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

Lecture Plan  HW1  Second degree price discrimination  Designing pricing plans for consumers to self-select themselves  Examples  Third degree price discrimination  Market segmenting  Examples 1 2

Second Degree PRICE DISCRIMINATION

Price Discrimination Based on Self- Selection  Often firms cannot distinguish between groups of consumers based on observable characteristics  Offer a menu of alternatives to let customers self-select  If properly designed, customers with different willingness to pay will choose different alternatives  Examples: supermarket discounts for shoppers who clip coupons, wireless phone companies with multiple calling plans Price Discrimination may still be possible

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.

Example: Coupons

Coupons Grocery Trends (2009) Coupons Distributed +12% Coupons Redeemed+19% Internet Coupons+83% 75% of coupon users say coupon had at least some influence on their decision to purchase a new product

Coupons  A form of second-degree price discrimination  Enables retailers to attract informed customers by discounting

Coupon Overview

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.

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. A two-part tariff is a lump-sum fee, p 1, plus a price p 2 for each unit of product purchased. Thus the cost of buying x units of product is p 1 + p 2 x. Q: What is the largest that p 1 can be?

Two-Part Tariffs  p 1 + p 2 x  Q: What is the largest that p 1 can be?  A: p 1 is the “entrance fee” so the largest it can be is the surplus the buyer gains from entering the market.  Set p 1 = CS and now ask what should be p 2 ? The monopolist maximizes its profit when using a two-part tariff by setting its per unit price p 2 at marginal cost and setting its lump- sum fee p 1 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 18-16

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 ViVi ViVi MR MC c Set the unit price equal to marginal cost This gives consumer surplus of (V i - c) 2 /2 The entry charge converts consumer surplus into profit V i - c Set the entry charge to (V i - c) 2 /2 Profit from each pair of Old and Young is now  d = [(V o – c) 2 + (V y – 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

Fixed fee : $40.50 = (90*.9)/2 Clearvoice Wireless Example  Fixed fee: $8 =(40*.4)/2 Low DemandHigh Demand If we could observe consumer characteristics, we would offer two-part tariff with 10-cent per-minute price

Profit-Maximizing Two-Part Tariff  Per-minute price of 10 cents and monthly fee of $40.50  High-demand customers …  Low-demand customers …  Per-minute price of 10 cents and monthly fee of $8  High-demand customers …  Low-demand customers …  Q: Which plan is better?  A: High Demand Low Demand Suppose Clearvoice wants to offer a single two-part tariff Question

Profit-Maximizing 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  Q: Which plan is better?  A: If there are a large number of low-demand customers, $8 monthly fee is better High Demand Low Demand Suppose Clearvoice wants to offer a single two-part tariff Question

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  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 fraction of low-demand consumer, the more worthwhile it is to raise the per-unit price Max Profits Intuition Conclusion

Benefits of Raising the Per-Minute Charge

Using Menus to Increase Profit  Even better by offering a menu of two-part tariffs, each designed to attract a specific type of consumer  Intuition:  Extract more surplus from high-demand consumers by making the low-demand plan less attractive to high-demand customers

High-Demand Consumers  First Option 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 Low Demand High Demand Suppose Clearvoice offers a pair of two-part tariffs Effects

Menu of Two-Part Tariffs 18-27

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