1. 1 Price Discrimination We thus far have studied a monopolist that charges: A. Same price for all units. B. Same price to all customers. Changing one or both of these is called Price Discrimination. Can one profit from this? –1st degree is different prices for both consumers and units (both A and B are changed) –2nd degree is different prices for different units (A changed). –3rd degree is different prices to different consumers (B changed).

2. 2 1st-Degree Price Discrimination Different prices for both consumers and units. To do this properly, a monopolist must have strong information on: –Consumers’ preferences. –Who is who. 1st degree captures the whole consumer surplus. 1st degree is efficient.

3. 3 Effort to Discriminate In 1990, IBM introduced the LaserPrinter E. The difference is that it printed 5 ppm rather than 10 ppm. They did so by ADDING 5 chips in the E model. The purpose of the chips was to make the printer WAIT. The price of the new laserprinter E was 60% of the old one. Why did IBM pay for a reduction in the speed?

4. 4 Effort to Discriminate Model Jim values the faster printer at 1000 and the slower printer at 700. Sean values the faster printer at 700 and the slower printer at 600. It costs 450 to make the faster printer and 500 to make the slower printer. What should IBM charge for either printer? If IBM only sells the fast printer, what should it charge? If IBM wants to sell the fast printer to Jim and the slow printer to Sean, what is the max/min price difference. What happens if the fast printer costs 1000 and the slow printer 600?

5. 5 Other Examples of Effort to Discriminate Intel with its SX processors had the math coprocessor disabled. Fast delivery service may hold back packages that are 2 nd day rather than overnight. Photo shops won’t give you films in 1 hour even though they may be ready if you have ordered the longer service. Sony Minidisc 60 minute vs. 74 minute versions minidiscs are the same except for a code on the 60 minute version written to stop it from writing the longer time. Hard disks in MP3 players. Sometimes is cheaper to buy the MP3 player and take out the hard disk. People did this so they had to take precautions.

6. 6 2 nd degree Price Discrimination Ari values 1 umbrella at 10 pounds and has no need for another umbrella. Jodi values 1 umbrella at 11 pounds and also values 2 umbrellas at 15 (together). They each want to maximize the difference between their value and the price they pay. What is the maximum a monopolist with zero marginal cost could make charging the same price per umbrella? What is the max it could make charging a price for 1 and a special for two together? Hint: what would happen if they charge 10 for one and 15 for two?

7. 7 Movie Release Dates Studios want to maximize revenue. Groups want the delay from the Theater release to be short and the release to the next outlet to be long. Consumers must decide when (if) to watch the film. What incentive does the studios have once the consumers have made their decision?

8. 8 Movie Release: A simple model. There are only two formats: Theater and Home. The home release can be early or late. The studio gets £5 for each Theater sale and £2 for each home viewer. Four Consumers. –A only wants to see the movie in the theater. –B only wants to see the movie at home. –C will see the movie in the theater if the release is late. Otherwise, C will see it at home. –D will see the movie at home only if only if the release is early. What is studio profit for early? Late? What should the studio do?

9. 9 Movie Release:further analysis After the studio announces release date and the movie is released, what should it do? What stops this from happening each time? Consumers judge the release date not by what the studio says, but by either previous record or what the studio has incentive to do. Do you remember which studio produced the Titanic? If consumers judge the industry as a whole rather than individual studios, then what happens?

10. 10 International Pricing of Pharmaceutical Companies Prices of antipsychotic drug in various countries. Why such a difference?

11. 11 3rd-degree price discrimination There are two groups of people that make up total demand D(p)=D1(p)+D2(p). Example: MC=0, D1(p)=100-p and D2(p)=60-p. q=D1(p)+D2(p)=160-2p. We find p=80-q/2. Marginal revenue is 80-q. MR=MC implies q=80 and p=40. Profit with one price is 3200. MR in market 1 is 100-2*q1 and in market 2 is 60-2*q2. Find q1, q2, p1 and p2. Show that combined profits are 2500+900=3400. At home: Try the same for D1(p)=100-p and D2(p)=100-p. Need to ensure one group can’t sell to another (leakage). Companies try to prevent leakage and take advantage when it is limited: DVDs and camcorders (PAL vs. NTSC).

12. 12 Examples of Price Discrimination. Book publisher having a cheap international edition of a book. How about paperbacks. Publisher charging libraries a higher rate to libraries than to individuals. Frequent Flyer Programs. First Class Train tickets. Saturday stayover for airfares.

13. 13 Two-Part Tariffs The sports center charges a fee to join and then a per usage fee. Why don’t they just charge one or the other to make it simple? What form of price discrimination (if any) is this? Sometimes this may have a high transaction cost: Disneyland dilemma.

14. 14 Other two-part pricing This is also the case with video games such as the Xbox. We also saw this with IBM and its punchcards (overpriced). There are two types of consumers. –A is a heavy user and will make calculations all day long: needs 100 punch cards. –B is a light user and will need to make calculations only at the end of the day: needs 50 punch cards. –C is a hobbiest and would only fool around with the machine: needs 5 punch cards. The value of each calculation is £100 (over the year). C values owning the machine at £1000. The machine costs £3000 to produce and punch cards £0.

15. 15 Two-part tariff: punch cards What is the monopoly’s profits if it charges 0 for each punch card? What happens if the monopoly charges 0 for the machine and only for the punch cards? What happens if the monopoly charges £1500 for the machine and £70 each punchcard?

16. 16 Bundling Two types of people: –A values $120 for Word, $100 for Excel. –B values $100 for a Word, $120 for Excel. If Microsoft charges separately for each program, it can make $200 for each software product for a total of $400. They could package both together (and stop selling it individually) and sell it for $220 making a total profit of $440.

17. 17 Anti-Competitive Bundling A library has £10,000 to spend on journals. There are 10 good journals out there. They want to buy as many journals as they can for the budget as long as each journal is less than £2000. Six journals are owned by one publisher -E. The 4 independent journals cost £1000 each. What is the maximum the E can make if it charges a separate price for each (assume marginal cost is zero)? How about if E bundles all 6 together? If E bundles all together, what can the independent journals do?

18. 18 Hotelling’s (1929) linear city Why do all vendors locate in the same spot? For instance, on Cowick street they just opened a new Pharmacy right next to another one. Why do political parties (at least in the US) seem to have the same agenda? This can be explained by firms trying to get the most customers. This isn’t efficient! If firms first choose location and then prices, what do you think would happen?

19. 19 Hotelling Party BParty A If Party A shifts to the right then it gains voters. Voters vote for the closest party. L R Party BParty A L R Each has incentive to locate in the middle.

20. 20 Hotelling Model Party BParty A L R Average distance for voter is ¼ total. Party BParty A L R Most efficient has average distance of 1/8 total.

21. 21 Hotelling Model Firms choose location and then prices. Consumers care about both distance and price. If firms choose close together, they will eliminate profits as in Bertrand competition. If firms choose further apart, they will be able to make some profit. Thus, they choose further apart.

22. 22 Future Profits? Do you want to spend more today (have higher costs) in order to save tomorrow (have lower costs)? This can be either an investment decision (patent/learning curve) or an inventory decision (save the best for last).

23. 23 Save the best for last? (salesman) A salesman is working on commission. He has two houses for sale. They are both similar except for one the seller is willing to sell for 150k and the other the seller is willing to sell for 170k. The salesman meets a buyer who is willing to pay 180k. (Assume the salesman gets the buyer to pay 180.) Which should he try to sell first? Does this strategy generate the highest surplus for the sellers?

24. 24 Save the best for last: solution. If the next buyer is willing to pay 175 (or anything above 170), it doesn’t matter. –Both houses would be sold and seller surplus would be 35. If the next buyer is willing to pay 165, then –If he sells the 170 first and the 150 second, then the salesman gets commissions on 180+165 while the surplus is 25. –If he sells the 150, then he can’t sell the 170 and gets commissions on 180 while the surplus is 30. If the next buyer is willing to pay only 145, then –In either case, only the first house will be sold. If it is the 170, surplus would be 10. If it is the 150, surplus would be 30.

25. 25 Summary Sales Seller Surplus Sales is maximized by selling the most expensive first. Surplus is maximized by selling the least expensive first.

26. 26 Learning curve. Learning economies depend on cumulative output rather than the rate of output and are not reversible. Applies to surgeons learning new procedures, lecturers, airframe makers etc. Learning leads to lower costs, higher quality and more effective pricing and marketing. Learning reduces unit cost through experience

27. 27 Learning curve strategy Expand output rapidly to benefit from the learning curve and achieve a cost advantage? May lead to losses in the short term but ensure long term profitability.

28. 28 Investment in Cost Reduction Similar to learning curve, a firm can invest today in a cost reducing technology. When does this make sense? Is it a straight-forward cost-benefit analysis? Is sales*savings per unit>investment plus interest? Or even taking into account extra sales (from lower price charged)

29. 29 Strategic gains. Firm A and Firm B are competing in quantity competition. They each can choose a small amount S of goods to sell or a large amount L of goods to sell. Firm A can invest in a cost reducing technology this will reduce his costs per unit. This makes a larger difference for L than for S. –Saves 15 for L. –Saves 5 for S

30. 30 Cost Reduction in Competition 50 S 40 55 60 45 50 45 L S L 50 S 40 70 55 65 45 55 60 L High CostLow Cost Firm A Firm B

31. 31 Shift in equilibrium The equilibrium of the game changes from Firm A choosing S and Firm B choosing L to Firm A choosing L and Firm B choosing S. Profit for Firm A shifts from 50 to 70. An investment of 17 would not look good on paper since the maximum savings on cost would be 15. This calculation would not take into account the strategy affect of the reduced cost. (Resulting in higher prices for goods sold.) Conclusion: Firms may “over-invest” in cost reducing measures or learning curve reasons for strategic reasons rather than simply Cost-Benefit.

32. 32 Planned Obsolescence Why does microsoft products have many bugs and are they always introducing updates? Why are certain durable goods not so durable? It is in the best interest for the manufacturer to keep us coming back for more.

33. 33 Planned Obsolescence There is 1 monopoly good (marg cost 0), 2 time periods and 2 types of consumers. –A is willing to pay 15 per time period. –B is willing to pay 5 per time period. If the monopolist sells a good that lasts for two periods, what should he do? If he charges a price of 30, he sells only to A. If he charges a price of 10, he sells to both A and B.

34. 34 Commitment problems If he chooses a price of 30 and A buys his good, what will he do at time 2. What should A do in this case? If he chooses a price of 20 at time 1 and 5 at time 2, what will A do and what will B do? What will the monopolists profits be? What will the monopolists profits be if he was able to limit the lifetime of the product to only one year? Limiting lifetime to one year is the same as renting. IBM recognized this early! Perhaps, once microsoft develops there software rental market, they will have incentive to get the bugs out.