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Chapter 11 Direct Price Discrimination COPYRIGHT © 2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Chapter 11 – Take Aways 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 the low-elasticity group. Price discrimination is the practice of charging different people or groups of people different prices that are not cost-justified. A direct price discrimination scheme is one in which we can identify members of the low-value group, charge them a lower price, and prevent them from reselling 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.

Review of Chapter 10 After acquiring a substitute product  Raise price on both products to avoid cannibalizing each other’s sales.  Raise price by more on the low-margin (more elastic demand) product.  Reposition the products so that there is less substitutability between them. After acquiring a complementary product  Reduce price on both products to avoid cannibalizing each other’s sales. If fixed costs are large relative to marginal costs, and capacity is fixed, you should price to fill available capacity. Price-related promotions (coupons, end-of-aisle displays, etc.) tend to make demand more elastic.  If you are making demand more elastic, it makes sense to reduce price concurrently Product-related promotions (quality advertising, celebrity endorsements, etc.) tend to make demand less elastic.  If you are making demand less elastic, it makes sense to raise price concurrently

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  Choose to attend conferences in own countries To increase attendance, the AACC proposed reducing price to more distant participants while maintaining prices to local attendees

Anecdote: Cell Phone Pricing Global cell phone manufacturer in 1997  World-wide uniform price of $120  Most sales in wealthy countries  Important future markets, like Philippines, ignored  Competitors underpricing in these future markets  10% penetration point is crucial The largest market share will grow 40% w/out marketing when market penetration grows to 30%  Considering charging different price in Philippines Philippines in 1997

Pricing Tradeoff & Discrimination Remember the tradeoff from the pricing chapter  Lower price  sell more, but earn less on each unit sold  Higher price  sell less, but earn more on each unit sold Price discrimination avoids the tradeoff  Higher prices to some  Lower prices to others

Why (Price) Discriminate? Example  Demand= {$7,$6,$5,$4,$3,$2,$1}  Marginal Cost= $1.50  Optimal price is $5 At price of $5, low-value consumers, {$4, $3, $2, $1}, don’t purchase  Even though their values are above MC  Unconsummated wealth-creating transactions! Set separate price for this group  Price at $3; sell 2 extra units

Direct 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  P 1 /MC 1  P 2 /MC 2. Optimal prices for two groups  (P 1 -MC 1 )/P 1 =1/|elasticity 1 |  (P 2 -MC 2 )/P 2 =1/|elasticity 2 |

Direct Price Discrimination The more unique, innovative and useful is the product, and the fewer substitutes, the more profit there is in designing a price discrimination scheme. 3 conditions  Market power  ID different groups with different elasticities  Prevent arbitrage Direct Price Discrimination  Can identify members of low-value group  Charge them a lower price  Prevent resale Indirect  When cannot ID consumer groups  ID high-value consumers by willingness to buy high-priced good

Direct or Indirect? Discussion: Movie theaters Discussion: Grocery stores Discussion: Airlines Discussion: Describe a price discrimination opportunity facing your company

Robinson-Patman Act  Prohibits providing price discount to a good sold to another business  Defenses Cost-justified; or Meet the competition Europe has similar and stronger laws Promotional allowances or vertical integration may avoid Robinson-Patman liability  Discussion: Herbicide that has both farming and home uses

Conference Price Discrimination More distant consumers have more elastic demand for the conferences. Adopt policy of lower prices for traveling attendees  Local: $800  National: $600  International: $400 Implementation ideas  Mail regional editions of conference brochures containing different prices to different customers.  Require a foreign mailing address to get international rate

Cell Phone Discrimination Manufacturer reduced price in Philippines to $90 Same standard (GSM)  Arbitrage threatened sales in other countries (15 million units annually)  SIM-locks allow calls only in local operators’ networks Turkish hackers broke SIM lock  15,000 phones to Western Europe 1998, Firm X sold 200,000 phones to Philippines  Share went from 10% to 25% in one year 1999, Firm X returned to global uniform pricing  Competitors followed  2000, penetration reached 12% Market share rose to 34%

Warning: Only Fools Pay Retail Consumers do not like knowing they are paying higher prices For example, when shown a box for a promotional code on a website, click-through rates dramatically dropped People don’t like knowing they are fools So, if you are price discriminating, it is important to keep the scheme secret if you can

Alternate Intro Anecdote: Medical Test Strips In Germany, Holland and Scandinavia  Machines for $25  50 test strips sells 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 acquire 30% of the market, the opportunity cost of not entering the southern markets is about $60 million in revenue

North/South Europe Price Discrimination Implementation Lower prices to Southern Europe  Test strips at $11  Measurement devices at $12.50 Arbitrage prevention  ROM key ensures north/south incompatibility EC antitrust laws reduce the measurement speed of the devices from 11 to 25 seconds. It is important that these slower devices cost less, so that the price difference has some cost justification.