Lecture 5: Price Discrimination

1. Lecture 5: Price Discrimination AEM 4160: Strategic Pricing Prof. Jura Liaukonyte

2. Lecture Plan • HW1, HW2 • Second degree price discrimination • Designing pricing plans for consumers to self-select themselves • Examples • Third degree price discrimination • Market segmenting • Examples

3. Second Degree PRICE DISCRIMINATION

4. 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.

5. Price Discrimination Based on Self-Selection • Often firms cannot distinguish between groups of consumers based on observable characteristics • Price discrimination may still be possible • Offer a menu of alternatives • If properly designed, customers with different willingness to pay will choose different alternatives • A common practice • Examples: supermarket discounts for shoppers who clip coupons, wireless phone companies with multiple calling plans 18-5

6. Example: Coupons

7. Coupons Coupons distributed in the first half of 2009 increased 12% while the number of coupons redeemed increased 19% Internet coupons, not favored but on the rise (83% increase since 2005) 75% of coupon users say the coupons had at least some influence on their decision to purchase a new product GroceryTrends http://www.couponsherpa.com/ask-coupon-sherpa/clip-this-top-22-coupon-trends/

8. Coupons • A form of second-degree price discrimination • Used to reduce heterogeneity in consumer search costs • Enables retailers to attract informed customers by discounting Beyond the Many Faces of Price: An Integration of Pricing Strategies

10. Coupon Usage Distribution

11. Coupons and Income • Trends relating to newspaper readership provide some explanation for this imbalance.  • According to Scarborough Research, better educated and higher income households buy and read the newspaper more than others and newspapers remain a key vehicle for delivering coupons. • Additionally, promotions are generally targeted in areas with more affluent consumers. • In essence, the better educated and more affluent consumers are much better at looking for deals as they recognize the value of money.

12. Two-Part Tariffs

13. More types of second degree price discrimination • 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.

14. Two-Part Tariffs • A two-part tariff is a lump-sum fee, p1, plus a price p2 for each unit of product purchased. • Thus the cost of buying x units of product is p1 + p2x.

15. Two-Part Tariffs • p1 + p2x • Q: What is the largest that p1 can be?

16. Two-Part Tariffs • p1 + p2x • Q: What is the largest that p1 can be? • A: p1 is the “entrance fee” so the largest it can be is the surplus the buyer gains from entering the market. • Set p1 = CS and now ask what should be p2?

17. Two-Part Tariffs • The monopolist maximizes its profit when using a two-part tariff by setting its per unit price p2 at marginal cost and setting its lump-sum fee p1 equal to Consumers’ Surplus.

18. Profit with a Two-Part Tariff • Per-unit charge equals marginal cost • Fixed fee is the consumer’s surplus at that per-unit price • Maximizes aggregate surplus • Leaves the consumer no surplus 18-18

19. Two-part pricing • Jazz club serves two types of customer • Old: demand for entry plus Qo drinks is P = Vo – Qo • Young: demand for entry plus Qy drinks is P = Vy – Qy • Equal numbers of each type • Assume that Vo > Vy: Old are willing to pay more than Young • Cost of operating the jazz club C(Q) = F + cQ

20. Two-Part Pricing $ Vi The entry charge converts consumer surplus into profit Set the unit price equal to marginal cost This gives consumer surplus of (Vi - c)2/2 c MC MR Set the entry charge to (Vi - c)2/2 Vi Vi - c Quantity Profit from each pair of Old and Young is now d = [(Vo – c)2 + (Vy – c)2]/2

21. Clearvoice Wireless Example • Clearvoice is a wireless telephone monopolist in a rural area • Two types of consumers, high-demand and low-demand • Distinct monthly demand curves for wireless minutes for each group • Clearvoice’s marginal cost is 10 cents

22. Two-Part Tariff with Two Types of Consumers

23. Clearvoice Wireless Example • If could observe consumer characteristics, would offer two-part tariff with 10-cent per-minute price • Fixed fee for low-demand customers: $8 =(40*.4)/2 • Fixed fee for high-demand customers: $40.50 = (90*.9)/2

24. Profit-Maximizing Two-Part Tariff • Suppose Clearvoice wants to offer a single two-part tariff • Per-minute price of 10 cents and monthly fee of $40.50 • High-demand customers accept • Low-demand customers reject • Per-minute price of 10 cents and monthly fee of $8 • All consumers accept • Which plan is better? • If there are a large number of low-demand customers, $8 monthly fee is better

25. Profit-Maximizing Two-Part Tariff • If the monopolist plans on selling to both types of consumers it is always profitable to raise the per-unit price at least a little above marginal cost • Regardless of the types’ relative proportions • INTUITION: Would like to extract some of high-demand consumers’ surplus without changing surplus of low-demand consumer (already zero) • Raise per-unit price to get more surplus from high-demand consumers • Adjust fixed fee so low-demand consumers’ surplus is unchanged • The smaller the faction of low-demand consumer, the more worthwhile it is to raise the per-unit price

26. Benefits of Raising the Per-Minute Charge

27. Using Menus to Increase Profit • Can do even better by offering a menu of two-part tariffs, each designed to attract a specific type of consumer • Extract more surplus from high-demand consumers by making the low-demand plan less attractive to high-demand customers

28. High-Demand Consumers • Suppose Clearvoice offers a pair of two-part tariffs • One designed for low-demand consumers: • Per-minute price of 20 cents, fixed fee of $4.50 • Second option intended to attract high-demand customers: • Per-minute price of 10 cents, equal to Clearvoice’s marginal cost • Fixed fee should be set as high as possible without causing high-demand consumer to choose the other plan • With menu of plans: • Firm profits are higher from high-demand consumers • Profits from low-demand consumers are the same

29. Menu of Two-Part Tariffs 18-29

30. Making the Low-Demand Plan Less Attractive • Can increase profit even more by making the low-demand plan less attractive to high-demand consumers • That plan determines the fixed fee the firm can charge a high-demand consumer • It is the level that makes the high-demand consumer indifferent between the two plans • Limit the number of minutes a consumer can purchase in the 20-cent-per-minute plan • Set the limit equal to the number low-demand consumers want • Will have no effect on value a low-demand consumer derives • Make the plan less attractive to high-demand customers • Will increase the fixed fee Clearvoice can charge high-demand consumers for the 10-cent-per-minute plan

31. Capping Minutes

32. Menu of Two-Part Tariffs • A firm can often profit by offering a menu of choices • Designed for different types of consumers • To maximize its profits, firm should try to make each plan attractive to one group only • And unattractive to other consumer groups • Firm benefits from setting the per-unit price in the plan intended for consumers with the highest willingness to pay equal to the marginal cost