Strategic Pricing: Theory, Practice and Policy Professor John W. Mayo [email protected].

Strategic Pricing:

Theory, Practice and Policy

Professor John W. Mayo

[email protected]

Nonlinear Pricing

So far, Uniform /nonuniform pricing

Price Quantity Expenditures

.90 1 $.90

.90 2 $1.80

.90 3 $2.70

.90 4 3.60

Cantaloupes

Exp.

Q

Q

Linear and Nonlinear Pricing

• Linear Pricing – expenditures increase proportionately with consumption

• E.g., Beer: P = $5 per beer

• Nonlinear Pricing – expenditures rise disproportionately with consumption

• E.g. Redskins tickets: • Exp = Personal Seat License + X per game

Two-part Tariffs

• Two-part Tariff involves a fixed fee plus a per unit price

• Examples:• Restaurants (á la carte v buffet)• Nightclubs: cover plus drinks• Country clubs: monthly charge plus greens fees

• Important Features of nonlinear pricing

• Requires ability to prevent resale• Creates vehicle for extracting consumer surplus that is

otherwise unattainable

Single-type consumers

P/Q

Q

MC = m

Optimal linear price: pm

pm

qm

Optimal two-part tariff:

A

B

C

= (A+B+C) + m*q

Multiple-type consumers

P/Q

Q

MC = m

pm

qm

Multiple (optional) two-part tariffs

P/Q

Q

MC = m

pm

qm

If knew customer types and can prevent resale, then charge two tariffs,

But suppose that all you knowis that there are different customers,Not their identity?

Multiple (optional) two-part tariffs

Q

Exp.

F1

F2

Consumers will tend To minimize expenditures(absent insurance considerations)

Receipts will tend to beDefined by the lower Envelope of the curves

Optional Two-part Tariffs in Practice:Telephone Pricing in the United States

• Unlimited (Flat-rate) service $17.01/month

• Limited Per Call Service• $10.16 + .10* Calls (for calls > 65/month)

• Economy Call Service• $5.92 +.10*Calls

Source: Verizon, Montgomery County White pages

Telephone Expenditures with Nonlinear Pricing

$

Calls

$17.01

110 134

$5.92

$10.16

What is the “logical” consumer response?

What is the actual consumer distribution among the calling plans ?

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Nonlinear pricing in practice

• Is the pricing of electricity in Basel (Washington) (elsewhere) linear or nonlinear? What are the economic and societal implications of such pricing?

• Why would such a firm ever set a price to encourage conservation?

• What is the structure of mobile telephone pricing? What competitive and economic dynamics have led to this pricing structure?

Discussion:Paying by the Gig

• What is the current pricing model for Internet usage?

• What is being trialed by Time Warner Cable?

• What are the business drivers of the pricing scheme?

Minimum quantity pricing

• Consider a good or service with a highly fluctuating intertemporal demand

• The demand for hotel rooms in Washington during the Inauguration activities versus a normal demand

• The demand for hotel rooms in Basel during Fachnacht

• Option one: Charge the linear price consistent with the extent of market power or impose minimum stay

Minimum Quantity Pricing

1 2

A

BC

DE F

Days

$/Day

mc

Profit Consumer Surplus

Monopoly Pricing

B+E A

Minimum Stay E+F+D A + B +C - D

Net F+D>B? B+C>D?Pm

Pstay

Price Discrimination

• Price discrimination – practice of charging consumers prices that differ by more than differences in the cost to produce the good

• (Pi/mci) ≠ (Pj/mcj ) [George Stigler]• (cost-based differences are not considered price

discrimination)

MC(Q)$

Q

Profit Maximization with Market Power

P*

D=Q(P)=P(Q)MR(Q)

Q*

Is Q*, P* profit max?

Why not sell these units?

MC(Q)$

Q

Market Power and Price Discrimination

P

D=Q(P)=P(Q)MR(Q)

“Consumer Surplus”

Unrealized Sales

What would be ideal for the firm?

MC(Q)$

Q

Market Power and Price Discrimination

P

D=Q(P)=P(Q)MR(Q)

“Consumer Surplus”

Unrealized Sales

Is this a violation of our MR=MC rule?

Effects of price discrimination

• Producer increases revenue and profits

• Low willingness-to-pay consumers typically gain as they would be under-served otherwise

• High willingness-to-pay consumers typically worse off

Forms of Price Discrimination

• First Degree – practice of charging each consumer her individual reservation price

• Second Degree – Practice of charging consumers a volume-sensitive price that is noncommensurate with cost charges

• Third Degree – practice of sorting consumers into different groups based on observable characteristics and charging different prices

Price Discrimination

D

mc

mr

pm

qmQ

$/QFirst Degree Price DiscriminationAllows firms to extract all consumer surplus

First-Degree (Perfect) Price Discrimination

• Hard to achieve in reality, but some strategies come close• Examples ?• Amazon.com “dynamic pricing” (more later)

• Used car dealers, mechanics, contractors, any negotiated price

• Haggling in the bazaar• Capital One• 1990s - Pricing long-distance telephone calls

First-degree price discrimination

• Advantages:• Extracts the most consumer surplus

• Disadvantages:• Difficult (costly) to do - Determining willingness

to pay is exceedingly hard • Risk consumer backlash (Amazon.com)

Second-Degree Price Discrimination

• Practice of charging consumers a volume-sensitive price that is noncommensurate with cost charges

M&Ms 1.74 oz. P = .89 or $8.18/lb

M&Ms 14 oz P=$2.50 or $2.85/lb

Second Degree Price DiscriminationExample: Electricity Pricing

Electricity pricing

First 1000kwh P= .10Next 10000 kwh P = .08Kwh > 11,000, p= .07

$/kwh

kwh1,000 11,000

.10

.08

.07

Second-degree price discrimination• Advantages:• Can target consumers with particular volume preferences• Can encourage or discourage consumption by pricing for

marginal customers• • Disadvantages:• Lower total revenue than 1st degree• Risk confusing consumers

Third Degree Price Discrimination

• Occurs when firm charges different consumers different prices for the same good

• Consider a firm selling to two distinct customer groups, so…

Third Degree Price Discrimination

π = P1Q1 + P2Q2 – C (Q)

mr1 = p1(1 + 1/ε1) and mr2 = p2(1 + 1/ε2) And profit maximization requires:mr1 = mc and mr2 = mc, sop1(1 + 1/ ε1) = p2(1 + 1/ ε2) = mc , or

p1/p2 = (1 + 1/ ε2) / (1 + 1/ ε1)

So, say ε1=-6 and ε2 = -4

Third-Degree Price Discrimination

• Practice of sorting consumers into groups based on observable characteristics associated with willingness to pay and charging different prices (a.k.a. group pricing)

• Examples of 3rd degree p.d.:• Senior/student discounts• Drycleaners and haircuts• AAA and AARP discounts• Spatial groupings

• (Canadians at DisneyWorld)

Implications

• If it is possible to identify separate elasticities, it is desirable to set different prices.

• How might firms identify elasticities?• Travelling tomorrow?• Number of substitutes • Self-identify (coupons)

Third-degree price discrimination

• Advantages:• Generally produces higher total revenue

than a one price constraint• Sorting mechanism is observable/verifiable• Disadvantages:• Lower total revenue than 1st degree• Risk consumer backlash

The Policy of Price Discrimiation• Price Discrimination [Clayton Act, Sec. 2]• It shall be unlawful for any person engaged in commerce, … to

discriminate in price between different purchasers of commodities of like grade and quality, …where the effect of such discrimination may be substantially to lessen competition or tend to create a monopoly in any line of commerce, or to injure, destroy, or prevent competition with any person who either grants or knowingly receives the benefit of such discrimination, or with customers of either of them:

• Provided that nothing herein contained shall prevent differentials which make only due allowance for differences in the cost of manufacture, sale, or delivery resulting from the differing methods or quantities in which such commodities are to such purchasers sold or delivered:

• Section 2(b) permits “good faith” meeting of competition

Peak Load Pricing

• Suppose that demand is predictably volatile

• Variation may be daily, seasonal

• Pricing response?

Intertemporal Price Discrimination:Peak Load Pricing

Pmc

D1

mr1

D2

mr2

q1

p1

p2

q2

Pizza for $2.99???

Examples of Peak-load pricing

• Pricing power by the hour• Average rate = $.11/kwh• Peak rate = $.81/kwh• Off Peak =$.09/kwh

• Reservations?

• How is this different than ‘paying by the gig’ for Internet downloads?

Necessary conditions for Price discrimination

• 1. Monopoly power

• 2. Ability to identify different customers

• 3. Ability to prevent arbitrage

European Commission Finds against Topps

• Facts?

• Should government concern itself with something as trivial as trading cards?

• Is Topps pricing policy consistent with the establishment of the EU?

The Economics of Price Discrimination

Finland Portugal

mr d

PF

QF

PP

QPQ

P

Combined Market

€/Q €/Q€/Q

QQ Q

mr d

D

MR

With linear demand and costs, price discrimination fails to benefit consumers

mc

Dynamic Pricing

• “Dynamic pricing” • is sometimes meant to connote price changes over

time for the same commodity or service • E.g., Caps’ pricing within a season• Coca-cola vending machines that adjust price depnding on

temperature

• Is sometimes meant to connote third degree price discrimination

• E.g., Amazon.com (setting different prices to different consumners for the same commodity (e.g. book or CD)

• Orbitz has discovered that Mac users pay on average 30 % more for hotel rooms per night than PC users – modify showing

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Orbitz Pricing : PC Search (July 6, 2012)

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1:PC: $103

2:PC: $134

3:PC:$129

4:PC:$159

But if Mac-based search???

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Hyatt Regency Crystal City

Hyatt Regency Crystal City

October 19- Oct 21

$103 per night

October 26- Oct 28

$169 per night

Takeaways

• When firms have market power, simple pricing can leave a lot of value “on the table”

• Price discrimination strategies can help firms increase profits

• Extract consumer surplus from existing high willingness-to-pay customers

• Make additional profitable sales to low willingness-to-pay consumers

• Be aware of legal restrictions