MBA201a: Versioning and Packaging

Professor WolframMBA201a - Fall 2009 Page 1 Types of price discrimination 1.First-degree PD: charge every consumer his or her willingness to pay. 2.Third-degree PD: sort customers into several groups based on observable, exogenous characteristics. 3.Second-degree PD: present all customers with a menu of prices and allow the customers to self-select.

Professor WolframMBA201a - Fall 2009 Page 2 Second-degree price discrimination Basic idea: Present consumers with a menu of (price, quality) pairs and let them sort themselves into groups. –A consumer’s willingness to pay for quality should be correlated with his or her willingness to pay a high price for the underlying good. –Examples: Retail: Old Navy, Gap and Banana Republic jeans. Airlines: first class and coach seats.

Professor WolframMBA201a - Fall 2009 Page 3 Specific types of second-degree PD Versioning: design product lines that appeal to different consumers. –Examples: student and professional software. Damaged goods: a particular case when the differences between products are obtained by "damaging" basic product. –Examples: Intel’s 486 chip, U.S. Postal Service.

Professor WolframMBA201a - Fall 2009 Page 4 Second-degree PD example (versioning 1.0) Strategy 1: Offer all tickets at price $300  Total revenue = $300  10 + $300  8 = $5,400 Strategy 2: Offer only unrestricted tickets at price $800  Total revenue = $800  8 = $6,400 Strategy 3: Offer Saturday-night-stay at price $300, unrestricted at price $800 Will the businessperson buy the unrestricted ticket? Willingness to pay for ticket Type of Consumer# of cons(unrestricted)(Saturday-night stay) Tourist 10 $300 Businessperson 8 $800 $400

Professor WolframMBA201a - Fall 2009 Page 5 Second-degree PD example (versioning 2.0) Strategy 3: Offer restricted tickets at price $300, unrestricted at price $800 DOESN’T WORK. Businessperson wont buy the unrestricted ticket. Strategy 4: Offer restricted tickets at price $300, unrestricted at price $699  Total revenue = $300  10 + $699  8 = $8,592 Willingness to pay for ticket Type of Consumer# of cons(unrestricted)(Saturday-night stay) Tourist 10 $300 Businessperson 8 $800 $400

Professor WolframMBA201a - Fall 2009 Page 6 Second-degree price discrimination principles 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.

Professor WolframMBA201a - Fall 2009 Page 7 More types of second degree price discrimination 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.

Professor WolframMBA201a - Fall 2009 Page 8 Takeaways –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 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.