Third Degree PRICE DISCRIMINATION

1. AEM 4160: STRATEGIC PRICINGPROF.: JURA LIAUKONYTELECTURE 6THIRD DEGREE PRICE DISCRIMINATIONBUNDLING AND TYING

2. Third Degree PRICE DISCRIMINATION

3. Third-degree price discrimination • Consumers differ by some observable characteristic(s) • A uniform price is charged to all consumers in a particular group – linear price • Different uniform prices are charged to different groups • subscriptions to professional journals [library/student] • airlines • the number of different economy fares charged can be very large indeed! • early-bird specials; first-runs of movies

4. Third-degree price discrimination • The pricing rule is very simple: • consumers with low elasticity of demand should be charged a high price • consumers with high elasticity of demand should be charged a low price

5. Third degree price discrimination: example • Harry Potter volume sold in the United States and Europe • Demand: • United States: PU = 36 – 4QU • Europe: PE = 24 – 4QE • Marginal cost constant in each market • MC = $4

6. The example: no price discrimination • Suppose that the same price is charged in both markets • Use the following procedure: • calculate aggregate demand in the two markets • identify marginal revenue for that aggregate demand • equate marginal revenue with marginal cost to identify the profit maximizing quantity • identify the market clearing price from the aggregate demand • calculate demands in the individual markets from the individual market demand curves and the equilibrium price

7. The example United States: PU = 36 – 4QU Invert this: QU = 9 – P/4 for P< $36 At these prices only the US market is active Europe: PU = 24 – 4QE Invert QE = 6 – P/4 for P< $24 Aggregate these demands Q = QU + QE = 9 – P/4 for $24 <P< $36 Now both markets are active Q = QU + QE = 15 – P/2 for P < $24

8. The example Invert the direct demands $/unit P = 36 – 4Q for Q <3 36 P = 30 – 2Q for Q > 3 Marginal revenue is MR = 36 – 8Q for Q< 3 17 MR = 30 – 4Q for Q> 3 Demand MR Set MR = MC MC Q = 6.5 6.5 15 Quantity Price from the demand curve P = $17

9. The example Substitute price into the individual market demand curves: QU = 9 – P/4 = 9 – 17/4 = 4.75 million QE = 6 – P/4 = 6 – 17/4 = 1.75 million Aggregate profit = (17 – 4)x6.5 = $84.5 million

10. The example: price discrimination • The firm can improve on this outcome • Check that MR is not equal to MC in both markets • MR > MC in Europe • MR < MC in the US • the firms should transfer some books from the US to Europe • This requires that different prices be charged in the two markets • Procedure: • take each market separately • identify equilibrium quantity in each market by equating MR and MC • identify the price in each market from market demand

11. The example $/unit Demand in the US: 36 PU = 36 – 4QU Marginal revenue: 20 MR = 36 – 8QU Demand MR MC = 4 4 MC Equate MR and MC 4 9 Quantity QU = 4 Price from the demand curve PU= $20

12. The example: $/unit Demand in the Europe: 24 PE = 24 – 4QE Marginal revenue: 14 MR = 24 – 8QE Demand MR MC = 4 4 MC Equate MR and MC 2.5 6 Quantity QE = 2.5 Price from the demand curve PE= $14

13. The example • Aggregate sales are 6.5 million books • the same as without price discrimination • Aggregate profit is (20 – 4)x4 + (14 – 4)x2.5 = $89 million • $4.5 million greater than without price discrimination

14. Some additional comments • Suppose that demands are linear • price discrimination results in the same aggregate output as no price discrimination • price discrimination increases profit • For any demand specifications two rules apply • marginal revenue must be equalized in each market • marginal revenue must equal aggregate marginal cost

15. Price discrimination and elasticity • Suppose that there are two markets with the same MC • MR in market i is given by MRi = Pi(1 – 1/hi) • where hi is (absolute value of) elasticity of demand • From rule 1 (above) • MR1 = MR2 • so P1(1 – 1/h1) = P2(1 – 1/h2) which gives Price is lower in the market with the higher demand elasticity

16. 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 different 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.

17. BUNDLING AND TYING

18. Introduction • Firms often bundle the goods that they offer • Microsoft bundles Windows and Explorer • Office bundles Word, Excel, PowerPoint, Access • Bundled package is usually offered at a discount • Bundling may increase market power • GE merger with Honeywell • Tie-in sales ties the sale of one product to the purchase of another • Tying may be contractual or technological • IBM computer card machines and computer cards • Kodak tie service to sales of large-scale photocopiers • Tie computer printers and printer cartridges • Why? To make money!

19. More Examples of Bundling • Telecommunications • firms bundle local, long-distance, and mobile telephone services, • Banks • bundle checking, credit, and investment services • Hospitals bundle an array of medical services.

20. Incentives to Bundle • Bundling may arise in many contexts to sort consumers in a manner similar to second-degree price discrimination • When consumers have heterogeneous tastes for several products, a firm may bundle to reduce that heterogeneity, earning greater profit than would be possible with component (unbundled) prices • Bundling—like price discrimination—allows firms to design product lines to extract maximum consumer surplus.

21. Bundling advantages • Simplifies consumer choice (as in telecommunications and financial services) • Reduces costs from consolidated production of complementary products • Reduces consumer search costs and product or marketing costs. • Bundling to extend market power and/or deter entry • as witnessed by antitrust challenges to Microsoft’s bundling of software applications (e.g. its Internet browser, media player) with its dominant Windows operating system

22. Cable TV • Crawford’s (2001) empirical study of bundling decisions of cable providers • bundle several networks into a basic bundle service, cable provider increases its profit on average above unbundled sales by 14% • 13% less CS than from unbundled sales • bundling together similar networks is less profitable than bundling dissimilar ones

23. Computer software suites • Microsoft and others bundle dissimilar programs—word processors and spreadsheets—into a suite • Gandal (2003): • survey of home PC users: 43% use both programs;50% used only one; 7% used neither • survey business PC users: 63% used both, 37% used only one • A lot of users use only one (but not both) pieces of software • consumers with a high value for spreadsheets had a low value for word processors and vice versa: negative correlation in demand

24. Tie-In sales. • Generally considered to be an ‘extension of monopoly’ by courts. In other words, courts believed it was an attempt to use one monopoly to create a second. • Frequently, tying good is sold very cheaply, while tied good is very expensive. Famous cases: IBM and computer cards, Xerox and toner, Canning machines and tin plate.

25. Printers and Ink Cartridges • High-intensity usage consumers => high willingness-to-pay • Low-intensity usage consumers => print small volumes => a low willingness-to-pay. • Strategy: lower the price of the initial, one-time purchase printer and raise the price of the aftermarket, repeat purchase ink cartridge. • Ink cartridge becomes the mechanism by which consumers' intensity of usage is metered: • inducing high-intensity users to pay a higher overall price • low-intensity users a lower overall price.

26. Examples cont’d • This basic idea holds for a variety of other aftermarket situations: • razors and razor blades • video game consoles and video games • etc.

27. Anti-trust and bundling • The Microsoft case is central • accusation that used power in operating system (OS) to gain control of browser market by bundling browser into the OS • need\ to show • monopoly power in OS • OS and browser are separate products that do not need to be bundled • abuse of power to maintain or extend monopoly position • Microsoft argued that technology required integration • further argued that it was not “acting badly” • consumers would benefit from lower price because of the complementarity between OS and browser

28. And now… • This view gained more force and support in Europe • bundling of Media Player into Windows • Competition Directorate found against Microsoft • no on appeal

29. Antitrust and tying arrangements • Tying arrangements have been the subject of extensive litigation • Current policy • tie-in violates antitrust laws if • there exists distinct products: tying product and tied one • firm tying the products has sufficient monopoly power in the tying market to force purchase of the tied good • tying arrangement forecloses or has the potential to foreclose a substantial volume of trade