+ Lecture 4: Price Discrimination AEM 4160: Strategic Pricing Prof. Jura Liaukonyte 1

+ Price Discrimination

+ Examples Paper towels, soft drinks in supermarket. Buying more, lower unit price Marlboro sold in different countries US. 3.5$ per pack China 1$ per pack Air fares Business class economy class Software Microsoft office $750 buy Microsoft offices each component individually $2060.

+ Price Discrimination What is this? Goal is to steal consumer surplus! Under what conditions is it possible? Four conditions required a. Monopoly power b. There are identifiable submarkets. c. Different price elasticities of demand. d. Prevention of arbitrage.

+ 3 Types of Price Discrimination First Degree Charge different price for every unit sold. Most Severe. Steal all CS Second Degree Have consumers self-select or charge different prices depending on volume of usage. Third Degree or multimarket (most common) Easily segmented markets.

+ First Degree PRICE DISCRIMINATION

+ First Degree Price Discrimination First unit charged its highest possible price. $ Q MC D P1P1 Q1Q1

+ First Degree Price Discrimination Second unit charged its highest possible price, and so on... $ Q MC D P1P1 Q1Q1 Q2Q2 P2P2 Q3Q3 P3P3

+ First Degree Price Discrimination What happens to CS? $ Q MC D=MR=P P1P1 Q1Q1 Q2Q2 P2P2 Q3Q3 P3P3 P4P4 Q3Q3

+ Example: Credit Card Industry

+ How The Industry Works Credit agencies keep track of consumer credit history. Banks originate credit lines and determine terms. Banks lend consumers lines of credit Fixed amount of money based primarily on income and FICO score Terms, including interest rates, are determined based on FICO score

+ Credit Agencies Credit agencies such as Experian, TransUnion, and Equifax collect information about consumers Tied to social security number Collect data on: Account history Age of Account Debt Available Credit Payment history (on time or late) Determine risk factor by looking at various metrics: Debt-credit ratio Average account age Accounts 30 days, 60 days, and 90 days late.

+ Understanding the FICO Score

+ First Degree Pricing Using FICO Score FICO scores provide a snapshot of the consumer's credit worthiness, and companies price on an individual basis Less risky consumers are worth more in the long run More responsible spending, payments on time High risk consumers are less desirable, but can be highly profitable. Higher risk means higher APRs, worse terms for consumer

+ Price Discrimination Slide 15 First Degree Price Discrimination: Summary Charge a separate price to each customer: the maximum or reservation price they are willing to pay.

+ Additional Profit From Perfect First-Degree Price Discrimination Slide 16 Question Why would a producer have difficulty in achieving first-degree price discrimination? Answer 1) Too many customers (impractical) 2) Could not estimate the reservation price for each customer

+ Price Discrimination Slide 17 First Degree Price Discrimination Other examples of imperfect price discrimination where the seller has the ability to segregate the market to some extent and charge different prices for the same product: Lawyers, doctors, accountants Car salesperson (15% profit margin) Colleges and universities

+ First Degree Price Discrimination However, first-degree price discrimination has found a place on the Internet in the form of reverse auctions. In a reverse auction, a customer names the price he is willing to pay, and the seller decides whether or not to offer him that price. (Customers are restricted from bidding on the same item multiple times within a certain amount of time, eliminating their ability to start out low and increase the bid until it is accepted). Priceline is the most commonly cited example of a reverse auction.

+ First-degree price discrimination 19 Suppose that you own five antique cars Market research indicates that there are collectors of different types keenest is willing to pay $10,000 for a car, second keenest $8,000, third keenest $6,000, fourth keenest $4,000, fifth keenest $2,000 sell the first car at $10,000 sell the second car at $8,000 sell the third car to at $6,000 and so on total revenue $30,000 Contrast with linear pricing: all cars sold at the same price set a price of $6,000 sell three cars total revenue $18,000

+ Informational Requirements Are four criteria satisfied? Do you think first degree price discrimination is common? What are the informational requirements for the seller?

+ First-degree price discrimination 21 The information requirements appear to be insurmountable but not in particular cases tax accountants, doctors, students applying to private universities No arbitrage is less restrictive but potentially a problem

+ First-degree price discrimination 22 First-degree price discrimination is highly profitable but requires detailed information ability to avoid arbitrage Leads to the efficient choice of output: since price equals marginal revenue and MR = MC no value-creating exchanges are missed

+ SECOND Degree PRICE DISCRIMINATION

+ Second-degree price discrimination 24 What if the seller cannot distinguish between buyers? perhaps they differ in income (unobservable) Then the type of price discrimination just discussed is impossible High-income buyer will pretend to be a low- income buyer to avoid the high entry price to pay the smaller total charge

+ Second-degree price discrimination Firms typically offer a list of different prices to consumers allowing the consumers to self-select. Also called VERSIONING pricing strategy: companies sell variations of a product or service at different prices to different groups of customers. Create versions of a product to appeal to different types of buyers. Customers then choose the version that best meets their needs. Distribute a physically similar product under different brand names, E.g. GAP, Old Navy, Banana Republic Filenes Basement, TJMaxx, Marshalls

+ Second-Degree Price Discrimination Movie studios and special editions of movies. DVD vs. Blu-ray Labeouf/dp/B000VR0570/ref=sr_1_1?ie=UTF8&s=dv d&qid= &sr=1-1 Segmenting by early adopters of new technology TurboTax

+ Second-Degree Price Discrimination Health clubs often charge less for memberships with restricted off peak hours. Self Selection (student vs. busy individual) GettyImages, an online photography library, charges users according to the resolution level. Self Selection (professional users vs. casual users)

+ Second-Degree Price Discrimination In some markets, consumers purchase many units of a good over time Demand for that good declines with increased consumption Electricity, water, heating fuel Firms can engage in other type of second degree price discrimination Practice of charging different prices per unit for different quantities of the same good or service

+ Second-Degree Price Discrimination Quantity discounts are an example of second- degree price discrimination Ex: Buying in bulk like at Sams Club Block pricing – the practice of charging different prices for different quantities of blocks of a good Ex: electric power companies charge different prices for a consumer purchasing a set block of electricity

+ Second-degree price discrimination 30 The seller has to compromise Design a pricing scheme that makes buyers reveal their true types self-select the quantity/price package designed for them Essence of second-degree price discrimination It is like first-degree price discrimination the seller knows that there are buyers of different types but the seller is not able to identify the different types

+ Second-degree price discrimination 31 Will the monopolist always want to supply both types of consumer? There are cases where it is better to supply only high-demand types high-class restaurants golf and country clubs Take our example again suppose that there are N l low-income consumers and N h high-income consumers

+ Second-degree price discrimination principles Page 32 Induce customers to select into high and low price groups themselves. Key constraint: you cant make the inexpensive version too attractive to those willing to pay more. If there arent many customers in the low-valuation group, you may want to ignore this group, since selling to it forces you to lower the price to the high valuation group.

+ More types of second degree price discrimination Page 33 Intertemporal price discrimination Idea: high valuation users are also less patient. Quantity discounts (price per unit depends on the quantity bought). Idea: high valuation consumers willing to pay more for more. Multiple two-part tariffs Examples of two-part tariffs: cell phone plans with monthly and per minute fees. Idea: separate between low volume users and high volume users.

+ Takeaways Page 34 Firms would prefer to use perfect (aka first-degree) price discrimination, but this may be impossible. Third-degree PD is one way to approximate perfect PD, but requires that firms can separately identify members of high and low value groups. Second-degree PD induces customers to sort themselves into groups. Recall the no arbitrage constraintconsumers cant resell to others. Price discrimination and other advanced pricing strategies are powerful tools; you now have the economic models to understand them.

+ Feasibility of price discrimination 35 Two problems confront a firm wishing to price discriminate identification: the firm is able to identify demands of different types of consumer or in separate markets easier in some markets than others: e.g tax consultants, doctors arbitrage: prevent consumers who are charged a low price from reselling to consumers who are charged a high price prevent re-importation of prescription drugs to the United States The firm then must choose the type of price discrimination first-degree or personalized pricing second-degree or menu pricing third-degree or group pricing

+ Example: Tablet Industry

+ Intertemporal pricing People value things differently depending on the point in time they will receive it Value now > Value later (Hyperbolic Discounting) eReader and Tablet companies exploit this discrepancy by marking up their product upon introduction Capture the consumer surplus of early-adopters They later lower their prices to reflect the reduction in value that occurs when the product leaves the initial market entry stage and more consumers begin to enter the market

+ Intertemporal Pricing: eReaders

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+ Example: Airline Industry

+ 2nd Degree Price Discrimination Price Dispersion Variation in prices for the same item Versioning Variations of a product or service at different prices to different groups of customers First Class vs. Coach seating

+ Price Dispersion Increases with competition Increases with variation in the population Decreases with homogeneity of the market Increases when there are more differing product attributes A firms responsiveness to price dispersion decreases when their market share increases

+ Price Dispersion The expected difference in fares paid is 36% Airlines likely to have 20 or more different fares on one given flight

+ Example: Ski Industry

+ Product Differentiation A form of second degree price discrimination Provide customers with many options and they choose what to purchase Ski resort industry offers a variety of products and services in order to: Meet consumer needs Maximize revenue Maximize producer surplus Increase customer base

+ Product Differentiation

+ Ski Pass Differentiation Type of ski pass Full day pass Half day pass Night pass Length of ski time One day pass Weekend pass Week pass Season pass

+ Ski Lift Ticket Prices: Bristol Mountain Price (in dollars) All Day and Night (Opening- 10pm) 57 8-hours (starting anytime)54 4-hours (starting anytime)51 Twilight (4pm-10pm)36 Evening (7pm-10pm)30 Adult Prices

+ Variations in Ski Pass Options As the number of days purchased at one time increases, the price per day of the ticket decreases Resorts do this to encourage customers to buy more days worth of tickets