+ Lecture 5: Price Discrimination AEM 4160: Strategic Pricing Prof. 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 cant 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

+ 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

+ 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.

+ 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, 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.

+ Two-Part Tariffs 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 ?

+ Two-Part Tariffs 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 18-18

+ 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 ViVi ViVi MR MC c Set the unit price equal to marginal cost Set the unit price equal to marginal cost This gives consumer surplus of (V i - c) 2 /2 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 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 Clearvoices 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 Clearvoices 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 18-29

+ 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