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

+

Lecture 5: Price Discrimination

AEM 4160: Strategic PricingProf. Jura Liaukonyte

1

+ 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

+

Second Degree PRICE DISCRIMINATION

+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.

+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

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Example: Coupons

+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

Grocery Trends

http://www.couponsherpa.com/ask-coupon-sherpa/clip-this-top-22-coupon-trends/

+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

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+ Coupon Usage Distribution

+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.

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Two-Part Tariffs

+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.

+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.

+Two-Part Tariffs

p1 + p2x

Q: What is the largest that p1 can be?

+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?

+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.

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

+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

+Two-Part Pricing

$

Quantity

Vi

Vi

MR

MCc

Set the unit price equalto marginal cost

Set the unit price equalto marginal cost

This gives consumer surplus of (Vi - c)2/2

This gives consumer surplus of (Vi - c)2/2

The entry chargeconverts consumersurplus into profit

Vi - cSet the entry chargeto (Vi - c)2/2

Set the entry chargeto (Vi - c)2/2

Profit from each pair of Old and Young is now d = [(Vo – c)2 + (Vy – c)2]/2

+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

+Two-Part Tariff with Two Types of Consumers

+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

+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

+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

+Benefits of Raising the Per-Minute Charge

+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

+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

+Menu of Two-Part Tariffs

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+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

+Capping Minutes

+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