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Lecture 4: Price Discrimination AEM 4160: Strategic Pricing Prof. Jura Liaukonyte 2

Price Discrimination

Examples Paper towels, soft drinks in supermarket Software Mass discount Business class Economy class Air fares US. 10$ per pack China 1$ per pack Microsoft office $750 buy Microsoft office’s each component individually $2060 Marlboro sold in different countries IndustryDiscrimination

Price Discrimination DefinitionConditions Oxford Dictionary the action of selling the same product at different prices to different buyers, in order to maximize sales and profits Suppliers try to steal consumer surplus by pricing as close as possible to their willingness to pay

Price Discrimination DefinitionConditions Four Conditions 1. Monopoly Power 2. Identifiable submarkets 3. Different price elasticities of demand 4. Prevention of arbitrage Arbitrage Definition: Buy a good and sell it for a higher price to someone/somewhere else Oxford Dictionary the action of selling the same product at different prices to different buyers, in order to maximize sales and profits Suppliers try to steal consumer surplus by pricing as close as possible to their willingness to pay

3 Types of Price Discrimination Charge different price for every unit sold Most effective – capture all Consumer Surplus Provide choices and let consumers self-select different prices depending on volume and usage Easily segmented market E.g: Geography Senior Citizen First Degree Second Degree Third Degree

First Degree PRICE DISCRIMINATION

First Degree Price Discrimination MC P1P1 Q1Q1 D Q P Q1Q1 D Q P Q2Q2 Q3Q3 P1P1 P2P2 P3P3 The first unit has the highest price The price drops for every additional unit based on each buyers willingness to pay

First Degree Price Discrimination MC Q1Q1 D Q P Q2Q2 Q3Q3 P1P1 P2P2 P3P3 P4P4 Q4Q4 +PS Consumers pay exactly what they are willing to pay Consumer Surplus = WTP-P = 0 Producer Surplus = P-MC │P=WTP Consumer Surplus in perfect competition = Additional producer surplus in case of first degree price discrimination

Price Discrimination Slide 11  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 12  Question  Why would a producer have difficulty in achieving first- degree price discrimination?

Additional Profit From Perfect First-Degree Price Discrimination Slide 13  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 14  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

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 Age of Account Debt Available Credit Account History Payment History Social Security Number Data Agencies Experian, TransUnion, Equifax Collect Risk Factor Debt-to-Credit Ratio Average Account Coverage Accounts 30 days, 60 days, 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

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.

Google’s IPO was the first hybrid-Dutch Auction

First-degree price discrimination 22  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? 1. Monopoly Power 2. Identifiable submarkets 3. Different price elasticities of demand 4. Prevention of arbitrage Do you think first degree price discrimination is common? What are the informational requirements for the seller?

Conclusions 24  The information requirements for first degree price discrimination appear to be insurmountable  but not in particular cases  tax accountants, doctors, students applying to private universities  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 26 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  Filene’s Basement, TJMaxx, Marshalls

Second-Degree Price Discrimination  Movies LinkLink  TurboTax LinkLink  Health Clubs  Getty Images  Buy Bulk at Sam’s ExampleSelf Selection HD vs. SD – Value of high definition Options: Individual with bigger need Off peak hours discount: busy individual vs. student Resolution – Professional vs Casual Self select price per unit based on quantity

Second-Degree Price Discrimination In some markets, consumers purchase many units of a good over time Demand declines with increased consumption Price Discrimination: Charge different prices to increase volume Charge different prices per unit for different quantities of the same good Quantity Discounts Block Pricing: Charge different price for blocks of a good e.g. Electric Power

Second-degree price discrimination 30  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  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 Seller has to compromise

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

Second-degree price discrimination principles Page 32  Induce customers to select into high and low price groups themselves.  Key constraint: you can’t make the inexpensive version too attractive to those willing to pay more.  If there aren’t 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 ExampleSelf Selection Intertemporal High Valuation users are less patient Quantity Discounts Example: cell phone plans with monthly and per minute fees – Separate between high and low volume users Multiple two-part tariff High valuation consumers pay high price for higher volume

Takeaways Page 34 Firms would prefer to use perfect (aka first-degree) price discrimination, but this may be impossible. Second-degree PD induces customers to sort themselves into groups. Recall the no arbitrage constraint—consumers can’t 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 1 2

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

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  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