Wired for price discrimination

The "Internet of Things" is coming; are you ready? Mattel Inc. is. The Internet of Things refers to the near future in which most consumer goods will be computerized and constantly connected to the Internet.

In the sunny depiction of the Internet of Things, life will become easier and more convenient. For instance, your refrigerator will simply order more milk when you run low. But there are also some dark predictions about the effects of the Internet of Things on our privacy. As if to illustrate these predictions, Mattel has rolled out a new "Hello Barbie" doll, which is computerized and Wi-Fi enabled. Hello Barbie includes a voice-activated microphone to record speech around her, as well as a speaker, software, and the ability to send recorded conversations over the Internet back to Mattel's servers, where they will be analyzed so the doll can engage in more personalized conversations with her child owner. Hello Barbie will be like Siri, but with an intense interest in getting to know all about you and then telling her boss.

The future is not only going to consist of more pervasive monitoring. Because of the legal treatment of software distribution, the Internet of Things will provide manufacturers the opportunity to sell their products in a different and more personalized way. Contract and property law will combine with the Internet of Things to allow never-before-seen price discrimination by manufacturers.

Early in the history of software distribution, there was controversy as to whether software transactions should be treated as sales or licenses. Software makers argued they were granting consumers licenses to copyrighted software, and therefore could attach many restrictions. The most prominent restriction they sought was prohibition of resale. This was important to them because under the first sale doctrine of copyright law, after an owner sells a copyrighted good, the purchaser can do anything she wants with it. Some consumers disagreed and argued that transfers of software for money constituted sales. Courts, however, sided with software makers, and characterized the transactions as licensing events.

To price discriminate, software makers have used their ability to restrict consumers through software licenses. Price discrimination occurs when a seller offers items to various consumers at different prices not determined by the seller's cost. An example is when Microsoft sets distinct prices for its Office software for individuals, families and students. In the seller's ideal world, it would sell to every consumer at the highest price she is willing to pay. In the real world, this is impossible to achieve, both because sellers do not know the top price that each customer is willing to pay, and because if a seller offers some customers the product at low prices, those who can buy it cheaply will turn around and resell to those willing to pay more. Thus, generally the best sellers can do is divide buyers into a few groups and offer different pricing to consumers depending on the group to which they belong.

The ability to license software and better monitor consumers that will come with the Internet of Things, however, will allow manufacturers to price discriminate in more refined and pervasive ways. Once most consumer products contain software, manufacturers will be able to separately license the software and thereby prohibit resale of the products containing it. These restrictions against resale will be combined with better knowledge of consumers' willingness to pay via increased monitoring and will result in more precise price discrimination.

To be sure, consumers sometimes do not like price discrimination, and backlash may temper it. But manufacturers are clever in their methods. They may allow consumers to enable extra features for more money, charge to personalize the way consumers interact with goods, or set a lower price for a good and combine that with variable monthly subscription prices for Internet functionality.

Some commentators have realized the potential for control that the Internet of Things provides and are calling for legal changes to prevent manufacturers from using software licenses to impose post-sale restrictions on their goods. This would be a mistake. Counterintuitively, the increased price discrimination in the sale of Internet of Things devices will likely be beneficial overall. When manufactures engage in more perfect price discrimination, those able to pay more - generally wealthier consumers - will indeed do so. The benefit will come when those willing to pay less - usually poorer consumers - are able to buy goods they could not otherwise have purchased.

Because software-enabled devices are subject to copyrights and patents that often give monopoly or semi-monopoly power, manufacturers can sell these products significantly above cost. If a manufacturer can only pick one price to offer consumers, it will be a higher, monopoly price. But if a manufacturer can engage in sophisticated price discrimination, it will offer various higher prices to consumers willing to pay more, and various lower prices to consumers only able to pay less.

Furthermore, because a large part of the cost of making technical products is incurred in the research and development phase, the cost of selling one more item - the marginal cost - is often much lower than the average price needed to make up the full costs of designing and manufacturing the product. Accordingly, if a manufacturer can prevent resale, it can sell some products to generally poorer consumers at significantly lower prices. There is no disputing that price discrimination is not good for everyone - low prices for some are made possible by high prices for others. But if we want economic growth and more goods for those able to pay less, we should not change anything about the law of software licensing.