1. PowerPoint Slides © Michael R. Ward, UTA 2014

2. Econ 5313
Bagel Shop
You run a small bagel shop. You have engaged in a market study to categorize your customers’ willingness to pay for a meal (coffee & bagel) into 8 equal sized groups: ($5.00, $4.50, $4.00, $3.50, $3.00, $2.50, $2.00, $1.50). All of your costs are fixed except labor and materials, which cost $2.25 per meal sold.
What price should you charge for a meal?

3. Bagel Shop Sort them from highest WTP to lowest
Econ 5313
Bagel Shop
Sort them from highest WTP to lowest
If you charge them their WTP or lower, they purchase
So this generates a demand curve
Price
Quantity
Total Rev MR MC
Profit
$5.00 1
$4.50 2
$4.00 3
$3.50 4
$3.00 5
$2.50 6
$2.00 7
$1.50 8

4. Multiply price times quantity to get total revenue
Econ 5313
Bagel Shop
Multiply price times quantity to get total revenue
Price
Quantity
Total Rev MR MC
Profit
$5.00 1
$4.50 2
$9.00
$4.00 3
$12.00
$3.50 4
$14.00
$3.00 5
$15.00
$2.50 6
$2.00 7
$1.50 8

5. Bagel Shop Multiply price times quantity to get total revenue
Econ 5313
Bagel Shop
Multiply price times quantity to get total revenue
Calculate the MR from the change in total revenue
Price
Quantity
Total Rev MR MC
Profit
$5.00 1
$4.50 2
$9.00
$4.00 3
$12.00
$3.00
$3.50 4
$14.00
$2.00 5
$15.00
$1.00
$2.50 6 7
($1.00)
$1.50 8
($2.00)

6. Bagel Shop Multiply price times quantity to get total revenue
Econ 5313
Bagel Shop
Multiply price times quantity to get total revenue
Calculate the MR from the change in total revenue
Compare this with the MC
Price
Quantity
Total Rev MR MC
Profit
$5.00 1
$2.25
$4.50 2
$9.00
$4.00 3
$12.00
$3.00
$3.50 4
$14.00
$2.00 5
$15.00
$1.00
$2.50 6 7
($1.00)
$1.50 8
($2.00)

7. Verify by calculating the profits at each price
Econ 5313
Bagel Shop
Verify by calculating the profits at each price
Price
Quantity
Total Rev MR MC
Profit
$5.00 1
$2.25
$2.75
$4.50 2
$9.00
$4.00 3
$12.00
$3.00
$5.25
$3.50 4
$14.00
$2.00 5
$15.00
$1.00
$3.75
$2.50 6
$1.50 7
($1.00)
($1.75) 8
($2.00)
($6.00)

8. Econ 5313
Bagel Shop
Does your profit maximizing price depend on the total number of consumers?
Not if the groups are equally sized
Suppose your market research tells you that the four lowest value groups are all students. Should you offer a student discount?
If so, how much?

9. Student Discounts Separate the last four students from the rest
Econ 5313
Student Discounts
Separate the last four students from the rest
Prices charged to them do not affect the revenues from non-students
Like a whole new demand curve
Maximize profits here yield a different “student” price
Implement with a $1.00 student discount
Price
Quantity
Total Rev MR MC
Profit
$3.00 1
$2.25
$1.00
$2.50 2
$5.00
$2.00
$0.50 3
$6.00
($0.75)
$1.50 4
($0.00)
($3.00)

10. Student Discounts You earn $5.25 in profit from the $4.00 price
Econ 5313
Student Discounts
You earn $5.25 in profit from the $4.00 price
You earn an additional $1 from the students at a $3.00 price
You have increased profits through “price discrimination”
That is, P1/MC1  P2/MC2
What did we need for this to work?
Need to be able to identify the groups which are less demand elastic from the groups which are more demand elastic (high WTP versus low WTP)
Need to prevent arbitrage

11. Econ 5313
Price Discrimination
Identifying demand segments is more common than you might imagine
Could be due to differences in demand
Ex Student or senior citizen discounts
Ex Household services (e.g., maid, yard, plumber) in Park Cities versus South Dallas
Ex Early bird special or matinee pricing
Ex Air travel with a Saturday stay-over
Ex Air travel booked a month in advance versus ‘week of’
Ex McDonalds on Cooper versus Champs d'Elise
Ex Patented pharmaceutical product in US versus Canada versus Mexico versus Haiti

12. Differences in Demand Could be due to differences in rivalry
Econ 5313
Differences in Demand
Could be due to differences in rivalry
Ex Cowboy boots in Texas versus Boston
Ex Pharmaceutical product in US pre-patent expiration versus in Brazil with price regulation
Ex Mobile phone service in US with many carriers or in the Philippines with few carriers
Always indicates difference in demand elasticity across groups
Direct = observe group membership
Indirect = infer group membership

13. Limiting Arbitrage Limiting Arbitrage can be tricky
Econ 5313
Limiting Arbitrage
Limiting Arbitrage can be tricky
What if group 3 could pass for students?
They get the lower price and your whole scheme falls apart
What if business travelers can book months in advance?
What if Florida retirees can travel to Canada for their medicines?

14. Econ 5313
Limiting Arbitrage
Need a cost to arbitrageurs that you do not face to prevent reselling product
High transportation costs
Shipping boots from Texas to Boston
High transactions costs
Prosecuted for re-importing possibly counterfeit drugs
Services versus products
Hard to resell a haircut or dry cleaning
No price discrimination scheme will work perfectly
You usually just need that there is not ‘too much’ arbitrage

15. Econ 5313
Limiting Arbitrage
In 1997 a global cell phone manufacturer (IRK) was losing sales in the Philippines because competitors offered a better, lower price.
The company charged a world-wide uniform price of $120
It sold most of its phones in wealthy countries
Important future markets, such as the Philippines, were ignored because demand was lower in less wealthy countries (“normal good”).
Competitors were under-pricing IRK in these future markets and were selling more.

16. Econ 5313
Limiting Arbitrage
Once sales hit 10%, diffusion from luxury to mass market happens very quickly

17. Econ 5313
Limiting Arbitrage
The Philippine market was quickly approaching the crucial 10% penetration point
At which this Rule of Thumb applies: the firm with the largest share at 10% penetration will grow to 40% w/out marketing when market penetration grows to 30%
The company considered charging a lower price in the Philippines to generate more sales before the 10% point
IRK reduced prices in Philippines to $90
Problem: the Philippine phones used the same standard (GSM) as higher-priced European phones

18. Econ 5313
Limiting Arbitrage
Thus, arbitrage threatened sales in other countries (15 million units annually)
To prevent this, the company sold models with SIM-locks, which allow calls only in the local operators’ networks
Turkish hackers broke the SIM-lock
15,000 phones were sold to Western Europe by the hackers before IRK changed the SIM-lock algorithm and again prevented arbitrage
Have to change the algorithm every few years in a never-ending “arms race”

19. Our typical profit maximizing situation from simple pricing
Econ 5313
Capturing Value
Our typical profit maximizing situation from simple pricing D P* Q P MC MR

20. What do the Blue regions represent?
Capturing Value
What do the Blue regions represent? P* D Q P MC MR

21. Capturing Value
These are part of the value that the product generates in excess of your cost going to the consumer P* D Q P MC MR
Un-captured Consumer Value

22. Price discrimination is a way to try to capture this
Capturing Value
Price discrimination is a way to try to capture this P* D Q P MC MR
Un-captured Consumer Value

23. Capturing Value
With perfect price discrimination, you would charge all N customers a different price and capture it all
Not possible but is the limiting case we aim for P* D Q P MC MR
Un-captured Consumer Value

24. Modified Simple Pricing
Econ 5313
Modified Simple Pricing
Simple rule for different groups
Set contribution margins to the inverse of their respective elasticities
(P1-MC1)/P1=1/|e1|
(P2-MC2)/P2=1/|e2|
So if you know demand for cowboy boots is less elastic in Boston (luxury good, few competitors), set prices higher

25. Price Discrimination Online
Econ 5313
Price Discrimination Online
Computer companies often sell to a wide variety of users with a wide variety of price sensitivities
To identify the price sensitivity of on-line customers Dell’s website has different categories in which users can shop (such as home & home office, small & medium business, large business, etc.)
Under the “Small and Medium Business” category, a laptop was listed as $1,197
Under the “Large Business” category, the same computer was $1,339 a 12% increase
This scheme allows Dell to sell identical computers at different prices based on the consumers’ price sensitivity

26. When is it Illegal? Robinson-Patman Act
Econ 5313
When is it Illegal?
Robinson-Patman Act
Prohibits providing a price discount on a good sold to another business
The Robinson-Patman act was designed to protect independent retailers from chain-store competition by preventing the chains from receiving supplier discounts
Defenses against a Robinson-Patman lawsuit are:
That the price discount was cost-justified; or
The price discount was given to meet the competition
Europe has similar, and stronger, laws
Promotional allowances or vertical integration may avoid Robinson-Patman liability

27. Blood Tests In Northern Europe (Ger., Holland and Scandinavia)
Econ 5313
Blood Tests
In Northern Europe (Ger., Holland and Scandinavia)
Medical blood test machines sell for $25
50 test strips sell for $22
12 million boxes of test strips
Southern Europe
Italy and Spain: insurance companies’ reimbursement rates are 50% lower
Firm has capacity to produce additional 6 million
Potential market for test strips is $200 million per year
If they acquire 30% of the market, they can make an additional $60 million in revenue

28. Blood Tests Lower prices to Southern Europe To prevent arbitrage
Econ 5313
Blood Tests
Lower prices to Southern Europe
Test strips at $11
Measurement devices at $12.50
To prevent arbitrage
ROM key ensures north/south incompatibility
Also reduce the measurement speed of the Southern devices from 11 to 25 seconds
It is important that these slower devices cost less, so that the price difference has some cost justification (so it wont violate antitrust laws)

29. Econ 5313
Distribution
Your family business produces a secret recipe salsa and distributes it through both smaller specialty stores and chain supermarkets. The chains have been demanding sizable discounts but you do not want to drop your prices to the specialty stores. How can you legally accommodate the chains without losing profits from the specialty stores?
Must alter it somehow to justify differences in prices
High volume implies full pallets which are cheaper to distribute

30. Econ 5313
Customer Perceptions
Consumers do not like knowing they are paying higher prices than others
“Only Schmucks pay Retail”
For example, when shown a box for a promotional code on a website, click-through rates decline
Online shoppers were less likely to complete their transactions once they realized a coupon existed that they didn’t have
People don’t like knowing they are schmucks
So, if you are price discriminating, it is important to keep the scheme secret if you can

31. From the Blog Chapter 13 Cable Car in Barcelona
Econ 5313
From the Blog
Chapter 13
Cable Car in Barcelona
Weekend airline purchases
Women’s Haircuts?
Price Discrimination at the FTC!

32. Econ 5313
Main Points
Price Discrimination is charging different markups to different groups of customers
Must be able to identify differences in WTP (elasticity)
Must be able to limit arbitrage
Engage in “simple pricing” for each group
Typically additional customers are served than would be under simple pricing