# Lecture 15 Price Discrimination The law of demand tells us that demanders are different, and so are willing to pay different amounts (elasticity of demand.

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Lecture 15 Price Discrimination The law of demand tells us that demanders are different, and so are willing to pay different amounts (elasticity of demand differs and values are different—so different willingness to pay) The law of demand tells us that demanders are different, and so are willing to pay different amounts (elasticity of demand differs and values are different—so different willingness to pay) What it means: What it means: –Charge different prices to different consumers –Recognize the fact of some odd perceptions by most people

The Goal: Higher Profits “Whether it’s a deli or SAP, it’s always about differentiating and serving the customers so they want to come back to you.” “Whether it’s a deli or SAP, it’s always about differentiating and serving the customers so they want to come back to you.” Bill McDermott, CEO of SAP Americas SAP Americas tripled market share in four years by: segmenting customers into different groups based on their size, industry, location and needs—by getting to know their customers better.

A simple example Suppose demand for your product Suppose demand for your product is Q = 100 - P Could be Could be –One demander with declining willingness to pay, or –Different demanders with different willingness to different willingness to pay for one unit each MC is zero MC is zero The single price solution is The single price solution is P = \$50, Q = 50 So that TR = \$2500 \$ Q 0 100 50 D MR 100 50

The ideal solution Charge a different price for each unit (assume MC = \$0) Charge a different price for each unit (assume MC = \$0) Thus, P = \$100, \$99, \$98, \$97, ……, \$1 Thus, P = \$100, \$99, \$98, \$97, ……, \$1 Yields an average price of \$50 per unit; 100 units sold Yields an average price of \$50 per unit; 100 units sold –Then, TR = \$5000 (think of a real world example) Suppose there is one demander, then “all or nothing” pricing Suppose there is one demander, then “all or nothing” pricing –Take all 100 at a fixed fee of \$5000, or take nothing (a bag of diamonds at de Beers) In practice, multiple pricing classes are common In practice, multiple pricing classes are common –For example, an airplane with 100 seats may have 43 different prices

A common problem… How to change different prices? There are two key issues: There are two key issues: –Correctly identify demanders Age (retired or students) Age (retired or students) Appearance (local or not; rich or poor) Appearance (local or not; rich or poor) Time (of day or day of week) Time (of day or day of week) Language Language Gender (Ladies’ night) Gender (Ladies’ night) –Prevent resale (and be polite) Picture ID (airlines) Picture ID (airlines) Arbitrage difficult or not worthwhile (hotels) Arbitrage difficult or not worthwhile (hotels)

What is it, what do you do? Price discrimination is: Price discrimination is: –Price difference without cost difference, or –Equal prices, despite cost differences –Different prices based on slight differentiation in products (CD players—basic model to fancy model all from same plant—better use of plant capacity) Lower price for additional units Lower price for additional units –Regular customers—frequent buyer plan –Volume discounts Lower price to consumers with more elastic demands Lower price to consumers with more elastic demands –Low time cost (willing to search) –Local residents in resort areas (Disney World) –Ample information (low search cost) –Sales after main season (fashions)

Simple example Ethernet cables made in a factory in China for a U.S. company sold for: \$29.95 with brand name wrapper \$19.95 with chain store wrapper \$15.95 on eBay under no name Exact same product (purchased for \$3)

Cost-Side Data Use Wal-Mart and other large retailers use sales data (15 minute increments) from one year to forecast for the next year when peak customer loads will occur. Wal-Mart and other large retailers use sales data (15 minute increments) from one year to forecast for the next year when peak customer loads will occur. Employee schedules are set based on when they are likely to be most needed, getting away from traditional eight hour shifts. Employee schedules are set based on when they are likely to be most needed, getting away from traditional eight hour shifts. Customers served better; higher output per employee. Customers served better; higher output per employee.

Price Discrimination: Get Higher Profits Coke customers can buy one Coke for \$1 (the profit maximizing price) or a pack of six cans for \$3. Why would Coke offer the six cans for \$3? \$ \$1 Quantity MC D Q* MR 0 \$0.25

Price Discrimination Why would Coke offer the 6 pack for \$3? It sells to all customers at \$1 for one can, but also moves down the D curve and sells 5 more cans for \$0.40 each. Extra consumer surplus (profit) captured. \$ \$1 Quantity MC D Q* MR 0 \$.25 \$.40

Reward Loyal Customers Cingular, a large cellphone company, shows their reps a ranking of the value of every customer who calls to complain, to change service, etc. Cingular, a large cellphone company, shows their reps a ranking of the value of every customer who calls to complain, to change service, etc. Based on past history of revenue and problems from a customer, loyal customers are offered better deals on new phones, expanded service, etc. Bad customers are offered no special deals. Based on past history of revenue and problems from a customer, loyal customers are offered better deals on new phones, expanded service, etc. Bad customers are offered no special deals. The company can predict expected future revenue (and cost of service) from customers based on past history. The company can predict expected future revenue (and cost of service) from customers based on past history.

Dump High Cost Customers? When we sell products for the same price to all customers we price discriminate because some customers cost more to service. It may be more profitable to charge higher-cost customers more or get rid of them. Does the additional (marginal) revenue justify the additional (marginal) cost?

Example from Mail-Order Company The best customers buy but do not insist on extra service. 16% of customer base, but 40% of profits. The worst customers buy some but impose high costs on company by returning goods and other service demands. 25% of customers but only 15% of profits. Other customer groups in between these two. Management must decide—should the worst (high cost) customers be dropped or made to bear more of their costs by price discrimination? Is that possible?

Some Customers More Costly to Serve: Price Discriminate Between the Two High maintenance customers Low maintenance customers High maintenance customers Low maintenance customers impose greater costs on seller.impose fewer costs on seller. impose greater costs on seller.impose fewer costs on seller. D Higher cost customers Lower cost customers D MC MR Q highQ low P P Q/time £ £

Different Prices for Different Customer Groups Different groups of customers are likely to have different elasticities of demand. Price discrimination can exploit different willingness to pay. Group 1: Inelastic D Group 2: Elastic D Groups 1 + 2€ €€ Q QQuantity MC Di De Pi Pe Qi Qe MRe MRi MRi + MRe Qt=Qe+Qi MC →

Example Coach, a maker of expensive leather handbags and other goods, has two methods of sale: Coach, a maker of expensive leather handbags and other goods, has two methods of sale: 1. Full price at its own stores and at selected retailers (and on the web). Full price only; never any discounting. Average age of shopper is 35; average expenditure is \$1,100. 2. Discount outlet stores that sell last season’s products for less. Stores usually 100 km away from nearest full-price retailer. Average age of shopper is 45; average expenditure is \$770.

Example: Jewelry Retailing Signet Group (U.K.) operates two sets of jewelry stores in the U.S.: Signet Group (U.K.) operates two sets of jewelry stores in the U.S.: Kay Jewelers focuses on middle class with lower price diamonds, etc. 781 stores average \$1.65 million sales. Jared focuses on upper income with expensive diamonds and Swiss watches. 110 stores with \$5.6 million avg. sales.

How Do You Want Your Drink? Starbucks menu: Starbucks menu: Regular coffee\$2.05 Tall (small) cappuccino\$2.55 Caffe Mocha\$2.75 Grande (medium) latte\$3.35 Venti (large) cappuccino\$3.60 Venti mocha w/ vanilla\$3.85 Cost difference to make these different drinks?

Same Goods to Different Customers at Different Prices Tie the sale of different goods together after customer agrees to buy one. Based on sales history, you know what goods are complements. Tie the sale of different goods together after customer agrees to buy one. Based on sales history, you know what goods are complements. Example: KFC lists one item (chicken) at \$2.29. Customer buys it but does not order another item (drink) listed at \$1.09. KFC knows those items are complements. The cash register tells the clerk to offer the second item for \$0.71, so the total sale would be \$3.00. Example: KFC lists one item (chicken) at \$2.29. Customer buys it but does not order another item (drink) listed at \$1.09. KFC knows those items are complements. The cash register tells the clerk to offer the second item for \$0.71, so the total sale would be \$3.00. Where used, sales rise about 5% and profits rise even more. Must change offer frequently. Where used, sales rise about 5% and profits rise even more. Must change offer frequently.

Customers Do It Too Price Discrimination may be practiced by demanders who understand sellers’ MC. Price Discrimination may be practiced by demanders who understand sellers’ MC. Buyers’ clubs form to bring together individuals to use market power as a group. Buyers’ clubs form to bring together individuals to use market power as a group. Buyers such as Wal-Mart know that by making large orders the supplier can lower MC of production for it and offer lower price. Buyers such as Wal-Mart know that by making large orders the supplier can lower MC of production for it and offer lower price.

Observations about Consumer Perceptions People view magnitudes, not absolutes: People view magnitudes, not absolutes: A new radio is being sold for €100 at a store near you. A new radio is being sold for €100 at a store near you. You hear it is being sold for 50% less, €50, at a store 15 kilometers away. You hear it is being sold for 50% less, €50, at a store 15 kilometers away. Will you go there to buy it and save 50% or €50? Will you go there to buy it and save 50% or €50? Most people will. Most people will. A new car you want to buy is being sold for €20,100 at a dealer near you. A new car you want to buy is being sold for €20,100 at a dealer near you. The same car is being sold for €20,050 at a dealer 15 kilometers away. The same car is being sold for €20,050 at a dealer 15 kilometers away. Will you go there to save 0.25% or €50? Will you go there to save 0.25% or €50? Most people will not. Most people will not.

Exploiting Perception Buyers more likely to buy an apartment if first shown a dirty, overpriced apartment before shown an ordinary apartment at a fair price compared to if buyers are first shown a nice apartment at a higher price and then an ordinary apartment at a fair price.

Exploiting Perception Restaurants encourage customers to buy more and feel good about purchases by putting a few expensive items on the menu, such as a bottle of wine for \$400 or a bowl of bird nest soup for 400RMB, followed by more normal price wine and soup. Restaurants encourage customers to buy more and feel good about purchases by putting a few expensive items on the menu, such as a bottle of wine for \$400 or a bowl of bird nest soup for 400RMB, followed by more normal price wine and soup. The normal prices then look like a bargain. The normal prices then look like a bargain.

Perception from Sales Sales, or the perception of sales, work: Sales, or the perception of sales, work: Identical vacation packages (A and B) are offered: Identical vacation packages (A and B) are offered: A marked down from \$600 to \$500 B priced at \$400 that was on sale the day before for \$300. A sells more than B. A sells more than B.

Humans Are Risk Avoiders: Evidence from Real Experiments You are given a 50% chance of winning \$150 and a 50% chance of losing \$100. What is the expected value of this gamble? \$25 (\$75 expected win - \$50 expected loss) But most people refuse this bet. Most will not accept it until the winning is raised to \$200. Humans are genetically averse to losing or what is perceived to be losing. Humans are genetically averse to losing or what is perceived to be losing. This has odd effects on decision making.

Consumer Preferences An experiment run on e-bay: An experiment run on e-bay: 1. Offer certain goods at auction beginning at \$0 with a \$4 shipping charge added if purchased. 2. Offer same goods at auction beginning at \$4 because shipping included (and cost of \$4 shipping is noted). More shoppers went to the first auction and bought more of the good and ran the prices up higher. More shoppers went to the first auction and bought more of the good and ran the prices up higher.

Perception and Presentation Side-by-side comparisons matter to consumer valuation: Side-by-side comparisons matter to consumer valuation: Group A consumers bid on new dictionary with 10,000 words. Average: \$24 Group B consumers bid on dictionary with 20,000 words and torn cover. Average: \$19 Group C consumers shown same dictionaries side by side: Average bid \$19 for 10,000 word version and \$27 for 20,000 word version with torn cover.

Price Discrimination Question A store in Chicago sells suitcases for \$100. It will give you \$30 if you trade- in and old suitcase to get a new one. They throw the old suitcases away. Why do they cut the price to \$70 for the owner of old suitcases but not the other customers? A store in Chicago sells suitcases for \$100. It will give you \$30 if you trade- in and old suitcase to get a new one. They throw the old suitcases away. Why do they cut the price to \$70 for the owner of old suitcases but not the other customers?

Why do they price like that? Hotel A & B have similar rooms and locations. Hotel A & B have similar rooms and locations. A charges 85 a night and has high prices for parking, drinks and food. A charges 85 a night and has high prices for parking, drinks and food. B charges 100 a night and has low prices for parking, drinks and food. B charges 100 a night and has low prices for parking, drinks and food. Customers at A & B average same bills. Customers at A & B average same bills. Which strategy is better? Which strategy is better?

Price Discrimination Question U.S. residents who travel to Canada and Mexico, which may just be a trip of a few miles, often report that the same products are being sold at lower prices in those countries. Why would producers sell for less? U.S. residents who travel to Canada and Mexico, which may just be a trip of a few miles, often report that the same products are being sold at lower prices in those countries. Why would producers sell for less?

Why do that? IBM sold a “LaserWriter” printer and a cheaper “Laser-Writer E” printer— identical except that the “E” model had an extra chip added to slow down its printing rate. Intel has done the same thing—make a slower version of a chip and sell it at a lower price.

Coupon Question When Disney sells a new DVDs of a movies, it often has a mail-in coupon that allows the customer to get a rebate (price discount). On a \$20 DVD, there may be a \$5 mail-in coupon. These are expensive to process, so why does Disney not just sell the movies for \$15? When Disney sells a new DVDs of a movies, it often has a mail-in coupon that allows the customer to get a rebate (price discount). On a \$20 DVD, there may be a \$5 mail-in coupon. These are expensive to process, so why does Disney not just sell the movies for \$15?

Helping Customers Many computer users are frustrated by the inability to get on-line assistance from the company that sold them the computer. How can the computer seller price discriminate to help overcome this problem? Many computer users are frustrated by the inability to get on-line assistance from the company that sold them the computer. How can the computer seller price discriminate to help overcome this problem?

Common Mistakes ( Thanks to Peter Drucker) 1. Short term high profit margins. Remember—the competition is coming. Xerox dominated copier market in early 1970s. High prices and profit margins. Canon entered with simpler, cheaper machines and swept the market away from Xerox. High profit margins today do not mean maximum profits over time. Price elasticity of demand drops over time due to alternatives.

Common Mistakes 2. Cost-Driven Pricing. Many companies derive prices based on cost recovery plus profit margin. The goal should be price-led costing. What will customers pay, given current and future competition? That is, what is the demand? Can your costs fit within those prices? Toyota and Nissan use that model and have taken larger and larger market shares away from German and American auto makers.

Common Mistakes 3. Using revenues to feed problems and starve opportunities. Many firms incur high costs trying to solve problems (often assigning the best people to solve problems). Problems are usually due to changes in competition and changes in technology—a sign that demand has changed. Opportunities should be the focus— look forward. GE dumps weak products rather than trying to fix them.

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