2 Econ 5313Bagel ShopYou 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 5313Bagel ShopSort them from highest WTP to lowestIf you charge them their WTP or lower, they purchaseSo this generates a demand curvePriceQuantityTotal RevMRMCProfit$5.001$4.502$4.003$3.504$3.005$2.506$2.007$1.508
4 Multiply price times quantity to get total revenue Econ 5313Bagel ShopMultiply price times quantity to get total revenuePriceQuantityTotal RevMRMCProfit$5.001$4.502$9.00$4.003$12.00$3.504$14.00$3.005$15.00$2.506$2.007$1.508
5 Bagel Shop Multiply price times quantity to get total revenue Econ 5313Bagel ShopMultiply price times quantity to get total revenueCalculate the MR from the change in total revenuePriceQuantityTotal RevMRMCProfit$5.001$4.502$9.00$4.003$12.00$3.00$3.504$14.00$2.005$15.00$1.00$2.5067($1.00)$1.508($2.00)
6 Bagel Shop Multiply price times quantity to get total revenue Econ 5313Bagel ShopMultiply price times quantity to get total revenueCalculate the MR from the change in total revenueCompare this with the MCPriceQuantityTotal RevMRMCProfit$5.001$2.25$4.502$9.00$4.003$12.00$3.00$3.504$14.00$2.005$15.00$1.00$2.5067($1.00)$1.508($2.00)
7 Verify by calculating the profits at each price Econ 5313Bagel ShopVerify by calculating the profits at each pricePriceQuantityTotal RevMRMCProfit$5.001$2.25$2.75$4.502$9.00$4.003$12.00$3.00$5.25$3.504$14.00$2.005$15.00$1.00$3.75$2.506$1.507($1.00)($1.75)8($2.00)($6.00)
8 Econ 5313Bagel ShopDoes your profit maximizing price depend on the total number of consumers?Not if the groups are equally sizedSuppose 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 5313Student DiscountsSeparate the last four students from the restPrices charged to them do not affect the revenues from non-studentsLike a whole new demand curveMaximize profits here yield a different “student” priceImplement with a $1.00 student discountPriceQuantityTotal RevMRMCProfit$3.001$2.25$1.00$2.502$5.00$2.00$0.503$6.00($0.75)$1.504($0.00)($3.00)
10 Student Discounts You earn $5.25 in profit from the $4.00 price Econ 5313Student DiscountsYou earn $5.25 in profit from the $4.00 priceYou earn an additional $1 from the students at a $3.00 priceYou have increased profits through “price discrimination”That is, P1/MC1 P2/MC2What 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 5313Price DiscriminationIdentifying demand segments is more common than you might imagineCould be due to differences in demandEx Student or senior citizen discountsEx Household services (e.g., maid, yard, plumber) in Park Cities versus South DallasEx Early bird special or matinee pricingEx Air travel with a Saturday stay-overEx Air travel booked a month in advance versus ‘week of’Ex McDonalds on Cooper versus Champs d'EliseEx Patented pharmaceutical product in US versus Canada versus Mexico versus Haiti
12 Differences in Demand Could be due to differences in rivalry Econ 5313Differences in DemandCould be due to differences in rivalryEx Cowboy boots in Texas versus BostonEx Pharmaceutical product in US pre-patent expiration versus in Brazil with price regulationEx Mobile phone service in US with many carriers or in the Philippines with few carriersAlways indicates difference in demand elasticity across groupsDirect = observe group membershipIndirect = infer group membership
13 Limiting Arbitrage Limiting Arbitrage can be tricky Econ 5313Limiting ArbitrageLimiting Arbitrage can be trickyWhat if group 3 could pass for students?They get the lower price and your whole scheme falls apartWhat if business travelers can book months in advance?What if Florida retirees can travel to Canada for their medicines?
14 Econ 5313Limiting ArbitrageNeed a cost to arbitrageurs that you do not face to prevent reselling productHigh transportation costsShipping boots from Texas to BostonHigh transactions costsProsecuted for re-importing possibly counterfeit drugsServices versus productsHard to resell a haircut or dry cleaningNo price discrimination scheme will work perfectlyYou usually just need that there is not ‘too much’ arbitrage
15 Econ 5313Limiting ArbitrageIn 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 $120It sold most of its phones in wealthy countriesImportant 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 5313Limiting ArbitrageOnce sales hit 10%, diffusion from luxury to mass market happens very quickly
17 Econ 5313Limiting ArbitrageThe Philippine market was quickly approaching the crucial 10% penetration pointAt 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% pointIRK reduced prices in Philippines to $90Problem: the Philippine phones used the same standard (GSM) as higher-priced European phones
18 Econ 5313Limiting ArbitrageThus, 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’ networksTurkish hackers broke the SIM-lock15,000 phones were sold to Western Europe by the hackers before IRK changed the SIM-lock algorithm and again prevented arbitrageHave to change the algorithm every few years in a never-ending “arms race”
19 Our typical profit maximizing situation from simple pricing Econ 5313Capturing ValueOur typical profit maximizing situation from simple pricingDP*QPMCMR
20 What do the Blue regions represent? Capturing ValueWhat do the Blue regions represent?P*DQPMCMR
21 Capturing ValueThese are part of the value that the product generates in excess of your cost going to the consumerP*DQPMCMRUn-captured Consumer Value
22 Price discrimination is a way to try to capture this Capturing ValuePrice discrimination is a way to try to capture thisP*DQPMCMRUn-captured Consumer Value
23 Capturing ValueWith perfect price discrimination, you would charge all N customers a different price and capture it allNot possible but is the limiting case we aim forP*DQPMCMRUn-captured Consumer Value
24 Modified Simple Pricing Econ 5313Modified Simple PricingSimple rule for different groupsSet 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 5313Price Discrimination OnlineComputer companies often sell to a wide variety of users with a wide variety of price sensitivitiesTo 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 $1,197Under the “Large Business” category, the same computer was $1,339 a 12% increaseThis 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 5313When is it Illegal?Robinson-Patman ActProhibits providing a price discount on a good sold to another businessThe Robinson-Patman act was designed to protect independent retailers from chain-store competition by preventing the chains from receiving supplier discountsDefenses against a Robinson-Patman lawsuit are:That the price discount was cost-justified; orThe price discount was given to meet the competitionEurope has similar, and stronger, lawsPromotional allowances or vertical integration may avoid Robinson-Patman liability
27 Blood Tests In Northern Europe (Ger., Holland and Scandinavia) Econ 5313Blood TestsIn Northern Europe (Ger., Holland and Scandinavia)Medical blood test machines sell for $2550 test strips sell for $2212 million boxes of test stripsSouthern EuropeItaly and Spain: insurance companies’ reimbursement rates are 50% lowerFirm has capacity to produce additional 6 millionPotential market for test strips is $200 million per yearIf 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 5313Blood TestsLower prices to Southern EuropeTest strips at $11Measurement devices at $12.50To prevent arbitrageROM key ensures north/south incompatibilityAlso reduce the measurement speed of the Southern devices from 11 to 25 secondsIt 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 5313DistributionYour 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 pricesHigh volume implies full pallets which are cheaper to distribute
30 Econ 5313Customer PerceptionsConsumers 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 declineOnline shoppers were less likely to complete their transactions once they realized a coupon existed that they didn’t havePeople don’t like knowing they are schmucksSo, 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 5313From the BlogChapter 13Cable Car in BarcelonaWeekend airline purchasesWomen’s Haircuts?Price Discrimination at the FTC!
32 Econ 5313Main PointsPrice Discrimination is charging different markups to different groups of customersMust be able to identify differences in WTP (elasticity)Must be able to limit arbitrageEngage in “simple pricing” for each groupTypically additional customers are served than would be under simple pricing