3. Price Discrimination

Question 1

3-1 Different Pricing Techniques

Accepted Answer

Uniform Pricing: A single “posted price” offer for one version for everyone l MRTotal = MC Price Discrimination: => beneficial, as it allows to increase output & extra profits encourage more R&D Price Discrimination can help spread the FC of R&D over larger population to everyone’s Benefit - 1st Degree: Perfect Customization: Each customer is priced at WTP using a tailored take-it-or-leave-it offer Individual Bargaining increases PS to "PS with haggling" (Bargaining Power x PS) Perfect Price Discrimination -> 0 Consumer Surplus No traditional Deadweight loss - 2nd Degree: A menu of prices for different qualities; buyers sort themselves l Upgrades at Incentive Compatibility Doesn’t involve having to observe customer’s spending records, and that prevents arbitrage - 3rd Degree: Direct Price Customization: Prices depend on observable customer characteristics that correlate with their price sensitivity l MR = MC in each market Customizing price unlocks additional profitability compared to uniform pricing Deadweight loss larger than with customized prices, but smaller than uniform prices

Question 2

3-0 Uniform Pricing

Accepted Answer

A single “posted price” offer for one version for everyone Total Market = Strong Micro-Market with higher WTP + Weak Micro-Market with lower WTP

Question 3

3-1 Perfectly Customization l First Degree

Accepted Answer

Each customer is priced at WTP tailored take-it-or-leave-it offer effect only if Bargaining Power high No traditional DWL Everyone is getting the product Effect of Haggling Bargaining surplus roughly proportional to each customers WTP. Total surplus split between consumers and producers When bargaining power is equal and demand is linear, PS is the same as in uniform pricing! Useful if Total Surplus large enough Bargaining Power > Buyer Bargaining Power [Bargaining Skills] Cost of bargaining not too high relative to value of product Convex Demand Curve => Some people really love the product and with uniform prices monopolist must leave too much rent to them.

Question 4

3-3 Direct Price Customization l Third Degree

Accepted Answer

- Prices depend on observable customer characteristics that correlate with price sensitivity - Involves charging different customers different prices for the same good Effect of Value-Based Pricing Unlocks additional profitability compared to uniform pricing DWL larger than Haggling, but smaller than with uniform prices Useful if: When bargaining not desirable When the market can be segmented according to observable customer Uniform pricing leads to high deadweight losS No arbitrage opportunity

Question 5

3-2 Indirect Customization l Second Degree

Accepted Answer

- A menu of prices for different qualities; buyers sort themselves. - Instead of charging different prices to different segments for the same product, create a menu of different versions of the product each with a different price Different segments self-select: let consumers choose what they want from the menu No need to observe customer’s spending records, and that prevents arbitrage Requires help of customer in eﬀort to charge customers a diﬀerent price (i.e. via coupons) Useful if: Without observable characteristics and with arbitrage may need to indirect price customization by selling “upgrades.” Characteristics are difficult to observe Arbitrage opportunity exists Algebraic Solution: Indirect segmentation with two qualities and two segments Two qualities: Latte (premium l MC = 0.5) and Regular Coffee (basic l MC = 0.2) Two customer segments: 10 connoisseurs & 10 casual customers Value Table Options for Monopolist: Customization l Sell premium to connoisseurs and basic to casual customers. Serve only upmarket l Sell premium to connoisseurs and do not serve casual customers Cover the whole market l Sell premium to all customers Algebraic Solution: Calculate Upgrade for each quality Price Basic product first Incentive-Compatible Price Upgrade L Add upgrade to Basic Price to be incentive compatible Incentive-Compatible Price Premium Upgrade l Add premium upgrade to Premium Price to be incentive compatible Optimal Strategy: Same number of connoisseurs and basic users: Customization Most of your customers are connoisseurs: Go upmarket Most of your customers are basics: Cover the whole market Examples: Toyota Camry vs. Lexus IS: “Underlying structure is the same, but what is built on top differs significantly. Whether or not that's worth an extra $10k, well, that's one of those questions only you can answer” IBM Laser Printer 5E vs. IBM Laser Printer 10L: "Upgrading is not based on cost. Sometimes lower quality costs more as in “damaged goods” Coffee Shops: “It doesn’t cost much more to make a larger cup, to use a flavoured syrup or to add chocolate powder or a squirt of whipped cream . . . by charging wildly different prices for products that have largely the same cost, Starbucks is able to smoke out customers who are less sensitive about the price. to identify lavish customers perfectly, so it invites them to hang themselves with a choice of luxurious ropes.”

Question 6

3-2 Incentive Compatibility

Accepted Answer

When pricing the premium product, we need to consider that high valuation customers have the option to “switch” to the basic product. The connoisseurs get “surplus” from the upgrade. They value the premium product at 4.8 but they pay 4.2 Why doesn’t the monopolist increase the price? Because connoisseurs will buy regular coffee instead of a latte! Upgrade is not worth that much.

Question 7

3-3 How to Directly Segment the Market

Accepted Answer

Identification is based on characteristics correlated with price sensitivity Too many segments may lead to cannibalization. Age or Life Status: Discounts for seniors • Discounts for students • Gender Discounts Key correlation: age and price sensitivity are often closely correlated, e.g., seniors are more likely have price elastic demand than others; sometimes students are as well Student discount at Apple: alone the action of calling signal high price sensitivity User Status: Loyalty Program Key correlation: Customers that face switching costs are more likely to have price inelastic demands than “virgins” Institution Type: Corporate l Library l Individual rates in journal subscription Key correlation: Individual, university, and corporate customers often have different price elasticities of demand due to different budget constraints and/or different perceived needs. Purchase Location: Ski resorts • Airports Key correlation: Location that consumer purchases at often is correlated with price sensitivity Knowledge: Employee Discounts in Cafeteria • LBS Discount Key correlation: Employees, unlike tourists, know the area well and know their alternatives and are more price sensitive

Question 8

3-3 How to stop Arbitrage across segments?

Accepted Answer

- Those who buy the product cheaper can transfer it to those who would have paid a higher price. - Sellers make it inconvenient for buyers to transfer the good by: Checking ID Warranties (only valid for first owner) Contracts (airline tickets are non-transferable) Poison to avoid arbitrage l (Ethanol / Fuel Ethanol) Product design (1 pill = $1.11, Proscar = $0.60 -> no change to cut Proscar into 5 Different product codes in different regions

3 Micro (Fach) / 3. Price Discrimination (Lektion)