Lecture 4: Price Discrimination

1. Lecture 4: Price Discrimination AEM 4160: Strategic Pricing Prof. Jura Liaukonyte

2. Price Discrimination

3. Examples Paper towels, soft drinks in supermarket. Buying more, lower unit price Marlboro sold in different countries US. 3.5$ per pack China 1$ per pack Air fares Business class economy class Software Microsoft office $750 buy Microsoft office’s each component individually $2060.

4. Price Discrimination Price Discrimination • What is this? • Goal is to steal consumer surplus! • Under what conditions is it possible? • Four conditions required a. Monopoly power b. There are identifiable submarkets. c. Different price elasticities of demand. d. Prevention of arbitrage.

5. 3 Types of Price Discrimination • First Degree • Charge different price for every unit sold. • Most Severe. Steal all CS • Second Degree • Have consumers self-select or charge different prices depending on volume of usage. • Third Degree or multimarket (most common) • Easily segmented markets.

6. First Degree PRICE DISCRIMINATION

7. First Degree Price Discrimination MC P1 D Q Q1 First unit charged its highest possible price. $

8. First Degree Price Discrimination MC P1 P2 P3 D Q Q1 Q2 Q3 • Second unit charged its highest possible price, and so on... $

9. First Degree Price Discrimination MC P1 P2 P3 P4 D=MR=P Q Q1 Q2 Q3 Q3 • What happens to CS? $

10. Example: Credit Card Industry

11. How The Industry Works • Credit agencies keep track of consumer credit history. • Banks originate credit lines and determine terms. •  Banks lend consumers lines of credit •  Fixed amount of money based primarily on income and FICO score •  Terms, including interest rates, are determined based on FICO score

12. Credit Agencies • Credit agencies such as Experian, TransUnion, and Equifax collect information about consumers • Tied to social security number • Collect data on: • Account history • Age of Account • Debt • Available Credit • Payment history (on time or late) • Determine risk factor by looking at various metrics: • Debt-credit ratio • Average account age • Accounts 30 days, 60 days, and 90 days late.

13. Understanding the FICO Score

14. First Degree Pricing Using FICO Score     • FICO scores provide a snapshot of the consumer's credit worthiness, and companies price on an individual basis • Less risky consumers are worth more in the long run • More responsible spending, payments on time • High risk consumers are less desirable, but can be highly profitable. • Higher risk means higher APRs, worse terms for consumer

15. Price Discrimination • First Degree Price Discrimination: Summary • Charge a separate price to each customer: the maximum or reservation price they are willing to pay.

16. Additional Profit From Perfect First-Degree Price Discrimination • Question • Why would a producer have difficulty in achieving first-degree price discrimination? • Answer 1) Too many customers (impractical) 2) Could not estimate the reservation price for each customer

17. Price Discrimination • First Degree Price Discrimination • Other examples of imperfect price discrimination where the seller has the ability to segregate the market to some extent and charge different prices for the same product: • Lawyers, doctors, accountants • Car salesperson (15% profit margin) • Colleges and universities

18. First Degree Price Discrimination • However, first-degree price discrimination has found a place on the Internet in the form of reverse auctions. • In a reverse auction, a customer names the price he is willing to pay, and the seller decides whether or not to offer him that price. (Customers are restricted from bidding on the same item multiple times within a certain amount of time, eliminating their ability to start out low and increase the bid until it is accepted). • Priceline is the most commonly cited example of a reverse auction. http://www.priceline.com/

19. First-degree price discrimination • Suppose that you own five antique cars • Market research indicates that there are collectors of different types • keenest is willing to pay $10,000 for a car, second keenest $8,000, third keenest $6,000, fourth keenest $4,000, fifth keenest $2,000 • sell the first car at $10,000 • sell the second car at $8,000 • sell the third car to at $6,000 and so on • total revenue $30,000 • Contrast with linear pricing: all cars sold at the same price • set a price of $6,000 • sell three cars • total revenue $18,000

20. Informational Requirements • Are four criteria satisfied? • Do you think first degree price discrimination is common? • What are the informational requirements for the seller?

21. First-degree price discrimination • The information requirements appear to be insurmountable • but not in particular cases • tax accountants, doctors, students applying to private universities • No arbitrage is less restrictive but potentially a problem

22. First-degree price discrimination • First-degree price discrimination is highly profitable but requires • detailed information • ability to avoid arbitrage • Leads to the efficient choice of output: since price equals marginal revenue and MR = MC • no value-creating exchanges are missed

23. SECOND Degree PRICE DISCRIMINATION

24. Second-degree price discrimination • What if the seller cannot distinguish between buyers? • perhaps they differ in income (unobservable) • Then the type of price discrimination just discussed is impossible • High-income buyer will pretend to be a low-income buyer • to avoid the high entry price • to pay the smaller total charge

25. Second-degree price discrimination • Firms typically offer a list of different prices to consumers allowing the consumers to self-select. • Also called VERSIONING pricing strategy: companies sell variations of a product or service at different prices to different groups of customers. • Create versions of a product to appeal to different types of buyers. Customers then choose the version that best meets their needs. •  Distribute a physically similar product under different brand names, • E.g. GAP, Old Navy, Banana Republic • Filene’s Basement, TJMaxx, Marshalls

26. Second-Degree Price Discrimination • Movie studios and special editions of movies. • DVD vs. Blu-ray http://www.amazon.com/Transformers-Shia-Labeouf/dp/B000VR0570/ref=sr_1_1?ie=UTF8&s=dvd&qid=1265061944&sr=1-1 • Segmenting by early adopters of new technology • TurboTax http://turbotax.intuit.com/

27. Second-Degree Price Discrimination • Health clubs often charge less for memberships with restricted off peak hours. • Self Selection (student vs. busy individual) • GettyImages, an online photography library, charges users according to the resolution level. • Self Selection (professional users vs. casual users)

28. Second-Degree Price Discrimination • In some markets, consumers purchase many units of a good over time • Demand for that good declines with increased consumption • Electricity, water, heating fuel • Firms can engage in other type of second degree price discrimination • Practice of charging different prices per unit for different quantities of the same good or service

29. Second-Degree Price Discrimination • Quantity discounts are an example of second-degree price discrimination • Ex: Buying in bulk like at Sam’s Club • Block pricing – the practice of charging different prices for different quantities of “blocks” of a good • Ex: electric power companies charge different prices for a consumer purchasing a set block of electricity

30. Second-degree price discrimination • The seller has to compromise • Design a pricing scheme that makes buyers • reveal their true types • self-select the quantity/price package designed for them • Essence of second-degree price discrimination • It is “like” first-degree price discrimination • the seller knows that there are buyers of different types • but the seller is not able to identify the different types

31. Second-degree price discrimination • Will the monopolist always want to supply both types of consumer? • There are cases where it is better to supply only high-demand types • high-class restaurants • golf and country clubs • Take our example again • suppose that there are Nl low-income consumers • and Nh high-income consumers

32. 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. If there aren’t many customers in the low-valuation group, you may want to ignore this group, since selling to it forces you to lower the price to the high valuation group.

33. More types of second degree price discrimination • Intertemporal price discrimination • Idea: high valuation users are also less patient. • Quantity discounts (price per unit depends on the quantity bought). • Idea: high valuation consumers willing to pay more for more. • 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.

34. 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 of high and low value 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.

35. Feasibility of price discrimination • Two problems confront a firm wishing to price discriminate • identification: the firm is able to identify demands of different types of consumer or in separate markets • easier in some markets than others: e.g tax consultants, doctors • arbitrage: prevent consumers who are charged a low price from reselling to consumers who are charged a high price • prevent re-importation of prescription drugs to the United States • The firm then must choose the type of price discrimination • first-degree or personalized pricing • second-degree or menu pricing • third-degree or group pricing

36. Example: Tablet Industry

37. Intertemporal pricing • People value things differently depending on the point in time they will receive it • Value now > Value later (Hyperbolic Discounting) • eReader and Tablet companies exploit this discrepancy by marking up their product upon introduction • Capture the consumer surplus of early-adopters • They later lower their prices to reflect the reduction in value that occurs when the product leaves the initial market entry stage and more consumers begin to enter the market

38. Intertemporal Pricing: eReaders

39. Intertemporal Pricing: eReaders

40. Intertemporal Pricing: eReaders

41. Example: Airline Industry

42. 2nd Degree Price Discrimination • Price Dispersion • Variation in prices for the same item • Versioning • Variations of a product or service at different prices to different groups of customers • First Class vs. Coach seating

43. Price Dispersion • Increases with competition • Increases with variation in the population • Decreases with homogeneity of the market • Increases when there are more differing product attributes A firms responsiveness to price dispersion decreases when their market share increases 

44. Price Dispersion • The expected difference in fares paid is 36% • Airlines likely to have 20 or more different fares on one given flight

45. Example: Ski Industry

46. Product Differentiation • A form of second degree price discrimination • Provide customers with many options and they choose what to purchase • Ski resort industry offers a variety of products and services in order to: • Meet consumer needs • Maximize revenue • Maximize producer surplus • Increase customer base

47. Product Differentiation

48. Ski Pass Differentiation • Type of ski pass • Full day pass • Half day pass • Night pass • Length of ski time • One day pass • Weekend pass • Week pass • Season pass

49. Ski Lift Ticket Prices: Bristol Mountain Adult Prices

50. Variations in Ski Pass Options • As the number of days purchased at one time increases, the price per day of the ticket decreases • Resorts do this to encourage customers to buy more days worth of tickets