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Lecture Plan

AEM 4160: Strategic Pricing Prof.: Jura Liaukonyte Lecture 6 – THU, FEB 10th 3 rd degree price discrimination Cell phone Pricing. Lecture Plan. 3 rd degree price discrimination Virgin Mobile Pricing. Third Degree PRICE DISCRIMINATION. Third-degree price discrimination.

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Lecture Plan

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  1. AEM 4160: Strategic PricingProf.: Jura LiaukonyteLecture 6 – THU, FEB 10th3rd degree price discriminationCell phone Pricing

  2. Lecture Plan • 3rd degree price discrimination • Virgin Mobile Pricing

  3. Third Degree PRICE DISCRIMINATION

  4. 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

  5. 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

  6. 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

  7. 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

  8. 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

  9. The example Invert the direct demands $/unit P = 36 – 4Q for Q <3 36 P = 30 – 2Q for Q > 3 30 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

  10. 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

  11. 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

  12. 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

  13. 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

  14. 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

  15. 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

  16. 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

  17. 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.

  18. Issue • Pricing decision: • Entering a highly saturated cell phone service industry, while targeting an unsaturated market segment • Attempting to earn a profit from a limited income market • Target market is: • Young (15-29) • Trendy • Different than traditional cell phone users • Different spending habits • Different usage • Different needs • Limited purchasing power • “According to marketing research, target market does not trust industry pricing plans.” -Dan Schulman, CEO, Virgin Mobile USA

  19. Objectives • Create value and profitability in cell phone service industry • Target market ages 15-29, opportunity for growth with this market segment • 1 million subscribers by year 1, 3 million by year 4 • “By focusing on the youth market from the ground up, we’re putting ourselves in a position to serve these customers in a way they have never been served before” -Dan Schulman, CEO, Virgin Mobile USA

  20. Options • Clone Industry Prices: contracts • Set prices below competition: contracts • A whole new plan: prepaid pricing

  21. Clone Industry Prices • Pros • Give customers more features for the same price • Easy to promote, use current models • Limited spending power on promotion may be a justifiable factor • Viable with Virgin Mobile’s limited advertising budget • Cons • May drive margins down if additional features are costly • Reduces competitive advantage • Difficult to penetrate saturated market with similar offer as competitors • Competitive with other cell phone providers and packages; does not support strong market differentiation

  22. Price Below Competition • Pros • Drive sales and market share • Accounts for limited spending power of target market • Cons • Margins and profitability will be driven down • Inconsistent with company goal of profitability • Cannot compete in price wars • Not a long term solution

  23. A Whole New Plan: Prepaid Pricing • Pros • Differentiate from competition • Cater to the needs of target market • Flexibility is attractive to target market • Profitability is key • Eliminates risk of missed payments • Cons • Risk of limited returns and loyalty • Churn rate may increase

  24. Pricing Structure from the Carrier Perspective • Contracts: • Annual churn rate WITH contracts =2% * 12 months = 24% (p.8) • Annual churn rate WITHOUT contracts =6% * 12 months = 72% (p.8) • The difference: 72% - 24% = 48% Take AT&T example: customer base = 20.5 million If AT&T abandons the contract based plan how many new customers would it need to acquire to offset customers from an increased churn rate? • Additional customers lost to churn: __________________ • Acquisition cost per customer: $370 (case p.2) • Total cost of offsetting higher churn rate: __________________ Not surprising that major players still continue to hold the contracts.

  25. “Menu” pricing: Actual Usage

  26. Bucket/”Menu” pricing • In reality most consumers are paying more than their optimal rate = if they new exactly how much they will consume • “industry makes money from consumer confusion” • Pricing menus allow carriers to advertise low per minute rates • But most consumers end up choosing the wrong menu.

  27. Hidden Fees • Able to promote low per minute prices, but still collect additional revenues

  28. Acquisition costs • Advertising per gross add: from $75 to $100 (p.5) • Sales commission paid per subscriber: $100 (p.5) • Handset subsidy provided to the subscriber: $100 to $200 (p.9) • Total: from $275 to $405 • (let’s assume somewhere in the middle = $370)

  29. Break Even point • Monthly ARPU (average revenue per unit): $52 (p.3) • Monthly Cost-to-Serve: $30 (p.3) • Monthly Margin: $22 • Time required to break even on the acquisition cost = __________________ • In the cellular industry the monthly margin is relatively fixed across periods, therefore the traditional LTV can be simplified (assuming infinite horizon): M = margin the customer generates in a year r = annual retention rate = (1-12*monthly churn rate) i = interest rate (assume 5%) AC = acquisition cost

  30. LTV with contracts • The annual retention rate in the industry = ______________

  31. LTV without contracts • Eliminate contracts -> churn rate increases to 6% • Calculate the LTV:

  32. Eliminate Hidden Costs • $ 29 cellular bill becomes $35 due to hidden costs • Increase of 21% • If these costs were eliminated, the $22 margin would be reduced to _______________ • Break even would become _________= __________

  33. What happens to LTV? • Without hidden costs, but with contracts • Without hidden costs and without contracts • Elimination of contracts drives LTV below zero • Hidden costs boost the bottom line

  34. Option 3: different pricing approach • Target audience: Youth • Loathe contracts • Fail credit checks • Ideal plan: no contracts, no menus, no hidden fees… • How to differentiate itself, and have a positive LTV • Look at the factors that affect LTV

  35. Options for Lowering Acquisition Costs • Advertising costs per customer • Industry=from $75 to $100 • Virgin planned ad costs = 60 mil/1min= $60 (p.5) • Handset subsidies: • Current industry handset cost: $150 to $300 (assume $225) (p.5) • Current industry handset subsidy: $100 to $200 (assume $150) (p.9) • Current industry handset subsidy as a %: 67% • Virgin’s handset cost: $60 to $100 (assume $80) • Assume Virgin’s subsidy around 30% = $30

  36. Acquisition costs • Then Virgin’s AC would be just ____vs. industry average $370 • Sales commission: $30 • Advertising per gross add: $60 • Handset Subsidy $30 • Total: _______

  37. Consumer friendly plan: how to achieve profitability • Break Even analysis: at what per minute price would Virgin break even: • Virgin’s monthly ARPU: ______________ where p=price per minute • Monthly cost to serve: ______________ • Monthly margin: _______________ p > ________

  38. Other price points • What if Virgin charged per minute price comparable to other industry prices, somewhere in between 10 and 25 cents: • At 10 cents: • At 25 cents:

  39. Virgin’s Pricing Plan: What happened • A prepaid plan • No contracts • No hidden charges • No peak off peak hours • Very low handset subsidies • No credit checks • No Monthly bills • Price: 25 cents per minute for the first 10 minutes; 10 cents/minute for the rest of the day • No exact numbers, but churn rate lower than 6%

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