The Market for “Melons”: Quantity Uncertainty and the Market Mechanism

Markets as diverse as labor, healthcare, restaurants, transportation, mobile telephony, and broadband Internet services often have providers that offer flatrate pricing; usage-based pricing; or both. Using agent-based simulation and analysis of an idealized model of a duopoly with one flat-rate and one usagebased provider, we demonstrate that flat-rate plans are unsustainable in a perfectly competitive market with independent, decentralized decision-making by active, self-selecting, rational utility maximizers engaged in a stochastic, multistep decision process driving iterative price adjustment. In this duopoly, all customers except those with maximum usage either sequentially or simultaneously defect to usage-based plans, with the remaining heaviest users having equal surplus under either plan. In the absence of usage-based alternatives, a type of market failure can occur. The proximate cause is consumption quantity dispersion. Information asymmetry may also play a role, but in distinction to Nobel Laureate Dr. George Akerlof’s quality uncertainty in a “Market for ‘Lemons’”, where the seller is advantaged by asymmetric information regarding the quality of the product or service being sold, in what we’ll call the “Market for ‘Melons’” it is the buyer that may be advantaged by asymmetric information regarding the ex-ante quantity of planned consumption. This asymmetric information is self-defeating, however, since as it eradicates the viability of flat-rate pricing, so it does thereby its own value. Moreover, we argue that effects such as adverse selection and moral hazard have less to do with quality uncertainty, information asymmetry, or morality, than with rational choice by consumers with dispersed consumption under flat-rate pricing: when a provider offers a flat-rate plan, marginal consumption has zero marginal cost to the consumer, who thereby may be rationally indifferent to level of consumption. Other flat-rate market models, such as a monopolist, whose individual customers, rather than defecting, decide to increase their consumption to be equal to or greater than the average, also fail to be sustainable or differentiated. Either all usage evolves in the limit to equal, maximal consumption, with equivalent payments as under pay-per-use; an unbounded spiral of escalating consumption occurs; or insufficient capacity degrades the customer experience. In practice, many factors ranging from transaction costs to behavioral economics and cognitive biases impact the application of these results. 1 The author is employed by a Fortune 10 company; however the views expressed herein are his own. The Market for “Melons:” Quantity Uncertainty and the Market Mechanism 2 © 2010, Joe Weinman