Presentation on theme: "Price discrimination The practice of charging different consumers different prices for the same good Two major flavors: - Direct price discrimination:"— Presentation transcript:
1 Price discriminationThe practice of charging different consumers different prices for the same goodTwo major flavors:- Direct price discrimination: based on observable characteristics of customers- Indirect price discrimination: making offers available to all consumers and letting them choose the offer that is best for themPrice discrimination is also known as value based pricing
2 Examples American Airlines’ yield management system Senior-citizen discount at a movieDiscounts to airline frequent flyersQuantity discounts such as ‘buy one and get the second at half price’Newspaper coupons and inserts
3 Issues for a long distance telephone company What are the types of potential customers?How will customers choose plans?Can customers ‘mix and match’ the plans?How will rivals react?
4 Illustrative examples International pricing by pharmaceuticalsMethyl methacrylate from Rohm and Haas: arbitrage anyone?Hand-me-down by Armani: what about snob appeal?IBM LaserPrinter E: it can be considerably costly to offer low quality- “…IBM has gone to some expense to slow the LaserPrinter in firmware so that it can market it at a lower price” (PC Magazine, May29, 1990)Sony MiniDisc
5 Illustrative examples Niagara Mohawk Power Corporation: an offer you can’t refuseIBM’s punchcard metering: a high marginal cost and a low fixed charge=illegal tying?Buying paint from an airline
6 Direct price discrimination Conceptually, the simplest pricing toolCharge customers more or less, depending on their identity or typeSome means of identifying customers:-location-other possessions or purchases-status-age-employment-genderThe goal is to identify customers characteristics with value that customers place on the firm’s products
7 Conceptualizing price discrimination The building block is the concept of price elasticityThe ‘monopoly pricing rule’ states that the profit-maximizing price-cost margin is(p-mc)/p=1/є, where є=elasticity of demand; p=price; mc=marginal costClearly, the profit maximizing price is higher when demand is less elasticA firm would like to set as price for each customer so that the monopoly pricing rule would hold for that customer’s demand
8 Student vs non-student prices .PricePriceNon-student demandStudent demandmcQuantityQuantity
9 Price elasticity and competitive advantage Cost advantage (low C vs competition)Benefit advantage (high B vs competition)High price elasticity of demandModest price cuts gain lots of market shareShare strategy: Underprice competitors to gain shareModest price hikes lose lots of market shareShare strategy: Maintain price parity with competitors (let benefit advantage drive share)Low price elasticity of demandBig price cuts gain little market shareMargin strategy: Maintain price parity with competitors (let lower cost drive higher margin)Big price hikes lose little market shareMargin strategy: Charge price premium relative to competitors.
10 Impediments to direct price discrimination Informational: it is not easy to observe customer’s willingness to payCustomers with inelastic demand have an incentive to conceal his factDifferent prices to different people create opportunities for arbitrage
11 Factors preventing arbitrage Transportation costsLegal impediments to resalePersonalized products or servicesThin markets and matching productsInformational problems
12 Indirect price discrimination Major advantages-not necessary to observe consumer characteristics-arbitrage is prevented by the design of the pricing scheme
13 Coupons Common method of indirect price discrimination Work as a price discrimination tool because they are costly to useBased on the idea that people who are more price sensitive also have a low value of timeWhat about in-store coupons?
14 Quantity discountsThese include ‘buy-one-get-one free’ offers, frequent-buyer programs etcFew quantity discounts are based on costsLinear or ‘two-part pricing’ schemes are sufficient for most indirect price discrimination schemes:- a fixed charge and a marginal, per unit charge
15 Quantity discounts Generally a modest number of offers is adequate The key element of the design is the prevention of arbitrageAlso, control of price-risk from frequent demand shifts is important
16 Risk as price discrimination A product may be sold for $10 or for $11 with a 1% chance of winning $90If state lottery payouts are 50% ($1 returning 50c), then 1% chance of winning $90 would be worth $1.80Thus the bundle represents a discount of 80c to those who like gamblingApplications to internet auctions
17 Product bundling Combining two (or more) products into one E.g. computers are often bundled with a monitor and/or printerThere is no price discrimination in Pure BundlingMixed Bundling is a very effective form of price discriminationSurprisingly, like co-promotions this can be done with unrelated products also
18 Product bundlingConsider a business suit and a drill selling for $300 and $75Assume the bundled product sells for $350The company is simultaneously offering a discount on the suit (for drill purchasers) and on the drill (for suit purchasers)Consider the perspective of drill purchasers
19 Product bundlingIf the initial prices were set at the profit maximizing level, the $25 discount on suits will not make much difference to profitsThe cost of the discount will be made up by more suit purchasesHowever, increased suit purchases also imply increased drill purchasesAnd that is pure profit for the firm!!
20 Peak-load pricingDuring peak capacity utilization, selling additional units reflects cost of adding capacityAt off-peak times, incremental costs are low since no capacity needs to be addedPeak-load pricing is about allocating the costs of capacity to the relevant demand
21 Peak-load pricingThis is important for airlines, hotels and electricity. Peak electricity costs can easily be five times the off-peak costsUsing average cost as indicator of incremental cost is ill-advised:Average cost will be much higher than incremental costs at off-peak times and vice versa at peak timesThus average cost pricing (average cost plus markup) may result in losses at peak periods and inability to recover cost of capacity
22 Yield management in airlines Main features:- seats reserved for full-fare passengers- discount seats are full of restrictions- there is dynamic price discriminationDynamic element is due to full-fare consumers appearing late in the processImportant to price the option value of the flexibility that is lost when a ticket is booked
23 Yield management in airlines Let there be full fare seats and discount seats with prices and >When to stop selling discount seats?Suppose q seats have been sold and Q-q remain out of a total QLet n be probability that next request comes from a passenger who will not pay full fareLet s be probability that the plane sells outThus seat sold at a discount today will displace a full fare passenger
24 Yield management in airlines Refusing to sell another discount seat produces revenue if:-next person to call will pay full fare (w.p. 1-n)-next person will not pay full fare and the plane sells out at full fare (w.p. n(1-s))It is better to sell an additional discount seat if> (1-n+n(1-s))Thus it is profitable to sell the discounted ticket ifns >Most important fact is probability that plane is full !
25 Yield management in airlines Implementation of this formula is a statistical problem of estimating n and sThis can be done through historical data or by managerial learning and judgmentFrom a pricing perspective the correct measure of capacity utilization is the proportion of full flights, rather then the proportion of occupied seats
26 Theatrical yield management Movies have a definite venue release patternDelay in each increases value of the formerBut, can there be a credible commitment??VenueWeek after theatrical releaseTheatrical releaseAirlines and hotel pay-per-view16Home video27Home pay-per-view34Premium cable (HBO)61Network TVSubstantial variation
27 Competition and price discrimination The attractiveness of price discrimination makes it very prevalentSome firms use it to offer discounts to attract rival’s customers, but do not offer discounts to their own best customersThis is usually a mistake!!The ‘best’ customers of one’s rival will usually be one’s price sensitive customersThey will require lower prices to switchIt’s much better to increase loyalty among one’s own customers
28 Opportunism and exclusive dealing In B2B contracts, after-the-fact opportunism by sellers can be major concernFranchisors opening new stores whenever franchisees are successful‘Holdup problems’ due to relationship-specific investments: e.g., electric power plant locates close to coal mine, but afterwards the coal mine raises its prices
29 Solving opportunistic pricing by sellers Create competition by licensingVertically integrate with the buyersLong-term contractsExclusive contractsMost-favored-customer clausesUniform, simple contracts
30 Price dispersion and sales Grocery stores announce sale items, and there is large variation in pricesThe price varies in unpredictable waysWhat explains price dispersion?A firm sells two different consumer types-well informed about competitive prices-uninformed consumers
31 Price dispersion and sales When a firm faces a mixture of consumers its prices should not be predictable to rivalsPredictable head-to-head competition for informed customers is unprofitableThus firms must run sales so that its prices cannot be forecast by rivalsAccording to the theory, sales promotions represent the balancing the profit from captive consumers and the additional sales to uninformed shoppers