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Chapter 13: Direct Price Discrimination Managerial Economics: A Problem Solving Approach (2 nd Edition) Luke M. Froeb, Brian.

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Presentation on theme: "Chapter 13: Direct Price Discrimination Managerial Economics: A Problem Solving Approach (2 nd Edition) Luke M. Froeb, Brian."— Presentation transcript:

1 Chapter 13: Direct Price Discrimination Managerial Economics: A Problem Solving Approach (2 nd Edition) Luke M. Froeb, luke.froeb@owen.vanderbilt.edu Brian T. McCann, brian.mccann@owen.vanderbilt.edu Website, managerialecon.com COPYRIGHT © 2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Slides prepared by Lily Alberts for Professor Froeb

2 Summary of main points If a seller can identify two groups of consumers with different demand elasticities, and it can prevent arbitrage between two groups, it can increase profit by charging a higher price to group with the less- elastic demand. Price discrimination is the practice of charging different people or groups of people different prices that are not cost-justified. Typically more people are served under price discrimination than under a uniform price. Arbitrage can defeat a price discrimination scheme if enough of those who purchase at low prices re-sell to high-value consumers. This can force a seller to go back to a uniform price.

3 Summary of main points (cont.) A direct price discrimination scheme is one in which we can identify members of the low-value (more price elastic) group, charge them a lower price, and prevent them from re-selling their lower- priced goods to the higher-value group. It can be illegal for business to price discriminate when selling goods (not services) to other businesses unless price discounts are cost-justified, or discounts are offered to meet competitors’ prices. Price discrimination schemes may annoy customers who know they’re paying more than others and can make them less willing to buy because they know someone else is getting a better price. If you can, keep them secret.

4 Introductory anecdote: cell phone pricing 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. The Philippine market was quickly approaching the crucial 10% penetration point. At which this Rule of Thumb applies: the firm w/ 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

5 Cell phone pricing (cont.) The company was worried, however, about the consumer response, and potential fallout, due to discriminatory pricing

6 Introduction: Pricing schemes This chapter looks at ways of (profitably) designing and implementing price discrimination schemes. So that sellers can charge different prices to different consumers based on differences in consumer demand. This allows sellers to increase profit above the profit available from setting a single, uniform price.

7 Pricing tradeoff & discrimination Frequently there is a pricing tradeoff based on simple demand curves: Lower price  sell more, but earn less on each unit sold Higher price  sell less, but earn more on each unit sold Marginal analysis tells us how to optimize around this tradeoff: MR=MC  (P-MC)/P=1/|e| Price discrimination allows sellers to avoid the tradeoff Higher prices for some Lower prices for others

8 Why (price) discriminate? Example: a simple demand curve Seven consumers willing to pay {$7,$6,$5,$4,$3,$2,$1} Marginal Cost of the good= $1.50 Optimal price is $5 At a price of $5, low-value consumers, {$4, $3, $2, $1}, don’t purchase Even though their values are above the MC This leaves unconsummated wealth-creating transactions! If a separate price is set for this group, i.e. price at $3 and sell 2 extra units, firm profit increases, and more customers are served.

9 Price discrimination Motivation: price discrimination allows a firm to sell items to low-value customers who otherwise would not purchase because the price is too high (the firm consummates a wealth-creating transaction!) Definition: Price discrimination is the practice of charging different prices that are not cost-justified to different people P 1 /MC 1  P 2 /MC 2. Price discrimination allows two optimal prices to be set for two groups with different levels of price elasticity: (P 1 -MC 1 )/P 1 =1/|elasticity 1 | (P 2 -MC 2 )/P 2 =1/|elasticity 2 |

10 Price discrimination The bigger the difference between group elasticities, the more profit there is in designing a price discrimination scheme. To price discriminate ID different groups with different price elasticities or different values Find a way to prevent arbitrage Direct Price Discrimination occurs when you can: ID members of the low-value group can be identified Charge low-value costumers a lower price Prevent resale (arbitrage) to higher-value consumers.

11 Indirect Price Discrimination occurs when you: Cannot ID members of groups; OR cannot prevent arbitrage Instead, discriminate by offering two products, a higher- priced, higher-quality good and a lower-priced, lower- quality good. Direct or indirect pricing schemes? Tickets to a movie theaters (senior citizen discount, student discount, etc.) Grocery stores (discount coupons, in-store or in weekly newspaper inserts) Airlines (business vs. economy tickets) Describe a price discrimination opportunity facing your company Price discrimination (cont.)

12 The Robinson-Patman Act (US) 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

13 Pricing for laptops 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 pricing scheme allows Dell to sell identical computers at different prices based on the consumers’ price sensitivity.

14 Back to cell phone pricing The cell phone manufacturer, IRK, reduced prices in Philippines to $90 PROBLEM: the Philippine phones used the same standard (GSM) as higher-priced European phones 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

15 IRK’s cell phone pricing (cont.) In 1998, IRK sold 200,000 phones to Philippines – much better than the 50,000 units they would have sold without price discriminiation IRK’s market share went from 10% to 25% in one year 1999, IRK returned to global uniform pricing Competitors followed, and raised prices as well. In 2000, the Phillipines cell phone penetration reached 12% and IRK market share rose to 34%

16 Warning: only schmucks pay retail Consumers do not like knowing they are paying higher prices than others. 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.

17 Alternate intro anecdote: medical test strips In Northern Europe (Ger., Holland and Scandinavia) 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

18 North/South Europe price discrimination implementation 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).

19 Anecdote: conference pricing The American Association for Clinical Chemistry (AACC) sponsors 3-day conferences 90% of the attendees from same city or surrounding region Foreign participants Greater travel costs Longer travel times Applying and interviewing for travel visas The majority attend conferences in own countries To increase attendance, the AACC proposed reducing price to foreign participants QUESTION: HOW DID THEY PREVENT ARBITRAGE?

20 20 1. Introduction: What this book is about 2. The one lesson of business 3. Benefits, costs and decisions 4. Extent (how much) decisions 5. Investment decisions: Look ahead and reason back 6. Simple pricing 7. Economies of scale and scope 8. Understanding markets and industry changes 9. Relationships between industries: The forces moving us towards long-run equilibrium 10. Strategy, the quest to slow profit erosion 11. Using supply and demand: Trade, bubbles, market making 12. More realistic and complex pricing 13. Direct price discrimination 14. Indirect price discrimination 15. Strategic games 16. Bargaining 17. Making decisions with uncertainty 18. Auctions 19. The problem of adverse selection 20. The problem of moral hazard 21. Getting employees to work in the best interests of the firm 22. Getting divisions to work in the best interests of the firm 23. Managing vertical relationships 24. You be the consultant EPILOG: Can those who teach, do? Managerial Economics - Table of contents


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