The value of personal information in vertically differentiated markets with privacy concerns

Information technology and data science have enabled firms to practice price discrimination on an unprecedented scale, arousing privacy concerns among their customers. When consumers know a firm is practicing price discrimination, they may take costly measures to conceal their identities so as to avoid being targeted. Governments, in turn, may require firms to disclose their price discrimination practices in order to protect consumers’ interests. In this paper, we consider a pricing game in which two competitive, vertically differentiated firms may implement price discrimination using information purchased from a third-party data supplier. We determine (1) the firms’ optimal pricing strategies when consumers can (or cannot) safeguard their personal information by paying a “privacy cost”; (2) the data supplier’s optimal sales strategy and the value of the data; and (3) the effects of the cost of consumer privacy and of the disclosure of price discrimination practices on firms and consumers. We find that for the data supplier, the optimal sales strategy is always to sell exclusively to one firm, regardless of whether consumers are aware that the firm practices “personalized pricing”. The question of which firm the data broker should sell to depends on what we term the “quality-adjusted cost”—the ratio between the additional cost of the high-quality product and the magnitude of the quality difference. If this ratio is smaller than 1/2, the data broker will sell to the high-quality firm; if greater, to the low-quality firm. Second, by comparing two scenarios involving the disclosure or non-disclosure of price discrimination, we find, somewhat counter-intuitively, that mandatory transparency increases industry profits and decreases consumer surplus when only the high-quality firm has access to consumer data. When only the low-quality firm has such access, transparency lowers industry profits once the quality-adjusted cost exceeds a certain threshold. When the quality-adjusted cost is in the intermediate range, mandatory transparency decreases social welfare. This means that the disclosure of price discrimination practices may have unfavorable consequences from a social planning standpoint. Thus, the new insights our findings offer into competitive personalized pricing in vertically differentiated markets will be useful not only to managers in the industry but also to regulators.