1. Chapter 13: Direct Price Discrimination
Ordering Information:
Betty Jung
Marketing Specialist, Finance/Economics/Decision Sciences
South-Western | Cengage Learning
5191 Natorp Boulevard, Mason, OH 45040
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Managerial Economics: A Problem Solving Approach (2nd Edition)
Luke M. Froeb,
Brian T. McCann,
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
P1/MC1  P2/MC2.
Price discrimination allows two optimal prices to be set for two groups with different levels of price elasticity:
(P1-MC1)/P1=1/|elasticity1|
(P2-MC2)/P2=1/|elasticity2|

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. Price discrimination (cont.)
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
Movie theaters – direct as they force people to show student IDs or driver’s license (senior discount)
Grocery stores – indirect as people reveal their type by being willing to clip coupons
Airlines – indirect; buyers reveal their types by accepting certain restrictions (like Saturday night stayovers)

12. The Robinson-Patman Act (US)
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?
ANSWER: The mailed all conference material to the foreign address, and did not allow on-site registration.

20. Managerial Economics - Table of contents
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