Chapter 9 Pricing 1

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Pricing  Pricing is the mechanism by which the business acquires revenue ;  Most profitable businesses pay great attention to pricing  in this chapter, focus on pricing as segmentation tool  other aspects of pricing – relation to marketing mix, new products, …  Pricing is especially difficult and profitable for information goods, like software, music CDs, databases.  marginal cost of production is almost zero  marginal cost of copying is almost zero. 3

4 Qantas  QF403, Sydney to Melbourne, July 20, 2011  Fully flexible fare: A$499  Flexi Saver fare: A$219  Red e-Deal: A$199 (from Sydney), $175 (from Melbourne)  Why not fill all seats and earn more profit?  What impose different conditions for change in Flexi Saver and Red e-Deal fares?  Why charge different prices for travelers originating in Melbourne vis-a-vis Sydney?

5 Learning objectives  Apply uniform pricing.  Appreciate how price discrimination can increase profit beyond uniform pricing.  Understand complete price discrimination.  Apply direct segment discrimination.  Apply indirect segment discrimination.  Appreciate the choice between alternative pricing policies.

6 Outline  Uniform pricing  Complete price discrimination  Direct segment discrimination  Location  Indirect segment discrimination  Selecting the pricing policy

7 Uniform pricing  Uniform pricing: charging the same price for every unit of the product and to every buyer

8 Uniform pricing  In airline business, when flight is about to take off, marginal cost of empty seat is almost zero  It doesn’t mean that the airline should try to fill the plane  to fill the plane, may have to cut price and lose revenue from people willing to pay relatively high price.

9 (c) , I.P.L. Png 9 Profit- maximizing price  MR = MC  Equivalently, set the incremental margin percentage equal to the inverse of absolute value of price elasticity of demand,

10  Always set price so that demand is elastic  If demand not elastic, raising price would increase profit.  Higher price + lower quantity (but proportionately less) => higher revenue  Lower quantity => lower cost  If demand more elastic, then lower incremental margin percentage (IM%)  e = –2  IM% = 1/2  e = –1.5  IM% = 2/3 Uniform pricing: Price elasticity

11 Minibar  Hotel room minibar has market power  barriers to competition, demand is inelastic  Compare pricing of Coca Cola with Carlsberg beer  Demand for both is inelastic: elasticity => IM% (not price)  Price = cost + margin  Different cost with the same margin  different prices

12 Outline  Uniform pricing  Complete price discrimination  Direct segment discrimination  Location  Indirect segment discrimination  Selecting the pricing policy

 Shortcomings of uniform pricing:  Leaves buyers with surplus  Does not sell to every potential buyer  Example: airline pricing leaves business travelers with a lot of surplus 13 Complete price discrimination

14 Complete price discrimination

15 Complete price discrimination  Sell down the demand curve  Quantity MB = MC  Price each unit at buyer’s benefit  Maximizes profit  Leaves no buyer with any surplus  Sells to every potential buyer marginal cost marginal unit $ 0 quantity total benefit = total price

16 Complete price discrimination  Contrast  Complete price discrimination: Price each unit at buyer’s benefit and sell quantity where MB = MC  Maximum profit: theoretical ideal  Uniform pricing: MR = MC => smaller scale  Implementation:  Must know entire marginal benefit and marginal cost curves  Must prevent resale:  price discrimination is more widespread in the sale of services

17 Complete price discrimination: Practice  Bargaining  Auctions: an institutional practice to approximate complete price discrimination  Online bidding  Google keyword auctions  eBay  Name your price  Priceline

18 Outline  Uniform pricing  Complete price discrimination  Direct segment discrimination  Location  Indirect segment discrimination  Selecting the pricing policy

19  Setting different prices to various segment of buyers.  Implementation  It is based on fixed identifiable characteristic  Age, gender, nationality  movie theatres, bus and subway service, airlines  No re-sale Direct segment discrimination

20 Direct segment discrimination  Homogeneous segments – all consumers identical within segment  Price = total benefit  Heterogeneous segments – consumers differ within segment  Uniform pricing within segment, or  Indirect segment discrimination within segment  Within each segment: IM% = ‒ 1/e  For segment with more elastic demand, then lower incremental margin percentage (IM%)

21 Direct segment discrimination  Heterogeneous segments – consumers differ within segment: Uniform pricing within segment  Within each segment: IM% = ‒ 1/e  For segment with more elastic demand, then lower incremental margin percentage (IM%)

Direct segment discrimination: Uniform pricing within segments 22

23 Direct segment discrimination: “Not for retail sale”  Heinz serves  institutional customers (food service, restaurants) directly  retail customers indirectly through supermarkets and grocery stores

24 Direct segment discrimination: “Not for retail sale” Demand from institutional customers is more price sensitive (corporate buyers specialize in negotiating good deals) Heinz sets lower margin  lower price to institutional customers (lower margin  lower price because marginal cost is the same); Heinz concerned that supermarkets will buy through food service companies and restaurants; so marks each bottle “Not for Retail Sale”.

25  University tuition  Citizens/non-citizens  Health care  Citizens/non-citizens  Value added tax  Refund to foreigners Direct segment discrimination: Government and non-profit sector

Direct segment discrimination( third degree price discrimination) We can also verify: With price discrimination: MR 1 =MR 2, and thus; If the demand curve is elastic  ε<-1 and if the demand curve is inelastic  -1<ε<0. Thus, price will be lower in the market with higher elasticity of demand. 26

27 Outline  Uniform pricing  Complete price discrimination  Direct segment discrimination  Location  Indirect segment discrimination  Selecting the pricing policy

28  Price discrimination by buyer’s location:  Should not set price in foreign market = price in domestic market + freight charge  Such pricing ignores differences in price elasticity  Set price according to  Elasticity of demand  Marginal cost (production + transportation)  Microsoft – cheaper versions of Windows for Thailand, Brasil  difference in language prevents cannibalization Location

29 Wall Street Journal Asia Price for annual subscription, March 2010 Print & online: Hong Kong (HK$ 2,800)US$361 Print & online : Japan (Yen 94,500)US$1044 Print & online : Singapore (S$ 600)US$430 Online only: WorldwideUS$ 104 Why different prices for print edition but not online edition?

 Why different prices for print edition but not online edition?  product is perishable: buyer in Tokyo won’t subscribe in Singapore to get newspaper a day later  buyer won’t switch locations just to get lower price  It is difficult to identify the location of an internet subscriber 30 Wall Street Journal Asia

31 (c) , I.P.L. Png 31 Location: Gray markets  Price differential between price and transportation cost;  Retailers/consumers buy cheap products in one market and ship them to another market -- parallel imports  parallel imports of car, cosmetics, branded cigarettes  With e-commerce, on-line retailers become major gray market channel;

32 Location: Gray markets  How manufacturers cope with parallel imports – product and distribution  Product  Technical differentiation, eg, DVD encoding  Packaging and labeling  Limit warranty service  Distribution  Limit sales to “suspect” channels  Pharmaceutical manufacturers limit sales to Canadian pharmacies

33 Location: Managing gray markets  How manufacturers cope with parallel imports – product and distribution  Product  Technical differentiation, eg, DVD encoding  Packaging and labeling  Limit warranty service  Distribution  Limit sales to “suspect” channels: Pharmaceutical manufacturers limit sales to Canadian pharmacies

34 Outline  Uniform pricing  Complete price discrimination  Direct segment discrimination  Location  Indirect segment discrimination  Selecting the pricing policy

35 Indirect segment discrimination  Direct segment discrimination may not be feasible  How to distinguish business and leisure travellers?  Use product attributes to discriminate indirectly among various buyer segments  restrictions on tickets  Structure a choice to earn different incremental margins from each segment  Segments differ in elasticity of demand

Indirect segment discrimination  Self-selection  Business traveller – buy unrestricted fare  Leisure traveller – buy restricted fare 36

37 restricted fare Indirect segment discrimination 0 marginal cost demand Quantity (Units a year) Price ($ per unit) non-refundable fare unrestricted fare

38 Qantas  QF403, Sydney to Melbourne, July 20, 2011  Fully flexible fare: A$499, Flexi Saver fare: A$219, Red e-Deal: A$199 (from Sydney), $175 (from Melbourne)  The more expensive the fare, the more flexibility it provides.  Business travelers willing to pay more for flexibility  Use more flexible fares to target business travelers  Differences in leisure demand  Higher price for outbound travel (from Sydney)  Lower price for return travel (from Melbourne)

Implementation of indirect segment discrimination  Seller controls some variable to which segments are differentially sensitive. e.g., flexibility  Buyers cannot circumvent the discriminating variable  E.g., airlines strictly enforces the conditions of restricted fares. 39

40 Outline  Uniform pricing  Complete price discrimination  Direct segment discrimination  Location  Indirect segment discrimination  Selecting the pricing policy

41 Selecting pricing policy Complete price discrimination Indirect segment discrimination Direct segment discrimination Uniform pricing Highest profit Least information and admin required

 Direct vs indirect segment discrimination:  if airline could directly identify business/leisure traveller, then no need to structure a choice of restricted/unrestricted fare;  if consumer products manufacturer could directly identify customer with higher benefit, no need to use coupons;  if Microsoft could directly identify high and low- value users, no need to create different versions of Office – academic/regular 42 Selecting pricing policy

43 (c) , I.P.L. Png 43 Selecting pricing policy: Product  Generally, resale of services is more difficult than resale of goods,  More price discrimination in services than goods  Price discrimination is especially prevalent in personal services Recommendation Transform good into service customization technical support consulting

Transforming goods into service  Advantage: more scope for price discrimination  Contrast  selling data vis-à-vis consulting  selling PCs vis-à-vis integrating systems  selling books vis-à-vis providing education  Disadvantage – more labor-intensive, less economies of scale 44

45 Information technology  The impact of information technology on price discrimination  conflicting effects  For sellers: easier to customize/re-configure  real-time/delayed stock prices  various versions of business software – professional, regular,…  For buyers, easier to search and compare prices

46 Information technology  More discrimination  more data on buyers  easier to customize products customize products  online auctions online auctions  More price competition (less discrimination)  easier to compare prices compare

47 (c) , I.P.L. Png 47 Cannibalization  Low-margin item draws customers away from higher-margin product.  Resolving cannibalization  Product design  Degrade low-end item  Upgrade high-end item  Use multiple discriminating variables  Supply: Limit availability of low-end item  Distribution: Use separate channels

 Mobile phone service:  High-income customers: sell post-paid service through direct channel  Low-income customers: sell pre-paid through secondary channels, eg, convenience stores 48 Cannibalization

49 (c) , I.P.L. Png 49 Pricing policies: Versioning  Information, music, computer software, book: once content is created, marginal cost is almost zero  Offer multiple versions – direct discrimination  HP inkjet cartridges – region  Pre-recorded DVDs – region  Offer multiple versions – indirect discrimination  On-line stock prices – real-time/delayed: professional/personal  Books – hard cover/paperback

50 (c) , I.P.L. Png 50 Pricing policies: Microsoft Office 2007 US$Regular price Home and student price Excel$229n.a. Powerpoint$229n.a. Word$229n.a. Office Suite$ $149.95

 Microsoft pricing illustrates:  direct segment discrimination -- cashier requires identification for academic discount  bundling – Office Suite (includes Excel, PowerPoint and Word) cheaper than two of the components. 51

52 (c) , I.P.L. Png 52 Pricing policies: Bundling  Strategy  Pure bundling – only offer bundle  Mixed bundling – offer bundle and separates  Example:  uniform pricing -- airline ticket for $300, two nights’ hotel for $150  pure bundling -- airline ticket and two night’s hotel for $400  mixed bundling -- airline ticket for $300, two nights’ hotel for $150, or package for $400.

53 (c) , I.P.L. Png 53 Pricing policies: Bundling  Bundling examples  IT: PC + printer  telecommunications: telephony + broadband + cable TV  software: MS Win+ Office  When to bundle?  Cost: economies of scope in provision or use  Indirect segmentation discrimination: segments are differentially sensitive to separate products and low marginal cost

54 Key takeaways  To maximize profit with uniform pricing, set the price so that the incremental margin percentage equals the reciprocal of the absolute value of price elasticity of demand.  Price discrimination can increase profit by taking buyer surplus and providing a quantity closer to economically efficient.  Complete price discrimination charges a different price for each unit of the product.  Direct segment discrimination sets prices to earn different incremental margins from each segment.

55 Key takeaways  Indirect segment discrimination structures a choice for buyers to earn different incremental margins from each segment.  Location is one profitable basis for segment discrimination.  The ranking of pricing policies from most to least profitable is complete price discrimination, direct segment discrimination, indirect segment discrimination, and uniform pricing.