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Tesla’s Tiered Pricing Is a Hurdle, but a Fair One

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Tesla, Elon Musk’s pioneering electric car company, originally offered its Model S sedan in two variants. The difference was a few lines of software code that restricted the energy available from one version’s battery.

A simple, over-the-air change in that code could instantly render the two cars’ battery output — and cruising range — identical. Yet the sticker price for the unrestricted model was thousands of dollars higher. (The company also offered variants of its Model X sport utility vehicle on similar terms.)

Tesla was engaging in what economists call price discrimination, the practice of charging different prices for essentially the same good or service.

Tesla provided a free upgrade to extend the range of its Florida customers as they tried to outrun Hurricane Irma in September. But the move provoked a backlash from critics who complained that Tesla had gratuitously constrained the restricted model’s range in the first place.

It’s easy to see why some took offense. But a closer look at the company’s pricing practices suggests that these complaints were misguided. Had the company not priced its offerings as it did, it would not have been able to offer the features that have made its cars so attractive to buyers. The Model S is an extremely fast luxury sedan and, despite some problems, has received generally good safety ratings. By some measures, it is environmentally friendly. Tesla has also had to invest in the extensive network of fast-charging stations without which electric cars would simply be impractical.

Those features were costly to develop. This year’s Model S starts at $68,000, but fully optioned models sell for almost $160,000. If Tesla priced every vehicle at $160,000, its sales would be far too small to cover its formidable development costs. To succeed, it must achieve greater scale, a goal that its new Model 3 sedan promises to promote. But that same goal is also served by its current pricing practices.

Tesla was transparent in its portrayal of its offerings. It told buyers that the premium prices for the unrestricted models were for software upgrades that unlocked the potential of the discount models’ batteries. Buyers who chose premium models might reasonably be viewed as having made voluntary contributions to the company’s development costs.

If Tesla had charged the same price to every buyer, smaller sales volumes would have required that price to have been even higher than for the premium models. Uniform pricing would have resulted in a worse outcome not only for the company but also for its customers.

That’s why it’s a disservice to call Tesla’s practice price discrimination. That label makes it almost impossible for neutral observers to approve.

As psychologists have long known, sounds that reach our ears provoke at least a weak valence — an emotional reaction to their intrinsic attractiveness or unpleasantness. “Puppy” evokes a positive valence, for example, while “snake” evokes a negative one.

Psychologists also explain that once we’ve experienced an initial valence, we activate a cognitive filter that tends to reinforce that assessment. If we react negatively upon first meeting someone, for instance, we tend to interpret ambiguous signals received during further interactions with that person as confirming our initial appraisal.

Is discrimination good or bad? For most people, the term evokes a strong negative valence. Any action bearing the label “discrimination” is destined to be viewed with initial skepticism — and with increasing disdain as time passes. That’s unfortunate in this case, because the consequences of Tesla’s pricing practices are completely benign.

In fact, companies like Tesla are practicing what might better be called the hurdle method of differential pricing. Under this method, sellers offer buyers a choice: They can buy the product at list price without further ado, or they can jump over some hurdle to be eligible for a significant discount.

Want a new stove? You can wait for the scratch-and-dent sales that occur periodically, or you can buy one right away at list price. A new blender? You can pay sticker price, or get a nice discount by mailing in a rebate coupon. In Tesla’s case, you could pay list price for an unrestricted car, or pay substantially less by tolerating the shorter range of a restricted model.

From the seller’s perspective, the ideal hurdle is one that only price-sensitive buyers are willing to jump. Such hurdles enable sellers to expand their sales by offering significant discounts without having to cut prices for everyone. Once you’ve spotted a few examples of the hurdle method in action, you will see it everywhere. You may even have trouble finding sellers who do not engage in some variant of the practice.

Because production is increasingly accompanied by large fixed research and development costs, differential pricing is becoming increasingly important. As the Duke University economist Philip Cook and I wrote in our 1995 book, “The Winner-Take-All Society,” roughly 80 percent of the cost of a computer in 1984 was in its hardware, and 20 percent in its software. Only six years later, that proportion was reversed, and this trend has intensified sharply since then.

Sellers with high fixed costs cannot remain solvent if they charge each buyer only a small markup over the cost of producing additional units. To cover fixed development costs, some buyers must pay substantially more than marginal cost.

Who better to shoulder that burden? The hurdle method allows buyers who care most about a product’s special features to identify themselves by their refusal to jump the seller’s hurdle. That those buyers end up paying a larger share of the product’s development costs is both fair and economically efficient.

Why discourage this practice by giving it a label certain to make people dislike it? Without effective ways to engage in differential pricing, many of the product design features that buyers care most about would quickly disappear.