geographical location or specific appeal, a new edia s (e.g., television channel or agazine) specialized content, or a new counity of consuers. Often, these systes will allow ore efficient access to one consuer type without ipacting the econoics of accessing the reaining consuers. For the access syste to be finer than the baseline syste involving arketing cost, access costs ust be restricted as follows: ' and '. 1 Returns to scale in arketing are assued, so that ' > ' > ' >. These assuptions iply that a finer access syste ust be a ore econoical way of offering variety, but it can t be a ore econoical way to arket a hoogeneous offering Equilibriu Concept The decision of interest concerns the interediary. He can ake M available to one fir, or to several firs, or he ay decide to prevent finer consuer access. The allocation of access can be paid for by type- consuers, type- consuers, or by one or several firs. The transaction cost involved in contracting with any of these agents is zero. Possible probles of coordination aong consuers of a certain type are assued away for the purpose of this paper. More forally, the decision of interest is an access allocation contract: an agent pays an aount x to the interediary and deterines whether M is to be ade available to no fir, one fir or ore than one fir. 6

7 n equilibriu access allocation is defined as an access allocation contract that is acceptable for the agent involved and carries a payent x* to the interediary such that no other agent could be willing to offer a better payent. To deterine the equilibriu access allocation, two stages are assued. In the first stage, the interediary picks an access allocation. In the second stage, firs deterine what good(s) to offer and at what price(s) under the chosen access allocation. coparison of second stage equilibriu outcoes reveals what the various agents would be willing to pay in order to favor any particular access allocation in the first stage. The equilibriu access allocation contract is then deterined by backward induction. 3. MONOPOLY CSE This section first identifies the onopolist s equilibriu decision under coarse access. Then the ipact of finer access is assessed, leading to a first proposition about access allocation aseline Monopoly Case In an ideal onopoly case, the fir could present each consuer separately with only his preferred good, leaving no surplus to consuers. However, the onopolist s inability to distinguish aong consuer types under access syste M leads to one of the three following second-best solutions, naed after their ipact on the deands of the inority consuers: Neglect. Deands of type- consuers are neglected, because they are too rare to justify the corresponding access cost. ll consuers are presented with good only, sold by the onopolist at price p = v. Expected onopoly profit per consuer is v. There is no consuer surplus. There is a waste of arketing costs (as copared to an ideal onopoly case) aounting to ( 1 )N, as type- consuers are addressed uselessly. Pooling. ll consuers are presented with good only, sold by the onopolist at price p = γv. s a result, all consuers buy, including type- consuers who coproise their preferences by buying a good that doesn t atch their type. Mass arketing could be a good label here, except for the fact that it has absolute size connotations that are irrelevant in this discussion. Monopoly profit per consuer is γ v. Consuer surplus in this case is ( 1 γ ) vn, as -type consuers obtain their preferred good at a discount. There is no waste of arketing cost. Self-selection. ll consuers are presented with both goods and pick the one they like ost. The onopolist sets prices p = v and p = v. Monopoly profit per consuer is v 2. There is no consuer surplus. The waste of arketing costs aounts to N, as copared to the ideal onopoly case. The onopolist s expected profit per consuer in the baseline (coarse access) case is therefore π * = ax( v, γv, v 2), and conditions for the three possible equilibria can be suarized as follows: 7

8 Lea 1 (Monopoly equilibriu under coarse access) In the onopoly case under coarse access syste M, the equilibriu is characterized by Neglect with p = v if γ and > ( 1 - ) v, Pooling with p = γv if γ > and > ( 1 γ ) v, Self - selection with p = p = v if ( 1 ax(, γ )) v. γ or low access cost each offer a path of salvation for a onopolist endowed with coarse arket access. Reark that high hoogeneity and high adaptability are substitute fro the fir s standpoint, while their ipact fro a consuer standpoint is radically different: pooling is preferred to neglect. Consuers should value a blend of diversity and tolerance for its ipact on welfare. Essentially, high hoogeneity ( ), high adaptability ( ) 3.2. Monopoly with Finer ccess The key ipact of using a finer access syste is to lower the cost of price discriination, thereby aking pooling (and consuer surplus) less likely. When the onopolist uses finer access syste M instead of M, offering variety yields greater profit, i.e, ( v ')N instead of ( v 2) N, and so does neglect, i.e., ( v ' )N instead of ( v )N. These two forces have been apparent in the real world, where progress in consuer inforation systes (e.g., through keeping track of custoer responses over tie) led to a trend in favor of either custoer selection (neglect) or custoization. The ter self-selection is now an inadequate descriptor of the variety equilibriu, as the fir is able to identify consuer groups before they ake a selection. The ter custoization, referring to the fir addressing both consuer types separately with their preferred good, is therefore adopted. The onopoly equilibriu is as follows (all proofs are in appendix): Lea 2 (Monopoly equilibriu under finer access) In the onopoly case under finer access syste M, the equilibriu is characterized by -' Neglect with p = v if { γ and v < ' }, or if γ > and v < ( < ' ) γ - ' ' Pooling with p = γv if γ > and ax, ' v 1 γ γ '- Custoization with p = p = v if { γ and v ' },or if γ > and v > ax, '. 1-γ ( ) cknowledging that v < ' is ore restrictive than ( 1 ) v < (neglect condition under Lea 1 when γ ), it appears that a shift to finer access induces the onopolist to shift fro neglect to custoization in a nuber of situations. cknowledging also that 8

9 ' v ax, ' is ore restrictive than ( 1 γ ) v < (pooling condition under Lea 1), 1 γ it appears that a shift to finer access induces the onopolist to shift away fro pooling (either to neglect or to custoization) in a nuber of situations, aking the occurrence of consuer surplus less likely. Overall, a finer access syste akes it ore likely that arginal consuers get what they want. However, in a nuber of instances, arginal consuers will be confronted with neglect instead of an opportunity to consue the ainstrea good Equilibriu ccess llocation vailability of a finer access syste creates a conflict between the onopolist and type- consuers, whenever it ay cause a shift away fro pooling. In order to induce an access allocation contract that allows hi to shift fro pooling to neglect, the onopolist is willing to pay up to ( v ' γ v + ) N = (( γ ) v + ' )N. In response, type- consuers resistance aounts to a bid equal to the lost surplus, ( 1 γ )vn. Coparing the two forces, it appears that the equilibriu access allocation ay involve preventing the fir to use finer access (i.e., privacy or coarsening) if ( 1 ) γv > '. In other words, privacy ay eerge to protect the ajority s surplus when the onopolist threatens to neglect arginal consuers for the sake of a coparatively sall saving in arketing costs. Siilarly, a onopolist s willingness to pay to shift away fro pooling and towards custoization aounts to ( v ' γv + ) N, which is less than type- consuers resistance if ( 1 )( 1 γ ) v < ', i.e., if the value created through getting arginal consuers what they want is less than the added arketing cost of price discriination. Soeties, a onopolist will want to shift to custoization for the sake of surplus appropriation, despite inefficiency. That is when privacy can create value and is chosen as equilibriu access allocation by the interediary. The precise conditions of an equilibriu access allocation featuring privacy, deonstrated in appendix, are as follows: Proposition 1 (Privacy or arket coarsening in the onopoly case). In the onopoly case, the equilibriu access allocation involves type- consuers paying the interediary to prevent usage of M in the following cases: (1) γ >, v > ', and ' > > ( 1 )( ' ), where = ( 1 )( 1 γ )v represents the value created by a shift fro pooling to custoization, and (2) γ > and ( 1 ) γv > ' > ( γ )v, where ' represents the cost saved by a shift fro pooling to neglect. 9

10 4. COMPETITIVE CSE In the previous section, the supplying fir was under no copetitive pressure. This section assues free arket entry. Each potential entrant decides siultaneously on (1) what good(s) to offer to each consuer type, and (2) at what price(s). The product offering ust be accesscopatible in the sense that it ust respect the constraints inherent to the available arket access syste. For instance, under access syste M, firs can only decide to offer to all consuers, or to all consuers, or both goods to all consuers. ll firs are identical in the baseline case involving M only, but a profit-inducing inequality in access costs could result fro the interediary s decision to allocate M to one fir in exclusivity. ecause of the strategic choice of an access-copatible product line and because of the possible asyetry in arket access, one cannot speak of ertrand copetition (which refers to pricebased copetition in a syetric context). However, siilar to ertrand copetition, the equilibriu concept adopted here is reached when no fir can profitably undercut the current prices. The undercut-proof equilibriu is reached with a cobination ( ) p p, of prices and a cobination of product offerings (product offer to type- consuers, product offer to type- consuers) such that no rival fir can ake profitable and access-copatible offerings that would involve lower prices and attract all consuers of any type. siilar definition of undercut-proof equilibriu in a different context can be found in Shy (2001) Equilibriu under Shared ccess When all firs are using the coarse consuer access syste M, the undercut-proof equilibriu intuitively depends on the strength of type- consuers desire to get what they want (as = 1 1 γ. opposed to consuing ), denoted by ( )( )vn Lea 3 (Copetitive equilibriu under coarse access) In the copetitive case under coarse access syste M, the only existing undercut-proof equilibria are Pooling with p = if, and Self-selection with p = and p = if > and ( 1 ) v. 1 Two rearks are in order. First, a coparison between Leas 1 and 3 reveals that copetition between suppliers akes pooling ore likely. No neglect equilibriu can be supported (at least when γ > 0. 5), and the condition for self-selection is ore restrictive under copetition (one can easily check that ( 1 γ ) v >, as required for self-selection under Lea 1 is less restrictive than / > ). Reiniscent of Schupeter (1942), this odel predicts that copetition reduces the likelihood of variety, while it also reduces neglect of arginal consuers. However, a second reark is that if < ( 1 )v, variety can be supported as an undercut-proof equilibriu even though it adds less value than the additional cost involved in 10

11 arketing a second good. The reason for this inefficiency lies in the asyetric flexibility between pooling and self-selection as weapons to undercut, with self-selection offering one ore degree of freedo (two prices to set instead of one in the case of pooling). It is harder for a copetitor to undercut with a pooling offer than with two separate self-selection offerings and, as a result, inefficient self-selection equilibriu can be sustained. In other words, coordination failure can lead copetition to produce ore variety than it should. When all firs share usage of the finer consuer access syste M (a situation denoted by M ' s ) the undercut-proof equilibriu iposes ore restrictive conditions on pooling and less restrictive conditions on variety, as expected intuitively: Lea 4 (Copetitive equilibriu under shared finer access) If ore than one copeting fir uses finer access syste M, the only existing undercutproof equilibria are Pooling with p = if ', and Custoization with p = ' and p = ' if ( 1 )( ' ) and v ' gain, it appears that custoization can be supported as an undercut-proof equilibriu even when it creates less value added than the iplied additional arketing cost (when ' ( 1 )( ' ) ). One purpose of this paper is to see whether the introduction of a arket for M can prevent an inefficient shift fro pooling to custoization Equilibriu under Exclusive ccess This section exaines the outcoe resulting fro aking finer arket access (M ) available to one fir (called the innovator ) while the other copeting firs continue to use M. This situation of exclusive appropriation can be denoted by M ' e. The innovator s copetitive advantage coes fro the ability to create variety at a lower cost, or to offer variety when the coarse access syste leads copetitors to favor pooling. In order to successfully copete against self-selection, the innovator can siply atch (in fact, slightly undercut) his copetitors best prices and derive a profit thanks to access costs savings associated with M. In order to copete against his copetitors attept to ipose a pooling equilibriu, the innovator can use M to econoically channel good to type- consuers, who will be willing to pay a preiu to get what they want and depart fro pooling. Having attracted type- consuers and thereby destroyed the other firs ability to ipleent pooling, the innovator then has an opportunity to charge good at a preiu as well. Obviously, returns to scale and consuer adaptability are two notable eneies of the innovator. 11

12 Lea 5 (Copetitive equilibriu under exclusive finer access) If an innovator obtains finer access syste M in exclusivity while other copetitors use coarse access syste M, then the innovator can profitably offer custoization at the following undercut-proof prices: p = and p = if and ( 1- ) v 1 2 ( ) ( ) ( 1 ) p = and p = + 1 γ v if > > ax ' 2, 2 ( ) ( )( ) ( 1 ) p = p = + 1 γ v if 1 ' < Otherwise (if is too sall), the innovator can t use M profitably. The last price cobination (which constrains the ability of the innovator to increase the price of good ) occurs when adaptability is high and returns to scale are not too high, liiting the 3 1 innovator s advantage ( γ > and ' < ). 2 coparison between Lea 5 and Lea 4 reveals that M ' e increases the possibility of custoization as copared to M ' s, if returns to scale in arketing are not too strong. This reinforces the earlier finding that onopolistic power is a source of product variety Privacy Equilibriu The key characteristic of finer access syste M is that it akes variety cheaper to offer. privacy equilibriu will occur (1) if soe agent wants M to be used even though it creates inefficient variety, in an instance where (2) a shift to M would hurt another agent who would then be willing to bid against M and ipose privacy. Leas 4 and 5 reveal that arginal (type-) consuers never suffer fro a shift to finer access, whatever its ode of allocation. Siilarly, firs are indifferent to finer access unless they can becoe an innovator and enjoy a positive profit. Thus, privacy equilibriu can only eerge fro a desire of ainstrea consuers to protect their surplus. Note that if self-selection reigns under M, a shift to M is either iproving type- consuers surplus, or leaving it unchanged. Thus, siilar to the onopoly context, privacy eerges fro an attept of ainstrea consuers to aintain pooling. De facto, it corresponds to ainstrea s willingness to subsidize type- consuers to help the adapt to ainstrea tastes. For privacy to becoe the equilibriu access allocation, type- s prospective surplus loss fro a shift away fro pooling ust be larger than an innovator s incentive towards M ' e, and larger than the type- consuers incentive towards M ' s. s expressed in Proposition 2, privacy will result whenever there is an inefficient drive on behalf of firs towards custoization: 12

13 Proposition 2 (Privacy or arket coarsening in the copetitive case). In the copetitive case, the equilibriu access allocation involves type- consuers paying the interediary to prevent usage of M if and only if pooling occurs in the baseline situation under M and ax{ ' ( 2 ), ( 1 )( ' ) } < '. It is interesting to copare Proposition 2 with Proposition 1. First, a onopolist s drive in favor of a shift to neglect ( custoer selection ) causes ore instances of privacy contracts in the onopoly context. Second, custoization is a little less attractive for an innovator than it is for a onopolist because, despite their copetitive disadvantage in case of exclusive finer access, copetition prevents full extraction of value. This akes the condition in Proposition 2 a bit ore restrictive than in Proposition 1 (condition (1)). Thus in total, it can be said that copetition aong firs reduces privacy concerns (and the likelihood of privacy contracts). In other words, ainstrea consuers have an easier tie iposing their tastes on arginal consuers when there is broad copetition on the supply side. One could venture an explanation for the practice of everyday low pricing in the fact that interediaries don t need to subsidize their arginal patrons when consuers are ore hoogenous, copetition is ore intense on the supply side and returns to scale are larger Exposure Equilibriu Who gains ost fro exposure and when? Starting fro self-selection under M, the additional profit fro custoization gained by an exclusive owner of finer access is equal to the su of the surplus that consuers would get fro a shift to shared finer access. Thus an innovator will be awarded exclusive access in that case. Starting fro pooling under M, ruling out privacy cases, custoization (given ' ) would occur in both odes of exposure. gain, the force in favor of exclusive finer access is greater than any consuer type s individual drive in favor of shared access. Proposition 3 (Exposure in the copetitive case). In the copetitive case, the equilibriu access allocation involves a fir paying the interediary to acquire exclusive usage of M in all cases where > '. The condition in proposition 3 reveals that consuer heterogeneity, low adaptability, and high involveent should lead interediaries to negotiate exclusive finer access, allowing the to capture (through copetition aong potential innovators) soe of the surplus lost by ainstrea consuers, at the sae tie that arginal consuers get ore of what they want ost. 13

14 5. CONCLUSION This paper has explored the iplications of recognizing that different agents have different preferences about how coarse or fine a arketing syste firs should use to approach consuers. Mainstrea consuers obtain a surplus when firs rely on a coarse access syste. Marginal consuers, in contrast, benefit fro firs copeting within the fraework of a finer access syste. Firs can gain a copetitive advantage by obtaining the finer access syste in exclusivity and extracting consuer surplus by treating different consuers differently. Firs have an incentive to use finer segentations and to ake custoized offers even when the iplied additional arketing costs (due to returns to scale in arketing) are larger than the value created for consuers through product custoization. When such is the case, an interediary can profitably supply arket coarsening, sharing the consuer surplus it helps to restore. These findings highlight the liits of assuing that profit-driven firs are in charge of coanding segentation and price discriination processes in their best interest, as coonly taught to students of arketing. nalysis also found that when the drive for consuer exposure doinates privacy concerns, finer access should always be negotiated in exclusivity with one fir. It aybe worthwhile to conclude with a list of testable iplications: - Privacy concerns are expressed by ainstrea consuers, not by arginal or underserved consuers. - Privacy concerns arise only when consuer inforation would cause firs (1) to drop service to arginal consuers or (2) to increase variety through custoized offers. There is no deand for privacy when consuer inforation is erely used by firs to shift fro self-selection (where variety is offered to all) to custoization (where variety is channeled in a ore targeted fashion), without an ipact on the aount of variety offered. - Privacy equilibria (whereby interediaries conceal the actual variety of their custoer base) are ore likely to occur when supplying firs face less copetition, when there are larger returns to scale in arketing, when consuers have ore hoogenous preferences, and when consuers are ore adaptable and less involved. The opposite circustances favor the equilibriu appearance of finer segentations and discriination opportunities. - Privacy equilibria require the interediary to copensate arginal consuers in order to keep the fro sticking out of the crowd (assuing that arginal consuers could coordinate to sell their type). 14

15 6. PPENDIX Proof of Lea 2 Profit is ( v ' ) N in case of neglect, ( γ v )N in case of pooling, and ( v ' )N in case of custoization. Neglect doinates custoization if and only if v ' > v ', i.e., ' ' > ( 1 )v, equivalent to ' > v. Neglect doinates pooling if ' ( γ ) v < ' ( > 0), which always holds if γ or if < γ and v <. One can γ ' easily check that ' >. Custoization doinates neglect if ' v and it also γ doinates pooling if ' < ( 1 γ )v. The sign of γ deterines which constraint is ore ' restrictive. Note that ' > if ( 1 γ ) ' > ' + ( 1 ) ', i.e., 1 γ ' ( γ )' > '. s ' 0, γ iplies ' >. 1 γ Proof of Proposition 1 Privacy occurs in two sets of circustances. The first set of circustances involves pooling ' under M, i.e., γ > and > ( 1 γ )v, cobined with self-selection under M, i.e., v < γ and an inefficient shift away fro pooling towards neglect, i.e., ( 1 ) γ v > '. Taken ' ' together, these conditions require γ > and > > ' > > v >. 1 γ 1 γ γ γ The second set of circustances involves pooling under M cobined with custoization under ' M, i.e., v > ax, ', and an inefficient shift away fro pooling towards 1 γ ' custoization, i.e. v <. Taken together, these conditions require γ >, v > ' ( 1 )( 1 γ ) ' ' and > v >. 1 1 γ 1 ( )( ) γ, Proof of Lea 3 First, there exists no neglect equilibriu. fir offering only will be undercut until p = by other firs offering only. This price can be undercut through pooling with p = + ε 15

16 if γv ε > 0 (profitability) and ε 0. This is always possible given that / v 1/ 2 and γ 1/ 2. Second, under what conditions does a pooling equilibriu exist? fir that offers good only to both type- and type- consuers can be undercut through pooling until p = (zero-profit condition). Pooling at price p = can be undercut through self-selection with p = and p such that v p > γ v. Price p = v( 1 γ ) + ε ( ε 0 ) ake such undercutting profitable only if + ( 1 )( 1 γ ) v + ( 1 ) 2 = ( 1 )( 1 γ ) v > 0. Thus pooling at price is undercut-proof if 1 1 γ ) v. p = ( )( Third, under what conditions does a self-selection equilibriu exist? self-selection equilibriu will require p and p to obey the following constraints: (i) p + ( 1 ) p 2 = 0 (zero-profit condition), (ii) p (ipossibility to undercut through a single-product offering of ), (iii) p (ipossibility to undercut through a single-product offering of ), 1 (iv) v p > γv p (type- consuers select good ), (v) v p > γv p (type- consuers select good ). (vi) in { p, p ( 1 γ ) v } < (ipossibility to undercut through pooling with good ). (vii) in { p, p ( 1 γ ) v } < (ipossibility to undercut through pooling with good ). If p <, then (i) iplies that p >, which is ruled out by (iii). Thus, by (ii), p =. 1 Then, by (i), p =. Constraint (iv) is always fulfilled. Constraint (v) requires <. Constraint (iv) iplies that constraint (vi) writes ( 1 γ ) v <, which is 1 equivalent to the stricter constraint <. Constraint (v) iplies that constraint (vii) writes ( 1 γ ) v <, which is equivalent to ( 1 ) < ( 1 γ )v. straightforward coparison shows that if > 1 2 then < 1 < 1 γ )v. is ore restrictive than ( ) ( Proof of Lea 4 n undercut-proof custoization equilibriu obeys the following set of constraints: (i) p + ( 1 ) p ' = 0 (zero-profit condition), (ii) p ' (ipossibility to undercut through a single-product offering of ), (iii) p ' (ipossibility to undercut through a single-product offering of ), (iv) in { p, p ( 1 γ ) v} (ipossibility to undercut through pooling with good ). (v) in { p, p ( 1 γ ) v} (ipossibility to undercut through pooling with good ). 16

17 Unlike in the case of Lea 3, there is no self-selection constraint. (i) to (iii) iply that p = ' and p = '. s neither p nor p is less than, (iv) requires ' ( 1 γ ) v, equivalent to ( 1 )( ' ), and (v) requires ' ( 1 γ ) v, equivalent to ( 1 )( ' ) (a less restrictive constraint). pooling equilibriu will require p = and + ( 1 ) + ' 0 (no possibility of profitable undercut through custoization), iplying '. Proof of Lea 5 Due to the presence of returns to scale, a finer access syste does not give any advantage to the innovator who would copete through pooling. However, custoization by the innovator can yield positive profit, under the following set of constraints: (i) p + ( 1 ) p ' 0 (ii) ), (iii) p (ipossibility for non-innovators to undercut through a single-product offering of p (ipossibility to undercut through a single-product offering of ), 1 in { p, p 1 γ v}, in p, p 1 γ v. (iv) ( ) (v) { ( ) } Constraints (ii) to (v) point to the following profit axiizing prices: p = and p = if + ( 1 γ ) v 1 1 p = and p = + ( 1 γ ) v if < + ( 1 γ ) v < 1 p = p = + ( 1 γ ) v if + ( 1 γ ) v These prices and accopanying conditions have to be checked for existence and profitability. First, + ( 1 γ ) v can occur if. One can check that if > 1 2 and γ > 1 2, 1 > ( 1 )( 1 γ ) 2 (the lower bound on ). Thus is the required existence condition for the first set of prices. Profitability is clear at these prices, as '< 2. 17

18 Second, < + ( 1 γ ) second set of prices requires ( ) 2 ( 1 ) > ' ( 2 ) if 2 v < is equivalent to ( 1 ) < <. Profitability with the ' 0, i.e., ' ( 2 ). Note that > '. ccounting for profitability, the third set of prices requires 2 {( )( ) ( )( )} ( 1 ) ax 1 1 γ 2, 1 ' <. For such a to exist, one needs both 3 1 γ > and ' <. 2 Proof of Proposition 2 s noted in the text, type- consuers are the only agent interested in aintaining coarse access, provided the baseline situation involves pooling. First, consider the condition under which an access allocation contract involving privacy can doinate an access contract involving shared finer access. Type- consuers, through exposure, look forward to a gain equal to ( 1 )( v ' γv + ) = ( 1 )( ' ). Type- consuers by discouraging exposure would gain ( v v + ' ) = ( ' ) > 0. Thus, a necessary condition for privacy to doinate is ( ' ) > ( 1 )( ' ) > 0, i.e., ' >. Second, consider the conditions under which privacy can doinate an access contract involving exclusive access. ased on Lea 5, if ' >, then the gain of discouraging exposure for type- consuers is N, which is greater than profit ( 2 ' )N if ' >, which ust be true (in a case with ' > ). Next, if <, profit fro exclusive access goes down while the incentive to protect surplus reains the sae. In the conditions under which p = + ( 1 γ )v, profit is ( + ( 1 γ ) v ' )N and the benefit fro privacy for type- consuers is ( 1 γ )vn, leading to privacy condition ' > again, which therefore appears to be both necessary and sufficient. Proof of Proposition 3 First, exaine the case where self-selection eerges under M. Following Lea 5, M ' e will lead to custoization without change in price, yielding innovator profit 2 '. Observe that ' < 2 ' and ( 1 ) ' < 2 ', i.e., no access allocation contract 1 involving either type- consuers or type- consuers can doinate an exclusivity contract with an innovator. Second, exaine the case where pooling eerges under M. ccounting for proposition 2, this eans focusing on cases with '. s ( 1 )( ' ) < ', Lea 4 iplies that 18

19 there will be custoization under shared finer access (assuing v > ' ). Siilarly, as ( 1 )( ' ) < ', Lea 5 iplies that the sae real outcoe (arketing costs and value created) will eerge fro exclusive finer access. Consequently, for a consuer type to be able to propose a doinating access allocation contract involving shared finer access, it ust be that the other type gains ore surplus under exclusive finer access than under shared finer access (so that the proposed allocation captures both the innovator s profit and soe of the other consuer type s surplus). However, one can check that if ' all the prices of good involved in Lea 5 are greater than ', and all the prices of good involved in the sae lea are greater than '. Thus the profit involved in M is larger than any surplus a consuer type could gain by inducing M instead of M '. ' s e ' e 19

20 7. REFERENCES Cate, Fred H Principles for Protecting Privacy. Cato Journal 22 (1) Calzolari, Giacoo and lessandro Pavan Optial Design of Privacy Policies. Mieo. Departent of Econoics, Northwestern University. Chen, Yuxin, Chakravarthi Narasihan, and Z. John Zhang Individual Marketing with Iperfect Targetability. Marketing Science 20 (1) Dasgupta, Partha The Theory of Technological Copetition. Partha Dasgupta and Ken inore, eds. Econoic Organizations as Gaes. asil lackwell: Oxford. Hagel, John, and Marc Singer Net Worth. Harvard usiness School Press: oston. Hann, Il-Horn, Kai-Lung Hui, To S. Lee, and I.P.L. Png The Value of Online Inforation Privacy: Evidence fro the US and Singapore. Mieo. Marshall School of usiness and National University of Singapore. Holt, Douglas Why Do rands Cause Trouble? Dialectical Theory of Consuer Culture and randing. Journal of Consuer Research 29 (1) Iyer, Ganesh, and David Soberan Markets for Product Modification Inforation. Marketing Science 19 (3) Posner, Richard The Econoics of Privacy. erican Econoic Review 71 (2) Schupeter, Joseph Capitalis, Socialis and Deocracy. George llen and Unwin: London. Scott Morton, Fiona, Florian Zetteleyer, and Jorge Silva-Risso Internet Car Retailing. Journal of Industrial Econoics 49 (4) Shy, Oz The Econoics of Network Industries. Cabridge University Press: Cabridge. Taylor, Curtis R Private Deands and Deands for Privacy: Dynaic Pricing and the Market for Custoer Inforation. Mieo. Departent of Econoics, Duke University. Taylor, Curtis R Privacy in Copetitive Markets. Mieo. Departent of Econoics, Duke University. The Econoist No Hiding Place, in Survey of the Internet Society (January 2 issue). Villas-oas, J. Miguel Dynaic Copetition with Custoer Recognition. RND Journal of Econoics 30 (4)

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