Marketing and Privacy Concerns - CiteSeerX

February 13, 2006

Marketing and Privacy Concerns Luc Wathieu1 Harvard Business School, Soldiers Field, Boston, MA 02163, [email protected]

When finer consumer information becomes available, competing firms sometimes target consumers too finely, disrupting scale economies prematurely. This leads to excessive product variety or to the wasteful exclusion of certain consumer types. This paper suggests that privacy concerns emerge in anticipation of these effects. This interpretation of the privacy issue yields a number of counter-intuitive but realistic implications regarding the identity and behavior of concerned consumers. Market intermediaries and consumer communities that aggregate diverse consumer types to coarsen market access provide the most adequate resolution of privacy concerns. Key words: privacy, consumer information, market access, segmentation, scale economies, free entry, inefficiency, customization, consumer communities

1. Introduction Following advances in information and communication technologies, firms have been able to handle increasingly detailed consumer segmentations. This trend has coincided with the emergence of privacy concerns, causing governments and firms to limit the dissemination and use of consumer information (see Hui and Png 2006 for a review). From the standpoint of conventional economic wisdom, privacy sentiments and the accompanying restrictions are difficult to understand. They clash with the dogma that market information is critical for economic efficiency. The purpose of this paper is to demonstrate that privacy concerns might be a symptom of underlying economic inefficiency that is present even in situations of free entry and vigorous price competition. The problem arises from the tendency of competing firms to use consumer information too aggressively, segmenting consumers with a degree of fineness that precludes efficient use of scale economies. Fine-grained segmentation is a central piece of marketing doctrine, whereas its opposite, mass marketing, is frequently regarded as a thing of the past despite its staying power in the real world. But even as it ignores the subtler shades of consumer needs, mass marketing generates two (connected) major benefits: low prices, and the indiscriminate inclusion of a broad range of diverse consumer types. This paper argues that free entry competition will, in the absence of privacy protection, sometimes cause these important benefits to dissolve prematurely. 1

Thanks are due to the editor, the associate editor, four anonymous reviewers, Alessandro Acquisti, David Bell, Marco Bertini, Allan Friedman, Teck Ho, Rajiv Lal, Ivan Png, Rafael Rob, Ozge Turut and seminar audiences at NYU, HBS, Dartmouth, Wharton, the Informs/Cornell Pricing Conference, HEC Montréal, and the AEA 2004 session on Privacy.

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Obviously, real life consumers’ privacy anxieties do not derive from a formal analysis of potential market inefficiencies. But it is realistic to consider that these anxieties correspond to an aversion to price increases and market exclusion. Analysis will show how this basic interpretation can help explain a number of puzzling observations commonly associated with privacy concerns. In particular, this theory explains why privacy concerns are not held unanimously (Hann et al., 2003), why, despite their intensity, they are addressed lethargically (Westin 2001), and why they might appear diffusedly even in the absence of a threat to disseminate personal information (Wathieu and Friedman 2005). Approaches to addressing privacy concerns warrant reexamination in the light of this theory. It is argued that neither government regulations nor privacy contracts between consumers and firms can completely dissipate privacy concerns. Rather, resolution must come from the action of market intermediaries that create value by enabling diverse consumers to identify each other while robustly aggregating their heterogeneous preferences into homogeneous, large-scale demands. Online communities, retailers, town and cities, professional and student associations, mutual companies, and other interest groups frequently play this role of favoring exchanges of information and allocating privileges within their diverse membership while providing a coarse access point for suppliers (e.g., Wathieu 2001, 2003). This paper argues that these mechanisms (which frequently constitute business opportunities) are an accurate response to privacy needs that might stem from increasingly refined consumer segmentations. 2. Related Literature A number of trends are distinguishable in the literature on privacy as it relates to economic efficiency. One camp seeks to characterize the economic benefits that accrue to weaker privacy protection, an approach articulated in Stigler’s (1980) opinion that “resources will be used less efficiently when [consumers] are less finely and accurately classified.” Essays by Posner (1981) and, more recently, Calzolari and Pavan (2005) and Acquisti and Varian (2005) analyze the opportunities afforded by the increased dissemination of consumer information. A popular opinion in view of such analyses is that there frequently exists a conflict between economic efficiency and an exogenous consumer predilection for privacy such that “there will be constant arguments about what trade-offs to make between privacy on the one hand, and security, economic efficiency and convenience on the other” (The Economist 2003). How firms should behave in the presence of this conflict has been the object of research by Hann et al. (2005) and Akçura and Srinivasan (2005). Closer to the present paper is the attempt by a few researchers, working from the intuition that privacy demands derive not from mere predilection but from an indirect utility that relates to real welfare concerns, to discover overarching causes for consumers’ privacy concerns. Taylor (2004), in a context in which information about purchase behavior in one market is useful to firms that compete in another market, demonstrates that a firm in the first market might decide to raise its price in order to elicit more diagnostic information useful in the second market. This mechanism can elicit privacy demands; consumers who anticipate the firm’s behavior might strategically misrepresent their preferences, contributing to the system’s inefficiency. Villas-Boas (2004) analyzes similar inefficiencies occasioned by strategic consumer behavior in a world characterized by consumer recognition, and Villas-Boas (1999), Iyer and Soberman (2000), and Chen, Narasimhan, and Zhang (2001), although they don’t focus

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specifically on privacy concerns, elucidate situations in which the mechanisms of information appropriation generate inefficient monopolistic positions. Hermalin and Katz (2006) examine, in a context of imperfect competition, the detrimental impact of consumer information on the resulting equilibrium, with particular emphasis on deadweight loss effects (whereby a monopolist excludes low-demand consumers) and adverse selection (whereby firms fail to employ higher-skilled workers). Hermalin and Katz insist, consistent with the theory advanced here, that better understanding of the inefficiencies behind privacy concerns might set the stage for a richer discussion of appropriate remedies. Specifically, they caution that endowing consumers with sellable privacy rights might not resolve privacy concerns. The present paper argues that a market-based solution to privacy concerns does exist if trade of privacy rights is not restricted to between consumers and firms, that is, if such trade is permitted as well between consumer types, perhaps through an intermediary or community. The general idea that competing entrants might engage in business stealing that incurs inefficient entry costs without creating compensating value for consumers is not new to this paper (see for instance Mankiw and Whinston 1986, Sutton 1991, Berry and Waldfogel 1999). The novelty here is the observation that such inefficiency is precipitated when finer consumer access becomes available, and the analysis, in a way that elucidates important aspects of the privacy debate, of its dynamic impacts in terms of winners and losers. 3. Model

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3.1. Consumers and Access Consumers are of two types. Type-A consumers prefer good A to good B and type-B consumers prefer good B to good A. Each consumer type has a reservation price of v for the preferred good and a reservation price of !v for the less preferred good ( 0 < " < 1 is a measure of taste adaptability). Type-A consumers number n A , type-B consumers n B = n " n A . That n A > n B renders type-A “mainstream consumers” and type-B “niche consumers.” To address the market a firm needs an access system, that is, a channel of communication ! and distribution. The model considers two types of access systems. A coarse access system, ! between type-A denoted by M, gives access to all ! n consumers absent the ! ability to distinguish and type-B consumers. To market a good (A or B) through this system costs m, to market both goods costs 2m.2 A fine access system, denoted by M' , allows firms to separately address type-A and type-B consumers. To market a good through this system to type-A consumers costs m'A , while the cost to access type-B consumers is m'B . Only fine access systems that dominate the coarse access system are considered !(i.e., it is assumed that m'A " m , m'B " m , and min{m'A ,m'B } < m ). ! ! 3.2. Firms ! ! To create a firm costs nothing and firms incur only market access costs. Because they vary with the number of goods marketed but are independent of the number of units sold, access costs are deemed conventional fixed costs and are associated with scale economies (i.e., the average cost of selling a good decreases with the number of units sold). Because incurring access costs yields no long-term benefit, it should not be considered a barrier to entry (McAfee, Mialon, and Williams 2004). 2

Economies of scope (Silk and Berndt 1993) are omitted for simplification.

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Firms compete on the basis of a marketing plan consisting of three elements: a product assortment, corresponding price(s), and a market access system. These elements are determined simultaneously (i.e., none is deemed more adjustable than any other). A plan to market n A units of good A at price v through the coarse access system would be denoted {qA = n A ; pA = v; M } ; a plan to offer targeted offers to all consumers at price v through the fine access system would be denoted {qA = n A ,qB = n B ; pA = pB = v;M'} . Plans must be feasible with respect to demand ! structure (i.e., demand equals supply at the posted prices). ! In combining free entry and economies of scale with simultaneous determination of quantities and prices we define a situation of contest whereby each market will be won by one !firm without implying any monopoly rent, consistent with Baumol, Panzar and Willig’s (1982) theory of contestable markets (see also Baumol and Willig 1981). As in Bertrand competition, firms in this setting undercut any profitable marketing plan until a zero-profit condition is reached. But demand heterogeneity renders zero profit insufficient as an equilibrium condition because entrants might also compete by offering a product assortment that better addresses the specific needs of some consumer type (if such plan were feasible and profitable given the structure of access costs). Thus, the marketing equilibrium obtains with a marketing plan that makes it impossible for a new entrant to offer an alternative feasible plan that would yield a strictly positive profit. 3.3. Privacy Concerns Privacy concerns are analyzed by comparing an initial situation in which only coarse access system M is available with a situation in which fine access system M' becomes also available. The availability of the latter is interpreted as a breakdown with respect to consumer privacy. Privacy concerns, being defined by a preference for reducing { M, M'} to { M } , involve a negative valuation of fine consumer access. A consumer’s !loss of surplus in the presence of M' can be termed an individual privacy concern. From the perspective of a social planner (or of consumers who do not know their preference type ex ante and express a general privacy ! economic!value associated with the sentiment), one can term a social privacy concern the total ! prevention of fine access, taking into account equilibrium changes in total value consumed and total access cost incurred. Both types of privacy concerns represent a preference for the equilibrium outcomes that occur under coarse market access, not a direct preference for coarseness. However, privacy concerns as defined here might still be expressed in terms of distaste for practices linked to M' such as intrusion (greater abundance of targeted marketing materials) and customer identification. 4. Coarse Access Equilibrium ! This section establishes the baseline marketing equilibrium that prevails when only coarse access M is available. The equilibrium implies outcomes with respect to product variety and price levels that vary widely as a function of the ruling parameters. Conditions under which fine access M' can generate privacy concerns are identified in the following section. The possible equilibrium states can be characterized with reference to three concepts. - Pooling occurs when all consumers consume the same good at a low price justified by the low marketing cost attributable to scale economies. Pooling might be termed “mass! marketing” inasmuch as consumers, notwithstanding their heterogeneity, are all accorded the same treatment. 4

- Self-selection occurs when firms make both goods (A and B) available to all consumers at prices high enough to justify the implied marketing waste. Self-selection might be referred to as a form of “mass customization” in that it achieves product customization while addressing all consumers indiscriminately. Intuitively, it occurs when the average access cost m/n is sufficiently low, when the niche segment is of significant size, and/or tastes are not too adaptable. These circumstances might be favored by channel or communication efficiencies, or by an enlargement of the consumer base (Waldfogel 2003). - Neglect occurs when the market overlooks one consumer type while addressing consumers of the other type with their preferred good at a high price. Neglect will emerge under coarse access when niche consumers are not adaptable enough to justify pooling, nor numerous enough to justify making good B widely available for self-selection. In the absence of market access refinement, a progressive decrease in market access cost (e.g., consequent to a reduction in mass communication or logistical costs) will occasion a realistic shift from neglect to pooling (mass marketing) to self-selection (mass customization). At the outset, the following basic characterizations of the marketing equilibrium are useful (proofs are presented in appendix). Lemma 1. (Behavioral Consistency) In any coarse access marketing equilibrium, all consumers of a given type adopt the same consumption behavior. Lemma 2. (Equilibrium Effectiveness) In any coarse access marketing equilibrium, at least one consumer type obtains its preferred good. The implication of lemmas 1 and 2 is that only five non-trivial product quantities assortments

(qA ,qB ) could possibly be featured in the marketing equilibrium plan: (0,n) , (n,0) , (n A ,n B ) , (0,n B ) , and (n A ,0) . Examining the conditions that make these assortments sustainable leads to ! ! !

proposition 1, with respect to which it is convenient to think in terms of average marketing cost demand heterogeneity (m n ) , niche customers’ desire to get what they want ((1" #!)v ) , and ! ! (relative weight of niche consumers, ). n n B A ! Proposition 1. (Coarse Access Marketing Equilibrium) ! When only coarse access system M is available, the marketing equilibrium plans are fully ! characterized as follows: • Pooling (with good A): {qA = n; pA = m n;M } if "v # m n > (1$ " )v n B n A • Pooling (with good B): {qB = n; pB = m n;M } if "v # m n > (1$ " )v n A n B • Self-selection: {qA = n A ,qB = n B ; pA = m n A , pB = m n B ;M } if (1" # )v n B n A $ m n and v " m n B ! ! • Neglect: {qA =!n A ; pA = m n A ;M } if min ! {m n B ,m "n} > v > m n A

! ! Proposition 1 implies that a firm can pool consumers of different types to exploit economies ! of scale and lower average marketing cost to create exchange opportunities that would otherwise ! ! be uneconomical (“Fordism”). Formally:

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Corollary 1. (No Exchange Condition) Taking into account the opportunity to leverage economies of scale through pooling, a trivial (no exchange) equilibrium occurs only when m > max{n A v, "nv} .

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Figure 1 supports intuition by highlighting two important demand-side factors that favor a pooling equilibrium: demand homogeneity and taste adaptability. Gains in marketing efficiency, on the other hand, appear to favor pooling over neglect and self-selection over pooling. m (marketing cost)

m (marketing cost)

nv

nAv neglect

no exchange

no exchange

n!v

nAv neglect pooling

n(1-!)v

(demand heterogeneity)

self-selection

0

pooling

nBv

1

Assuming ! = 2/3

nB nA

(taste adaptability)

self-selection

0

nB n

1

!

Assuming n B n = 1/3

" " Figure 1: Coarse Access Marketing Equilibrium (Representative Cases)

" of proposition 1 for the relationship between In terms of more sensitive implications competition and economic efficiency, consider the conventional wisdom that vigorous competition begets economic efficiency (e.g., by favoring efficient firms and discouraging counter-productive rent-seeking behaviors). It is apparent from the present analysis that this does not hold when the amount of variety offered in the economy is not pre-determined. The problem is that competing firms do not make a practical distinction between consumer switching and real value creation. The condition for value-adding self-selection would be m < (1" # )vn B , that is, the value created for type-B consumers by moving away from pooling would compensate for the extra access cost incurred. The actual self-selection equilibrium condition is the weaker condition, m n < (1" # )v n B n A . Indeed, to profitably compete against a zero-profit pooling plan ! requires ( m n + (1" # )v ) n B > m , which means that the entering firm does not compare access cost with the additional value it creates, but rather checks whether the total value extracted through competitive pricing breaks even with the marketing expense. The result is an ! exaggerated incentive to produce more variety. ! Corollary 2. (Case of Inefficient Variety) When marketing cost is at an intermediate level such that ((1" # )vn B ) n n A $ m > (1" # )vn B , the marketing equilibrium generates inefficient product variety. Earlier demonstrations of an imperfect link between free entry and market efficiency ! consequent to business stealing (Mankiw and Whinston 1986) relied on the proliferation of competing firms in a context of perfect product substitutability. In the present zero-profit 6

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framework, inefficiency is also consequent to exaggerated business stealing, but it relies on the proliferation of product varieties in a context that requires imperfect product substitutability ( " < 1) and heterogeneous consumer types. Note that a monopolist would cause an even greater problem of inefficient variety, switching to self-selection whenever nv " 2m > n#v " m (i.e., m < (1" # )vn , a weaker condition than the socially optimal m < (1" # )vn B or the competitive rule m < (1" # )v nn B n A ). The second potential source of inefficiency evident from proposition 1, notwithstanding free entry, is that one ! cannot rule out a marketing equilibrium whereby all consumers adapt to the ! niche product (good B) when more utility would derive from joint adoption of the mainstream ! product!(good A). Corollary 3. (Case of Inefficient Standard) When "v # m n > (1$ " )v n A n B (i.e., marketing cost, taste adaptability, and/or market heterogeneity are/is high), the marketing equilibrium can sustain an inefficient situation whereby every consumer adjusts to non-mainstream preferences. ! Note that the equilibrium with niche good B imposed on all consumers is never a unique equilibrium (pooling with mainstream good A is always an equilibrium for the same set of parameters) and can be seen as a coordination failure (Heller 1986). It would be avoided by assuming that the tastes of the mainstream are less adaptable than the tastes of the minority. The adoption of a “wrong” standard of consumption in the presence of scale economies has been studied before, albeit under different competitive assumptions (Farrell and Saloner 1985, Katz and Shapiro 1986). 5. Fine Access and the Emergence of Privacy Concerns In this section, the expansion of the set of available access systems from { M } to { M, M'} is examined, with particular attention to identifying equilibrium changes that might coincide with individual or social privacy concerns.3 Privacy concerns only arise when the baseline situation involves pooling. Indeed, the advantage of pooling is that the access cost is shared across !a large!number of diverse consumers. When an entrant uses a fine access system to target a specific consumer type, scale economies are dismantled and the remaining consumers necessarily suffer from an externality. This mechanism can lead to these consumers being excluded, or faced with a high-price customized offer that constitutes a loss of surplus and signals the end of benefits customarily associated with mass marketing. In contrast, if the baseline case involves self-selection or neglect, the availability of a fine access system cannot cause an externality, because in such cases the access costs are spread over homogenous consumer bases. In particular, availability of a fine access system necessarily disrupts any baseline self-selection equilibrium and replaces it with a customization equilibrium whereby all consumers continue to get their preferred good but at a lower price that reflects reduced marketing waste.

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It is assumed throughout this section that there is no coordination failure in the baseline case (i.e., the pooling equilibrium under M entails consumption of mainstream good A).

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Proposition 2 formalizes this reasoning by establishing that privacy concerns arise only when the baseline situation involves pooling and when a fine access system, by favoring one consumer type, disrupts scale economies in marketing to the detriment of the other consumer type.

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Proposition 2. (Individual Privacy Concerns) Individual privacy concerns arise only under two sets of conditions. Niche concern: %"v # m n > (1$ " )v n B n A (initial pooling) ' & m'A n A < m n (mainstream consumers gain) ' ( m'B n B > (1$ " )v + m n (niche consumers lose) Mainstream concern: %"v # m n > (1$ " )v n B n A (initial pooling) ' & m'A n A > m n (mainstream consumers lose) ' ( m'B n B < (1$ " )v + m n (niche consumers gain) The following corollary highlights several characteristics of privacy concerns apparent from proposition 2. Corollary 4. (Remarks on Individual Privacy Concerns) (1) Privacy concerns occur only when the baseline equilibrium involves pooling of consumer types. (2) Privacy concerns are never unanimous. (3) Privacy concerns arise from the cheaper access of another consumer type. (4) The first order cause of privacy concerns is a loss of consumer surplus experienced as a result either of market exclusion or of a price increase linked to increased cost of targeted marketing. Figure 2 relies on the proof of proposition 2 to map all possible equilibrium shifts occasioned by the availability of a fine access system and identify those shifts associated with individual privacy concerns.

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Figure 2: Possible Equilibrium Shifts Occasioned by the Availability of a Fine Access System

Now, which of these equilibrium shifts correspond to a social privacy concern, a negative value of making a fine access system available, accounting for all losses and gains incurred in the economy? Overall, the various statements in the following proposition suggest that sufficiently intense individual concerns signal the presence of a social privacy concern. In other words, there is (unfortunately) no way to diagnose a social privacy concern just based on the type of the complaining consumers or the immediate cause of their complaint (whether exclusion or price increase).

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Proposition 3. (Social Privacy Concerns) (1) The presence of individual privacy concerns is a necessary, but not sufficient, condition for a social privacy concern. (2) If mainstream (type-A) consumers are neglected when fine access system M' becomes available, there exists mˆ 'B , with mn B n + (1" # )vn B > mˆ 'B > 0 , such that if mˆ 'B " m'B " 0 there is no social privacy concern (despite a mainstream privacy concern and market exclusion), and if mn B n + (1" # )vn B > m'B > mˆ 'B there is a social privacy concern. ! (3) If niche (type-B) consumers are neglected when fine access system M' becomes ! ! ! available, and if "v < m n B , there exists mˆ 'A , with mn A n > mˆ 'A > 0 , such that if mˆ 'A " m'A " 0 there is no social privacy concern (despite a niche privacy concern and ! market exclusion), and if mn A n > m'A > mˆ 'A there is a privacy concern. ! (4) If "v > m n B neglect of niche consumers (consequent to the availability of fine access ! ! ! system M' ) is always a source of a social privacy concern. (5) If there is a shift from pooling to customization there is no social privacy concern unless ! m'A +m'B > m + (1" # )vn B .

! Figure 3 below supports the intuition for part (5) of proposition 3. The intuition for part (2) is that if type-A consumers are neglected when the fine access system becomes available it must be ! that v is low and the coarse access pooling equilibrium bordered a situation of no-exchange with little surplus attached for consumers. If the availability of the fine access system increases the 9

surplus for type-B consumers, the total effect might be positive. Part (3) is interpreted similarly to suggest that if type-B consumers are easily shifted to a neglect state, the pooling equilibrium must have been producing little social value in the first place. Part (4) suggests a condition under which a social planner will not want to neglect the importance of type-B consumer demands and in which pooling is particularly valuable. m'B

Niche Concern (Type-A Win, Type-B Lose)

= Social Concern

m + (1" # )vn B

!

m

! Pooling

(m n + (1" # )v )nB !

Customization Without Concern

Mainstream Concern (Type-A Lose, Type-B Win)

mn A n

m

m'A

Figure 3: Illustration of Proposition 1 and Proposition 3(5) !

6. The Function of Communities

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Analysis thus far has shown that free entry competition will, on many occasions, lead to situations of inefficient product variety or consumer exclusion. Entrant firms can be expected to adopt new access systems that favor a single consumer type but prematurely disrupt scale economies. This section explores remedies to the resulting social privacy concern. Although remedies could take the form of regulations, individual privacy concerns might motivate further economic exchanges of privacy rights, suggesting the possibility of a market that would complement the shortcomings of free entry competition on the market for goods. Specifically, privacy concerns create a business opportunity for marketing intermediaries (e.g., retailers, consumer communities) able to provide the technology needed to coordinate diverse consumer types and support an efficient degree of coarsening of market access. An obvious remedy to privacy concerns is to assume a benevolent dictator who imposes a ban (or tax) on its use whenever M' occasions a social privacy concern. But according to propositions 2 and 3 social privacy concerns will sometimes coincide only with the concerns of mainstream consumers and sometimes only with the concerns of niche consumers, and therefore it is impossible for any voting rule to consistently manage social privacy concerns. ! Corollary 5. (Impossibility of Efficient Access Bans) There is no voting rule capable of establishing a system of bans and taxes to handle social privacy concerns efficiently under all circumstances. 10

This difficulty could be removed by asking consumers to vote on a menu of bans and taxes before they are made aware of their consumer type, assuming the existence of such an ex ante state. One might consider, for example, regulating genetic privacy (Shankar 2003) ahead of the appearance of genetic tests. Because social privacy concerns emerge from an analysis of the total value created for consumers in a competitive economy, average voters ignorant of their type will make socially appropriate choices.4 But these choices, being dynamically inconsistent, will be revoked ex post when consumers know their type and are exposed to specific finer access systems. The discussion to this point assumes that government ultimately controls access rights and can choose between permitting public access to any firm (as assumed earlier in the case of M' being freely available to every possible market entrant) and banning access to all firms. A natural alternative to these options would be to endow consumers with the right to protect their own privacy, that is, to retain or sell their right to be accessed. But this turns out to be no different ! from making property rights public (consistent with Hermalin and Katz 2006). Indeed, in all instances in which a social privacy concern is present, one consumer segment will see its surplus increase and should seek to sell access, creating for the remaining segment a non-negative incentive to sell its own access (as max{mA ,mB } " m ). Corollary 6. (Impossibility of Efficient Access Trading between Firms and Consumers) Allowing trade of privacy rights between firms and individual consumer types leads to an ! to making fine consumer access freely available. equilibrium equivalent The discussion to this point continues to make the false assumption that the opposing interests in the privacy issue are firms (which value finer access) and consumers (who sometimes want privacy). But according to the present theory, firms in equilibrium do not earn a positive profit in any case, and a firm trying to negotiate exclusive access rights would easily be forced to leave all resulting rents on the table, given the threat of free entry. More logically connected with the present theory of privacy is the idea of permitting trade of access rights between consumers: consumers of the type who want exposure might receive compensation from consumers of the type who want privacy, in exchange for remaining private and prolonging the coarse access system. When the privacy concern of one consumer type is greater than the benefits to the other when firms consider switching to a finer access system, transfers between consumers could compensate unconcerned consumers for their willingness to remain pooled. In the absence of social privacy concerns, the demands of privacy are less than those of exposure and deals between consumers would not be feasible. Thus, there is for an intermediary equipped with the appropriate technology (e.g., a community or retailer) a theoretical opportunity to implement transfers between consumers and coarsen consumer access when entrants threaten to introduce inefficient fine access systems. Potential problems with this remedy are that (1) consumers of one type might pose as the other in order to receive a transfer (e.g., a social benefit in the context of a community, a targeted discount in the case of a retailer), and (2) the intermediary could sell its knowledge of consumer types to a self-interested firm. Although the details associated with

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Rodrick and Fernandez (1991) suggest that voting rules often are incapable ex ante of implementing decisions that would be democratically acceptable ex-post, after winners and losers are identified. The present analysis suggests that regulation of privacy suffers from the opposite curse.

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these problems are beyond the scope of this research, one can readily formulate a communitybased remedy to privacy concerns as follows. Proposition 4 (Efficiency of Generalized Access Trading) Assuming provable preferences and the prohibition of information re-sell, if free trading of access rights is permitted between consumers (or their representative) as well as with firms, granting individualized privacy rights resolves social privacy concerns. In the presence of fixed marketing cost, free entry does not guarantee efficient handling of preference externalities and social privacy concerns are engendered by the premature disruption of mass markets. In this section we have argued that solidarity exchanges among consumers (directly motivated by fears of exclusion and price increases) could create value by preserving a degree of access coarseness greater than that pursued by competing entrants. Cities, for example, might be viewed as managing the coexistence of diverse consumer types and providing commercial suppliers with a coarse access system (Quiley 1998, Steenburgh, Ainslie and Engebretson 2003). Service companies, retailers, and online communities could also be described as aggregators of diverse consumer types, maintaining cohesiveness towards suppliers while internally managing various sub-groups (based, for example, on “loyalty” or intensity of use) internally tagged or “branded” (Deighton 2005) to receive differentiated privileges within the confines of these entities. Buying groups in markets such as consumer goods and insurance (Wathieu 2001, 2003) typically find that their existence depends on striking a balance between promoting a joint identity outside of the group and masking diversity (or the defense of privacy) within the group. 7. Conclusion Competing firms able to identify and individually address specific types of consumers with targeted offers will do so notwithstanding that such action might raise the average cost of marketing the (mainstream) good previously consumed by the targeted consumers. This externality might imply for other consumers an effect of surplus reduction or even market exclusion. The resulting disutility indirectly caused by the availability of a finer access system is a realistic source of individual privacy concerns, which sometimes may override the benefits associated with finer access and targeting, generating a social privacy concern. Thus, firms in the presence of finer-grain consumer information are sometimes unable to handle economies of scale efficiently, even in the presence of zero-profit, free entry competition. The model used to demonstrate these effects was characterized by two consumer types with adaptable tastes on the demand side, and fixed marketing costs combined with free entry competition on the supply side. Viewed in this perspective, an analysis of privacy concerns reveals a number of testable implications in the areas of circumstances, nature of potential solutions, and locus of concern. Taking these in order, (1) privacy concerns are likely to occur in product categories where it is costly to invite self-selection and expose all consumers to all goods, (2) privacy concerns can be addressed by consumer communities and market intermediaries that form and dissolve, creating a buffer against the tendency of competing firms to reach exaggeratedly fine segmentations and (3) the locus of the concern is those consumers who don’t directly benefit from firms being better informed about differences between consumer types.

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This theory may explain why privacy concerns are often perceived as remote, difficult to control, and complex. Privacy concerns are linked to changes in the marketing cost structure, not merely to dissemination of personal information. They may correspond to transitory states arising from incomplete or imbalanced progress in segmentation technologies. Therefore the adoption of finer access systems that provide substantial marketing cost reductions without excluding important consumer types will not raise privacy concerns. The idea that the coarse aggregation of diverse consumer types might be a value-adding activity in the presence of dysfunctional segmentations is a realistic complement to the usual notion that retailers and marketing intermediaries primarily seek to zoom in on segments that share common traits. Appendix

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Proof of Lemma 1. Consider the possibility that some type-B consumers choose good A and others (say, n'B < n B of them) good B, which is conceivable only in a situation of indifference in which "v # pA = v # pB (i.e., (1" # )v = pB " pA ). Because 0 < " < 1, this requires that pA < pB , in which case all type-A consumers are buying good A. Consequently, only n'B < n B consumers support the marketing of B. If this were to occur in equilibrium, applying the zero-profit ! condition n'B pB " m = 0 , pB = m n'B > m n B , and a new firm could enter, undercut this price ! ! ! ! slightly and attract all type-B consumers while securing a profit n B ( m n'B "#) " m > 0 . There thus ! exists no marketing equilibrium under which type-B consumers are split between consuming good A and good B. Consider now the possibility that some type-B consumers choose good B ! ! and others to consume nothing, which can occur only if there is indifference between the two ! type-A consumer choosing good B. This choices, that is, v = pB , which is incompatible with any cannot be sustained as an equilibrium because all type-B consumers could profitably be attracted at a price between v and m n B . Finally, consider the possibility that some type-B consumers choose good A and others choose to consume nothing. This can occur only if "v = pA and ! 0 > v " pB , in which case a firm could enter at price pB < v , attract all type-B consumers, and earn a profit. A similar line of reasoning can be used to show that it is impossible to have a ! marketing equilibrium in which type-A consumers behave non-homogenously.  ! ! choose good B and type-B consumers to choose Proof of Lemma 2. For type-A consumers to good A would require that "v # pB > v # pA and "v # pA > v # pB , which conditions cannot hold simultaneously. For type-A consumers to consume good B and type-B consumers to consume nothing would require that "v > pB # m n A and pB > v , which is also impossible. It necessarily follows that if type-A consumers consume good B type-B consumers consume good B as well. A ! ! similar line of reasoning proves that if type-B consumers consume good A type-A consumers consume good A as well.  ! ! Proof of Proposition 1. (1) Assortment (0,n B ) can be ruled out as a marketing equilibrium because of the implication, owing to the zero-profit condition, that pB = m n B , and if v " m n B it must be true that v > m n A , which represents an opportunity to channel good A to type-A consumers at a profit. (2) Assortment ( n,0) requires that both types of consumers agree to ! consume good A, that is, that pA " #v . Because the zero-profit condition ! ! further imposes !

13

! !

!

! ! !

! !

! !

!

! ! !

! ! ! !

pA = m n , m n " #v is required. A new entrant could earn a profit by offering good B to type B consumers, unless is true, which requires v " pB > #v " m n $ n B pB " m < 0 m n B > (1" # )v + m n , which is equivalent to m n > (1" # )v n B n A . A new entrant could earn a profit by offering good B to all consumers unless ! is true, which simplifies to " v # p > v # m n $ v # p > " v # m n % np # m < 0 ( ) B B B !) ( is always true. A new entrant could offer good A (m n " (1" # )v > pB ) $ m n > pB , which ! exclusively to type A consumers, but profitability ( pA > m n A ) cannot be reached at a price that undercuts pA = m n . There thus exists an equilibrium plan {qA = n; pA = m n;M } if "v # m n > (1$ " )v n B n A . (3) To find a marketing equilibrium plan that features assortment participation, and self-selection constraints and (n A ,n B ) it is necessary to check zero-profit, ! establish no profitable entry with a different assortment. A new ! ! entrant with assortment ( n A ,0) could profitably attract all type-A consumers unless pA " m n A . Similarly, pB " m n B is required. These two conditions, together with the zero-profit condition n A pA + n B pB = 2m , lead to prices pA = m n A and pB = m n B . Participation constraints v " pA # 0 and v " pB # 0 thus ! reduce to v " m n B . Self-selection (behavioral separation of types) imposes ! ! v " m n A > #v " m n B and v " m n B > #v " m n A , only the latter being binding given that ! . It is equivalent to . A new entrant!could offer only good A 1" # v $ m n " n n n n > n ( ) ( ) A B A B A B ! ! ! to both ! consumer types and earn a profit as long as v " m n B < #v " m n , in which case (1" # )v $ mn A n B n! is required. As n A < n , n A n B n > ( n A " n B ) n A , resistance to a new “pooling” entrant ! is sufficient to guarantee self-selection. A new entrant that offers (0,n ) could earn a profit as long as v " m n A < #v " m n , in which case (1" # )v $ mn B n A n is required, but ! this condition, (1" # )v $ mn A !n B n , is weaker. There thus exists an equilibrium marketing plan ! {qA = n A ,qB = n B ; pA = m n A , pB = m n B ;M } if (1" # )vn B n A $ m n and ! v " m n B . (4) An assortment ( n A!,0) (implying neglect of type-B consumers) can be sustained in equilibrium if ! v " pA!# 0 (participation), pA = m n A (zero-profit), "v < m n A (exclusion of type-B consumers), assortment ( n,0) ), and! v < m n B (no possibility to "v < m n (no profitable entry with pooling ! target ! type-B consumers separately). The marketing plan {qA = n A ; pA = m n A ;M } is thus equilibrium if min n A . (5) An assortment (0,n ) can be sustained in ! {m n B ,m "n} > v > m ! equilibrium if pB = m n (zero-profit) and m!n " #v (participation of both consumer types). ! Moreover, no entrant can profitably address ! type-A consumers separately if pB = m n ) simplifies to (v " p! A > #v " pB ) $ n A pA " m < 0 is true, which (accounting for ! m n > (1" # )v n A n B . An entrant could successfully offer pooling with good A if ! ! that is, but a negative profit, pA < (" #1)v + m n , v " m n < #v " pA , ((" #1)v + m n)n # m = (" #1)vn < 0, is implied. !

Proof of Proposition 2. The!proof considers each equilibrium case from proposition 1 (except pooling with good B), identifies the new equilibrium when M' becomes available, and, if there was a choice between { M } and { M, M'} , examines the implied privacy preference of each consumer type. (1) Starting from a self-selection equilibrium in which only M is available, the appearance of M' becomes an opportunity for an!entrant to post prices pB = m n B " # and/or pA = m n A " # (" > 0) that undermine the self-selection equilibrium at a profit m " #n B " m'B > 0 ! !

! !

!

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! !

! !

!

!

!

! ! !

!

and/or m " #n A " m'A > 0 . Imposing the zero-profit condition yields the new “customization” equilibrium {qA = n A ,qB = n B ; pA = m'A n A , pB = m'B /n B ;M'} , which implies no change in product assortment, at least one lower price, and a universal preference for { M, M'} (i.e., there is ! no privacy concern). (2) Starting from a neglect equilibrium in which only M is available, if m'A " m and m > m'B > n B v the equilibrium marketing plan remains unchanged. If m'A < m and ! m'B > n B v the price associated with the initial (neglect) equilibrium can be profitably undercut ! and, imposing zero-profit, the new neglect equilibrium marketing plan is {qA = n A ; pA = m'A n A ;M'} , which is preferred by type-A consumers and does not occasion any ! ! loss for type-B consumers. If m'B " n B v an entrant can make a profitable offer to type-B consumers and the initial neglect equilibrium is not equilibrium in the presence of M' . Imposing the zero-profit condition, the customization equilibrium prevails and all consumers are better off. (3) q = n ,q = n ; p = m' n , p = m' /n ;M' {A A B B A } A A B B B ! Starting from a pooling equilibrium in which only M is available, !four cases should be considered. (3.1.) If m'A n A " m n and m'B n B " m n + (1# $ )v , availability of a fine access system does not undermine the pooling equilibrium, which persists without privacy concerns. (3.2.) If m'A n A < m n and m'B n B < m n + (1" # )v , the pooling marketing plan (equilibrium when only M profitably undermined by getting the preferred good to both ! is available) can be ! consumer types with greater consumer surplus attached. Imposing the zero-profit condition leads to the customization equilibrium, with no privacy concern implied. (3.3.) If m'A n A < m n but ! m'B n B " m n + (1#!$ )v , an entrant can use M' to profitably disrupt the pooling plan for the market for good A; imposing the zero-profit condition, good A will be priced at pA = m'A n A . Consumption of good A by type-B consumers is no longer supported!by scale economies and the lowest possible price is m n B , which a competitor using M' can undercut by posting ! m'B n B (" m n B ) and selling preferred good B. But if m'B n B > v , the new equilibrium plan ! {qA = n A ; pA = m'A n A ;M'} involves neglecting type-B consumers who, because they lose surplus when M' is ! made available, become concerned with privacy. If, instead, ! v " m'B n B > m n + (1# $ )v , the customization! plan described earlier is equilibrium, albeit accompanied by a privacy concern for type-B consumers who “get what they want” but lose !surplus relative to the pooling equilibrium that prevails when only M is available. (3.4.) If m'A n A " m n but m'B n B < m n + (1" # )v , an entrant can compete against a pooling equilibrium by getting type-B consumers what they want at a profit. If m'A n A > v " m n , type-A consumers can be neglected since the marketing of good A is not supported by economies of scale. Equilibrium is then {qB = n B ; pB = m'B n B ;M'} , which implies an individual privacy ! concern for type-A consumers. If v " m'A n A > m n , the customization equilibrium obtains with ! a privacy concern for type-A consumers. Finally, were there no exchange equilibrium under M, the neglect or customization equilibrium could arise under M' , weakly preferred by all ! privacy concern).  consumers (hence, no ! Proof of proposition 3. (1) If the initial equilibrium was self-selection, the availability of M' can ! no change in gross value created for only cause a shift to the customization equilibrium with consumers (vn ) and a decrease in total access cost from 2m to m'A +m'B ; if there was no initial exchange, the availability of M' can only coincide with new access costs to the ! extent covered by the value created for consumers; if the initial situation involved neglecting the niche

!

!

!

!

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!

! !

!

consumers, previously served consumers will pay less and newly served consumers (if any) will pay a price that covers their access cost. Starting from a pooling equilibrium, if there is no individual privacy concern the changes yield increased surplus for all consumers, which means no social privacy concern. In all the other cases (i.e., a pooling equilibrium when only M is available, a non-pooling equilibrium when M' is available), a social privacy concern occurs when SPC = m " #vn B + max{vn B " m'B ,0} " min{m'A ,vn A } < 0 . (2) If mainstream consumers are ! neglected, SPC = m " (1" # )vn B " m' !B "vn A , which reaches an upper bound when m'B = 0 , at which point SPC = m + ((1" # ) n B " n A )v , which is negative if v > m ( n A " (1" # ) n B ) > m n A . Taking into account that m'A n A > v when type-A consumers are neglected, such that m!n A " m'A n A > v , there cannot be a social privacy concern when ! m'A = 0 . When mn B n + (1" # )vn B = m'B , a lower bound is reached at SPC = mn A n " vn A < 0 . By ! ! monotonicity, there must exist mn B n + (1" # )vn B > mˆ 'B > 0 that has the property stated in the ! proposition. (3) If niche consumers are neglected, SPC = m " #vn B " m'A , which has two bounds, ! SPC = mn B n " #vn B < 0 (see the conditions of pooling equilibrium) when m'A is at its upper ! bound mn A n , and SPC = m " #vn B when m'A is minimized at 0. That m n < "v (the pooling ! equilibrium condition) does not imply m n B < "v , although if the latter were false there would be ! no social privacy concern when m'A = 0. Using monotonicity, this observation leads to statements ! (3) and (4) of proposition 3. Statement (5) is straightforward.  ! ! ! ! ! ! References Acquisti, Alessandro and Hal R. Varian. 2005. Conditioning Prices on Purchase History. Marketing Science 24 (3) 367-381. Akçura, M. Tolga and Kannan Srinivasan. 2005. Customer Intimacy and Cross-Selling Strategy. Management Science 51 (6) 1007-1012. Baumol, William J. and Robert D. Willig. 1981. Fixed Costs, Sunk Costs, Entry Barriers, and Sustainability of Monopoly. The Quarterly Journal of Economics 96 (3) 405-431. Baumol, William, John C. Panzar, and Robert D. Willig. 1982. Contestable Markets and the Theory of Industry Structure. Harcourt Brace Jovanovich, New York, NY. Berry, Steven T. and Joel Waldfogel. 1999. Free Entry and Social Inefficiency in Radio Broadcasting. RAND Journal of Economics 30 (3) 397-420. Calzolari, Giacomo and Alessandro Pavan. 2005. On the Optimality of Privacy in Sequential Contracting. Journal of Economic Theory, forthcoming. Chen, Yuxin, Chakravarthi Narasimhan, and Z. John Zhang. 2001. Individual Marketing with Imperfect Targetability. Marketing Science 20 (1) 23-41. Deighton, John. 2005. Consumer Identity Motives in the Information Age. S. Ratneshwar and David Glen Mick, eds. Inside Consumption: Frontiers of Research on Consumer Motives, Goals, and Desires. Routledge, London. Farrell, Joseph and Garth Saloner. 1985. Standardization, Compatibility, and Innovation. Rand Journal of Economics 16 70-83. Hann, Il-Horn, Kai-Long Hui, Tom S. Lee, and Ivan P.L. Png. 2003. The Value of Online Information Privacy: An Empirical Investigation. AEI-Brookings Joint Center for Regulatory Studies, Related Publication 03-25 (October). 16

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