A zero price can be special

Joshua Gans 10 February 2020

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When firms set a price at zero it is somewhat confounding. After all, a basic first step towards making profits is that someone has to pay you. The economist’s instinct is, of course, to look for payments elsewhere. Maybe they are selling a complement (‘free’ shipping is an illusion). Alternatively, Google and Facebook do not charge customer for their core search and social media services, but they do find a way to make money from customer use – by selling their attention to advertisers. This is not a new model; the media has operated this way for over a century. 

When it comes to antitrust, challenges arise when a firm is both dominant in their market and ‘selling’ products in that market at a price of zero. The initial instinct of many is to suggest that they aren’t exercising market power if they are giving a product away. But suspicion should still contextualize this situation. As legal scholar John Newman documented in an influential 2015 article, just because a price is free doesn’t mean there isn’t a market to be made more competitive (Newman 2015). In fact, a zero price may be reflective of that. 

More recently, economists have argued that zero is just another price. It is not special and nor is it a lower bound. For instance, Fiona Scott Morton of the Yale School of Management argues that there is no reason why prices cannot be negative.

“… free is not some special zone. Free just means the money price is equal to zero. The money price is often positive when we go to the store and buy a loaf of bread, but it’s also possible for prices to be negative. Now, why would Gmail or Facebook pay us? Because what we’re giving them in return is not money but data. We’re giving them lots of data about where we go, what we eat, what we buy. We let them read the contents of our email and determine that we’re about to go on vacation or we’ve just had a baby or we’re upset with our friend or it’s a difficult time at work. All of these things are in our email that can be read by the platform, and then the platform’s going to use that to sell us stuff.” (Capitalisn’t Podcast 9 May 2019)

What Scott Morton is arguing is that we can still think about antitrust in terms of maximising consumer welfare when prices are zero. In that situation, we may expect competition to drive prices negative precisely because firms can earn money from consumers elsewhere.

The idea that prices have no special lower bound at zero is, of course, standard economic teaching. Moreover, in some markets, such as credit cards, negative prices are seen and, ironically, have themselves brought consternation from regulators (Gans 2018). But there is a puzzle. Why do firms who have power over what price to set choose precisely zero? And if we understand the answer to this question, do the conditions that lead to zero price mean that our normal intuition regarding competition will apply?

Modelling negative costs

I examined these questions in a recent paper (Gans 2019). My starting was to model a market where there is a monopoly whose (net) costs are negative. The idea was that even if there were some costs of serving consumers, the offsetting benefits (such as advertising earnings) would make those costs negative. The lower the costs (including being more negative), the lower we expect a monopolist price to be. However, there is no reason for it to be exactly zero except by chance. 

Two additional ingredients were needed.

  • The first was to note that while costs can be negative, consumer value rarely is. The standard microeconomics assumption is that consumers have free disposal. They can ‘buy’ anything and throw it away if they don’t like it. That means that a lower bound on utility – or willingness to pay – is zero. Almost every market is likely to have this point and, thus, there is a group of consumers who would not purchase a product unless they were paid to do so (i.e. the price was negative).1 This means that if we observe a monopolist pricing at zero, they have chosen not to supply that group of zero-utility consumers. 

This introduces a new puzzle. If costs are negative, why don't monopolists charge a slightly negative price and ‘earn’ money from those zero-utility consumers?

  • This gives rise to a second ingredient: marginal costs may be negative for consumers who most value your product, but they become less negative as you attract consumers who do not like your product as much. For instance, consumers who like reading The Guardian are more lucrative advertising targets precisely because we know they like that newspaper. If prices were negative, advertisers could no longer be assured that consumers were reading for the ‘right’ reasons. Or worse, they may be ‘bots’. So, advertising revenue from a marginal consumer would fall – that is, costs would rise. Thus, the reason firms do not price below zero is precisely because the costs of doing so would be prohibitive and would reduce profits. 

Selection markets

Markets where costs change in this way are called selection markets. Such selection markets (as studied by Mahoney and Weyl 2017) have interesting welfare properties. Moving from monopoly to competition does potentially reduce prices (unless average costs of supplying the whole market are positive). But does it increase welfare? What I show is that it does not necessarily do so. The key are the costs of ‘supplying’ the group of zero-utility consumers. The monopolist chooses not to supply them because those costs exceed their revenue (i.e. zero). The social planner would not choose to supply them if those costs exceed their utility (also zero). So their incentives to supply that group are aligned. In contrast, competitive firms take into account average rather than marginal cost. So, they may supply those consumers, but social welfare would be harmed as doing so is too costly.

This suggests that we must be cautious in treating markets in which zero prices prevail as ordinary. The fact those prices arise means that there are underlying factors – particularly on the cost side – that make them ‘special.’ Put simply, our intuition that competition is clearly welfare-improving can be wrong. This does not mean that firms which have market power in such industries can be ignored for their behaviour. But it does mean that we need to understand why prices are at the level they are before deciding on appropriate interventions.

References

Gans, J S (2018), "Are we too Negative on Negative Fees for Payment Cardholders?" mimeo.

Gans, J S (2019), “The Specialness of Zero,” NBER Working Paper 26485.

Mahoney, N and E G Weyl (2017), “Imperfect Competition in Selection Markets,” Review of Economics and Statistics 99(4): 637–651.

Newman, J M (2015), "Antitrust in zero-price markets: Foundations", University of Pennsylvania Law Review 164: 149-206.

Endnotes

[1] Technically, as I show in the paper, it could be that at a price of zero everyone buys the product and the market is covered. In this situation, there is no reason for a monopolist to charge below zero and so competition may reduce prices. However, competition won’t increase welfare in this case as everyone is consuming anyway. In contrast, they won’t buy a product even at a price of zero if there are even very small costs of, say, transacting. This justifies a default to not purchase.

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Topics:  Industrial organisation

Tags:  zero prices, lower bound, selection markets

Professor of Strategic Management and Jeffrey S. Skoll Chair of Technical Innovation and Entrepreneurship, Rotman School of Management, University of Toronto

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