Arnold Kling  

Peak Load Pricing and Mental Transaction Costs

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Comments of the Week, 2003-03-... The Budget Debate, VI...

Clay Shirky used (coined?) the term mental transaction costs to describe the problem with using micropayments (small payments to download articles or music). I believe that economists tend to over-rate the value of peak-load pricing systems, because they fail to take into account mental transactions costs. As Andrew Odlyzko has pointed out, consumers prefer flat-rate pricing even though it costs them more.

In the electricity market, to avoid severe shortages, such as occurred in California two years ago, power companies must induce consumers to reduce their demand at peak times. Often, the reduction is small. However, having electricity rates that vary according to the pressure on capacity imposes costs on the power companies to develop the metering system as well as mental transaction costs on consumers, who would have to spend time monitoring electricity prices.

An alternative, used where I live, is to allow consumers to sign up for a program that allows rationing at peak times. In exchange for a discount on my electric bill, I allow the electric company to shut off my air conditioner for 15 minutes at a time when demand is high. This saves on mental transaction costs, and it accomplishes what otherwise might be accomplished by peak load pricing.

Stephen Kirchner points to this debate about spectrum pricing. Eli Noam argues for a peak-load pricing scheme for spectrum usage. Lawrence Lessig argues that the Internet has avoided over-congestion without peak-load pricing, and that the wireless spectrum could do the same.

For Discussion. For communication networks, what sort of pricing mechanisms would provide incentives against congestion while minimizing mental transaction costs?


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COMMENTS (2 to date)
Joe Lanter writes:

The scheme used for cell phones seems to work quite well. By offering rationed "minutes" at peak times, but virtually unlimited use at off-peak hours, the companies can provide a disincentive for use during peak times. It would seem to me that mental costs would not be an issue after a short period of adjustment. If a provider frames a service as having a "peaking" demand, the consumer will begin to alter his/her behavior accordingly. By providing financial (dis)incentives for peak use, the congestion can be diminished.
P.S. Of course, this would be moot if we would agree to increase the load capacity with infrastucture improvements. I've rarely heard people complain that the government spends too much on streets. Is internet access a public good? It should be.

The problem with the electricity example that you cite is that, like Bush's 'Freedom Car' program, it might not be the most efficient way to resolve the problem (i.e. smooth the grid load, thus avoiding both blackouts and unnecessary new power plants).

Yes, real time pricing for electricity would initially have high 'mental transaction costs' for customers, but that's why intermediaries still have value. There's a business opportunity for someone to come in and install all sorts of automated, energy-price-aware appliances, energy-efficient light bulbs, etc. and then manage the interface between the home and the utility's variable pricing.

(I am extrapolating the existence of technologies/products that do not yet have wide commercial availability, but it's a chicken and egg situation right now - due to the high level of industry and regulatory stasis as a result of a century of monopoly regulation, there is virtually no availability of RTP at the retail level. This reduces the potential for economies of scale in manufacturing of both advanced metering systems (which are almost cost-effective as it is) as well as other automation equipment.)

Also, as Joe noted above, consumers can adjust pretty easily to the simpler (although less effective) Time of Use-style pricing, where there are just a few big bands with different prices. Just as we all know to avoid driving during rush hour when possible, it's easy enough to run the dishwasher or washing machine a few hours later, even if the appliance isn't yet smart enough to wait for the cheaper power on its own.

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