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Chapter 12

Chapter 12. Pricing. Key issues. why and how firms price discriminate perfect price discrimination quantity discrimination multimarket price discrimination two-part tariffs tie-in sales. Nonuniform pricing. prices vary across customers or units

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Chapter 12

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  1. Chapter 12 Pricing

  2. Key issues • why and how firms price discriminate • perfect price discrimination • quantity discrimination • multimarket price discrimination • two-part tariffs • tie-in sales

  3. Nonuniform pricing • prices vary across customers or units • noncompetitive firms use nonuniform pricing to increase profits

  4. Single-price firm • nondiscriminating firm faces a trade-off between charging • maximum price to consumers who really want good • low enough price that less enthusiastic customers still buy • as a result, single-price firm usually sets an intermediate price

  5. Price-discriminating firm • avoids this trade-off • earns a higher profit by charging • higher price to those willing to pay more than the uniform price: captures their consumer surplus • lower price to those not willing to pay as much as the uniform price: extra sales

  6. Extreme examples of tradeoff • maximum customers will pay for a movie: • college students, $10 • senior citizens, $5 • theater holds all potential customers, so MC = 0 • no cost to showing the movie, so  = revenue

  7. Example 12.1a

  8. Example 12.1b

  9. Broadway theaters increase their profits 5% by price discriminating rather than by setting uniform prices

  10. Geographic price discrimination • admission to Disneyland is $38 for out-of-state adults and $28 for southern Californians • tuition at New York’s Fordham University is $4,000 less for commuting first-year students than for others

  11. Successful price discrimination • requires that firm have market power • consumers have different demand elasticities, and firm can identify how consumers differ • firm must be able to prevent or limit resales to higher-price-paying customers by others

  12. Preventing resales • resales are difficult or impossible when transaction costs are high • resales are impossible for most services

  13. Prevent resales by raising transaction costs • price-discriminating firms raise transaction costs to make resales difficult • applications: • U.C. Berkeley requires anyone with a student ticket to show a student picture ID • Nikon warranties cover only cameras sold in this country

  14. Prevent resales by vertically integrating • VI: participate in more than one successive stage of the production and distribution chain for a good or service • VI into the low-price purchasers

  15. Prevent resales by government intervention • governments require that milk producers charge higher price for fresh use than for processing (cheese, ice cream) and forbid resales • governments set tariffs limiting resales by making it expensive to import goods from lower-price countries • governments used trade laws to prevent sales of certain brand-name perfumes except by their manufacturers

  16. Flight of the Thunderbirds • 2002 production run of 25,000 new Thunderbirds included only 2,000 for Canada • potential buyers are besieging Ford dealers in Canada • many hope to make a quick profit by reselling these cars in the United States • reselling is relatively easy and shipping costs are relatively low • why a T-Bird south? • Ford is price discriminating between U.S. and Canadian customers • at the end of 2001, Canadians were paying $56,550 Cdn. (Thunderbird with the optional hardtop), while U.S. customers were spending up to $73,000 Cdn.

  17. Thunderbirds (cont.) • Canadian dealers try not to sell to buyers who will export the cars • dealers have signed an agreement with Ford that explicitly prohibits moving vehicles to the United States • dealers try to prevent resales because otherwise Ford may cut off their Thunderbirds or remove their dealership license • one dealer said, “It’s got to the point that if we haven’t sold you a car in the past, or we don’t otherwise know you, we’re not selling you one.” • nonetheless, many Thunderbirds were exported: eBay listed dozen of these cars on a typical day

  18. 3 types of price discrimination • perfect price discrimination (first-degree): sell each unit for the most each customer is willing to pay • quantity discrimination (second-degree): charges a different price for larger quantities than for smaller ones • multimarket price discrimination (third-degree): charge groups of customers different prices

  19. Perfect-price-discriminating monopoly • has market power • can prevent resales • knows how much each customer is willing to pay for each unit purchase (all knowing)

  20. All-knowing monopoly sells each unit at its reservation price • maximum price consumers will pay (captures all possible consumer surplus) • height of demand curve • MR is the same as its price (AR)

  21. Figure 12.1 Perfect Price Discrimination p , $ per unit 6 5 e MC 4 3 Demand, Marginal revenue MR = $6 MR = $5 MR = $4 1 2 3 2 1 0 1 2 3 4 5 6 Q , Units per day

  22. Perfect price discrimination properties • perfect price discrimination is efficient • competition and a perfectly discriminating monopoly • sell the same quantity • maximize total welfare: W = CS + PS • have no deadweight loss • consumers worse off (CS = 0) than with competition

  23. p , $ per unit p 1 MC A e s p s B C e p = MC c c c E D MC s Demand, MR d MC 1 MR s Q Q = Q , Units per day Q c s d

  24. Amazon • in 2000, Amazon revealed that it used “dynamic pricing”: gauges shopper’s desire and means, charges accordingly • example • a man ordered DVD of Julie Taymor’s “Titus” at $24.49 • checks back next week and finds price is $26.24 • removes cookie: price fell to $22.74 • after newspaper articles, Amazon announced it had dropped this policy

  25. Botox revisited • how much more would Allergan earn from Botox if it could perfectly price discriminate?

  26. Application Botox Revisited , p $ per vial 143.0 ≈ A $187.5 million e s 75.0 Demand B ≈ $375 million C ≈ $187.5 million e c 7.5 MC 1.30 2.61 2.75 0 MR Q , Million daily doses of Botox

  27. Solved problem How does welfare change if firm in Table 12.1 goes from charging a single price to perfectly price discriminating?

  28. Table 12.1a

  29. Answer: Panel a • welfare is same with single price or price discrimination because output unchanged • single price: if theater sets a single price of $5 • it sells 30 tickets and  = $150 • 20 seniors pay their reservation price so CS = 0 • 10 college students (reservation prices of $10) have CS = $50 • welfare = $200 = profit ($150) + consumer surplus ($50)

  30. If firm perfectly price discriminates • it charges all customers their reservation price so there’s no consumer surplus • seniors pay $5 and college students, $10 • firm's profit rises to $200 • welfare W = $200 = profit ($200) + CS ($0) is same under both pricing systems where output stays the same

  31. Table 12.1b

  32. Answer: Panel b • welfare is greater with perfect price discrimination where output increases • if theater sets single price of $10 • only college students attend and have CS = 0 •  = $100 • W = $100 • if it perfectly price discriminates: • CS = 0 •  =$125 • W = $125

  33. Quantity discrimination • firm does not know which customers have highest reservation prices • firm might know most customers are willing to pay more for first unit (demand slopes down) • firm varies price each customer pays with number of units customer buys • price varies only with quantity: all customers pay the same price for a given quantity • note: not all quantity discounts are a form of price discrimination

  34. Utility block pricing • public utility (electricity, water, gas…) charges • one price for the first few units (a block) of usage • different price for subsequent blocks • both declining-block and increasing-block pricing are common

  35. (a) Quantity Discrimination (b) Single-Price Monopoly p , $ per unit p , $ per unit 2 1 90 90 A = $200 70 E = $450 60 C = $200 50 F B = = $900 D = $1,200 = G $450 $200 m m 30 30 Demand Demand MR 0 30 90 0 20 40 90 Q , Units per day Q , Units per day Figure 12.3 Quantity Discrimination

  36. Multimarket price discrimination • firm knows only which groups of customers are likely to have higher reservation prices than others • firm divides potential customers into two or more groups • firms set a different price for each group

  37. Theater • senior citizens pay a lower price than younger adults at movie theaters • by admitting people as soon as they demonstrate their age and buy tickets, theater prevents resales

  38. International price discrimination: Cars • even including shipping and customs, European price for BMW 750IL • price is 13.6% more from an American firm than imported from Europe

  39. International price discrimination: Software • Australia's Prices Surveillance Agency criticized American software industry for charging Australians 49% more than Americans, • then, Agency called for an end to import restrictions so that Australian retailers could import software directly

  40. Price discriminating: 2 groups • marginal cost = m • monopoly charges Group i members pi for Qi units • profit from Group i is i= piQi – mQi

  41. To maximize total profit • monopoly sets its quantities so that marginal revenue for each group i, MRi, equals common marginal cost, m: MR1 = m = MR2. • example: Sony’s Aibo robot dog

  42. Figure 12.4 Multimarket Pricing of Aibo (b) United States (a) Japan p , $ per unit p , $ per unit US J 4,500 3,500 CS US p = 2,500 CS US J p = 2,000 J D J D US p US p J DWL J DWL US 500 M C 500 M C MR MR J US 0 Q = 3,000 7,000 0 Q = 2,000 4,500 J US Q , Units per year Q , Units per year J US

  43. Profit-maximizing condition • MRi = pi(1 + 1/i), so • MR1=p1(1 + 1/1) = m = p2(1 + 1/2) = MR2

  44. Solved problem • monopoly sells in two markets • constant elasticity of demand is • 1 = -2 in first market • 2 = -4 in second market • MC = $1 • resales are impossible • what prices should monopoly charge?

  45. Answer  p1 = 1/(1 – ½) = 2 p2 = 1/(1 – ¼) = 4/3 p1/p2 = 2/(4/3) = 1.5

  46. Coca-Cola Version 1 • a two-liter bottle of Coke costs 50% more in the U.K. than in EU nations (SF Chronicle, May 17, 2000: D2) • if Coke’s marginal cost is the same for all European nations, how does the demand in the U.K. differ from that in the EU?

  47. Answer • pUK/pEU = 1.5 • an example that is consistent with this ratio is UK = - 2 and EU = -4 • generally: or 1.5EU - UK = 0.5 UK EU

  48. Generics and brand-name loyalty Why do prices of some brand-name pharmaceutical drugs rise when equivalent, generic brands enter the market?

  49. Entry of generics • generics enter when patent for profitable drug expires • generics: 40% of U.S. pharmaceutical sales by volume • name-brand drugs with sales of about $20 billion went off patent by 1997 • most states allow/require pharmacist to switch prescription from more expensive brand-name product to generic unless doctor or patient object

  50. Price effects 18 major orally-administered drug products that faced generic competition 1983-1987 • on average for each drug, 17 generic brands entered and captured 35% of total sales in first year • price effects • brand-name drug prices rose an average of 7% • but average market price fell over 10% • because generic price was only 46% of brand-name price

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