Customer Privacy and Competition

• DOI: http://doi.org/10.1111/jems.12157
• Author: Rune Stenbacka,Oz Shy
• Published date: 01 September 2016
• Date: 01 September 2016

Customer Privacy and Competition

OZSHY

MIT Sloan School of Management

100 Main Street, E62-613, Cambridge, MA 02142

ozshy@ozshy.com

RUNE STENBACKA

Hanken School of Economics

P.O.Box 479 00101 Helsinki Finland

Rune.Stenbacka@hanken.fi

We analyze how different degrees of privacy protection affect industry profits, consumer welfare,

and total welfare in a model with switching costs. Firms earn higher profits under weak privacy

protection compared with strong or no privacy protection. The relationship between the degreeof

privacy protection and equilibrium profits is not monotonic. Consumer surplus and total welfare

increase with the degree of privacy protection unless firms recognize consumer-specific switching

costs. In that case, pricing conditional on switching costs has favorable implications for consumer

surplus and total welfare.

1. Introduction

Technologicalprogress, and, in particular, the Internet, have made it possible for firms to

implement increasingly sophisticated methods of customer recognition that can serve as

a basis for designing discriminatory pricing schemes. In particular, online retail stores,

payment card networks, and search engines collect information that can reveal customer

preferences, willingness to pay, and willingness to try out new brands of a wide variety of

products and services. Overall, the advances in technology have enabled firms to acquire,

store, sell, and share customer-specific information that can be used for implementing

targeted advertising and differential pricing tactics.1

The exploitation of customer-specific information for advertising and pricing pur-

poses raises important privacy concerns.2The Federal Trade Commission has recently

issued a report that establishes best practices for firms to protect consumer privacy

with a recommendation for Congress to consider reforms of the legislation dealing with

Wethank the editor, co-editor,and two anonymous referees for most valuable comments and suggestions. Our

manuscript has benefited from comments by Henrik Horn, Julian Jamison, YossiSpiegel, seminar participants

at The Research Institute of Industrial Economics in Stockholm, NORIO 2012 in Copenhagen, IIOC 2013

in Boston, The Searle Conference on Internet Search and Innovation 2013 at Northwestern University and

CRESSE 2013 on Corfu, as well as from comments by our discussants Eirik Kristiansen, Ludwig von Auer,

Liad Wagman and David Ulph. Financial support fromthe Hanken Foundation is gratefully acknowledged.

1. This can be illustrated with a number of examples. An article in the June 30, 2012 issue of The Economist

entitled “How Deep Are YourPockets” describes software designed to detect the willingness of consumers to

pay.A December 7, 2012 Wall Street Journal article entitled “They Know What You’re Shopping For” describes

companies that track and sell information about realidentities of online shoppers. The world’s largest company

of this type, Acxiom, and implied privacy concerns are discussed in a June 16, 2012 New York Times article

entitled “Mapping, and Sharing, the Consumer Genome.”

2. Goldfarb and Tucker (2012) present empirical documentation of how privacy concerns have changed

over time and across age groups.

C2015 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume25, Number 3, Autumn 2016, 539–562

540 Journal of Economics & Management Strategy

consumer protection, see FTC (2012). Furthermore, Brill (2011) addresses the important

question of how the FTC might balance competition issues with consumer protection

concerns arising in the context of privacy. In particular, should governments regulate

how firms can collect and exchange customer-specific information such as surfing habits

on the Internet, or should firms be trusted to engage in self-regulating as far as privacy is-

sues are concerned? Consumer protection law as well as competition law play important

complementary roles for privacy protection. Hammock and Rubin (2011) emphasize that

high priority should be given to systematic economic analysis of the effects of consumer

privacy protection.

Intuitively, weaker privacy protection may facilitate the design of more aggres-

sive poaching offers. These offers may compensate consumers for their switching costs,

thereby making it possible for these consumers to benefit from intensified competi-

tion. On the other hand, within the framework of an established customer relationship,

an incumbent firm may also be able to exploit weak privacy protection by designing

consumer-specific prices, thereby offsetting the potential benefits from more aggressive

poaching offers. More precisely, with weak privacy protection the firm could target high

prices to those inherited consumers who have strong preference for its brand. It is ex

ante impossible to evaluate the price effects of relaxed privacy protection on industry

profits and consumer surplus without a formal analytical study.

In this study, the degree of privacy protection determines the extent to which

firms can set prices based on consumer-specific information. We evaluate the effects

of mandating firms to adhere to different degrees of privacy protection on industry

profits, consumer surplus, and total welfare. More precisely, we compute, evaluate, and

compare market performance associated with the following three increasing levels of

privacy protection:

rNo privacy (N): Each firm collects information about its customers’ specific preferences

and is mandated to share it with other firms in the industry.Sharing can be facilitated

through, for example, a system of information exchange between the firms.3

rWeak privacy protection (W): Each firm collects information about its own customers’

preferences, but is not allowed to share this information with other firms.

rStrong privacy protection (S): Firms are not allowed to collect information about their

customers’ preferences. However,firms can identify their previous customers and set

different prices to consumers switching from competing brands relative their own

customers.

The present study solves for the price equilibria associated with each of these three

degrees of privacy protection.4In particular, we focus on the following questions: How

do profits depend on the degree of privacy protection? How do different degrees of

privacy protection affect consumer and total welfare? Our benchmark assumption is

that consumers do not view pricing conditional only on their purchase history (what

3. It should be emphasized that this study does not analyze the incentives of firms to engage in information

exchange. The perspective is that of a policy analysis, where we impose differentregimes of privacy protection

and compare the resulting outcomes. Mandated information exchange is a central feature of many industries,

for example the lending industry.Jappelli and Pagano (2002) and Hunt (2005) provide good overviews in this

respect.

4. A conceivable and more strict definition of privacy would be to define complete privacy protection,

which requires firms to set uniform prices. We do not include complete privacy protection in our analysis,

because, as we will make clear later on, a significant number of studies have presented comparisons of

the performance of uniform pricing with the performance under various forms of price discrimination, for

example, behavior-based price discrimination.