PowerPoint Slides © Michael R. Ward, UTA 2014

Econ 5313 Bagel Shop You run a small bagel shop. You have engaged in a market study to categorize your customers’ willingness to pay for a meal (coffee & bagel) into 8 equal sized groups: ($5.00, $4.50, $4.00, $3.50, $3.00, $2.50, $2.00, $1.50). All of your costs are fixed except labor and materials, which cost $2.25 per meal sold. What price should you charge for a meal?

Bagel Shop Sort them from highest WTP to lowest Econ 5313 Bagel Shop Sort them from highest WTP to lowest If you charge them their WTP or lower, they purchase So this generates a demand curve Price Quantity Total Rev MR MC Profit $5.00 1 $4.50 2 $4.00 3 $3.50 4 $3.00 5 $2.50 6 $2.00 7 $1.50 8

Multiply price times quantity to get total revenue Econ 5313 Bagel Shop Multiply price times quantity to get total revenue Price Quantity Total Rev MR MC Profit $5.00 1 $4.50 2 $9.00 $4.00 3 $12.00 $3.50 4 $14.00 $3.00 5 $15.00 $2.50 6 $2.00 7 $1.50 8

Bagel Shop Multiply price times quantity to get total revenue Econ 5313 Bagel Shop Multiply price times quantity to get total revenue Calculate the MR from the change in total revenue Price Quantity Total Rev MR MC Profit $5.00 1 $4.50 2 $9.00 $4.00 3 $12.00 $3.00 $3.50 4 $14.00 $2.00 5 $15.00 $1.00 $2.50 6 7 ($1.00) $1.50 8 ($2.00)

Bagel Shop Multiply price times quantity to get total revenue Econ 5313 Bagel Shop Multiply price times quantity to get total revenue Calculate the MR from the change in total revenue Compare this with the MC Price Quantity Total Rev MR MC Profit $5.00 1 $2.25 $4.50 2 $9.00 $4.00 3 $12.00 $3.00 $3.50 4 $14.00 $2.00 5 $15.00 $1.00 $2.50 6 7 ($1.00) $1.50 8 ($2.00)

Verify by calculating the profits at each price Econ 5313 Bagel Shop Verify by calculating the profits at each price Price Quantity Total Rev MR MC Profit $5.00 1 $2.25 $2.75 $4.50 2 $9.00 $4.00 3 $12.00 $3.00 $5.25 $3.50 4 $14.00 $2.00 5 $15.00 $1.00 $3.75 $2.50 6 $1.50 7 ($1.00) ($1.75) 8 ($2.00) ($6.00)

Econ 5313 Bagel Shop Does your profit maximizing price depend on the total number of consumers? Not if the groups are equally sized Suppose your market research tells you that the four lowest value groups are all students. Should you offer a student discount? If so, how much?

Student Discounts Separate the last four students from the rest Econ 5313 Student Discounts Separate the last four students from the rest Prices charged to them do not affect the revenues from non-students Like a whole new demand curve Maximize profits here yield a different “student” price Implement with a $1.00 student discount Price Quantity Total Rev MR MC Profit $3.00 1 $2.25 $1.00 $2.50 2 $5.00 $2.00 $0.50 3 $6.00 ($0.75) $1.50 4 ($0.00) ($3.00)

Student Discounts You earn $5.25 in profit from the $4.00 price Econ 5313 Student Discounts You earn $5.25 in profit from the $4.00 price You earn an additional $1 from the students at a $3.00 price You have increased profits through “price discrimination” That is, P1/MC1  P2/MC2 What did we need for this to work? Need to be able to identify the groups which are less demand elastic from the groups which are more demand elastic (high WTP versus low WTP) Need to prevent arbitrage

Econ 5313 Price Discrimination Identifying demand segments is more common than you might imagine Could be due to differences in demand Ex Student or senior citizen discounts Ex Household services (e.g., maid, yard, plumber) in Park Cities versus South Dallas Ex Early bird special or matinee pricing Ex Air travel with a Saturday stay-over Ex Air travel booked a month in advance versus ‘week of’ Ex McDonalds on Cooper versus Champs d'Elise Ex Patented pharmaceutical product in US versus Canada versus Mexico versus Haiti

Differences in Demand Could be due to differences in rivalry Econ 5313 Differences in Demand Could be due to differences in rivalry Ex Cowboy boots in Texas versus Boston Ex Pharmaceutical product in US pre-patent expiration versus in Brazil with price regulation Ex Mobile phone service in US with many carriers or in the Philippines with few carriers Always indicates difference in demand elasticity across groups Direct = observe group membership Indirect = infer group membership

Limiting Arbitrage Limiting Arbitrage can be tricky Econ 5313 Limiting Arbitrage Limiting Arbitrage can be tricky What if group 3 could pass for students? They get the lower price and your whole scheme falls apart What if business travelers can book months in advance? What if Florida retirees can travel to Canada for their medicines?

Econ 5313 Limiting Arbitrage Need a cost to arbitrageurs that you do not face to prevent reselling product High transportation costs Shipping boots from Texas to Boston High transactions costs Prosecuted for re-importing possibly counterfeit drugs Services versus products Hard to resell a haircut or dry cleaning No price discrimination scheme will work perfectly You usually just need that there is not ‘too much’ arbitrage

Econ 5313 Limiting Arbitrage In 1997 a global cell phone manufacturer (IRK) was losing sales in the Philippines because competitors offered a better, lower price. The company charged a world-wide uniform price of $120 It sold most of its phones in wealthy countries Important future markets, such as the Philippines, were ignored because demand was lower in less wealthy countries (“normal good”). Competitors were under-pricing IRK in these future markets and were selling more.

Econ 5313 Limiting Arbitrage Once sales hit 10%, diffusion from luxury to mass market happens very quickly

Econ 5313 Limiting Arbitrage The Philippine market was quickly approaching the crucial 10% penetration point At which this Rule of Thumb applies: the firm with the largest share at 10% penetration will grow to 40% w/out marketing when market penetration grows to 30% The company considered charging a lower price in the Philippines to generate more sales before the 10% point IRK reduced prices in Philippines to $90 Problem: the Philippine phones used the same standard (GSM) as higher-priced European phones

Econ 5313 Limiting Arbitrage Thus, arbitrage threatened sales in other countries (15 million units annually) To prevent this, the company sold models with SIM-locks, which allow calls only in the local operators’ networks Turkish hackers broke the SIM-lock 15,000 phones were sold to Western Europe by the hackers before IRK changed the SIM-lock algorithm and again prevented arbitrage Have to change the algorithm every few years in a never-ending “arms race”

Our typical profit maximizing situation from simple pricing Econ 5313 Capturing Value Our typical profit maximizing situation from simple pricing D P* Q P MC MR

What do the Blue regions represent? Capturing Value What do the Blue regions represent? P*   D Q P MC MR

Capturing Value These are part of the value that the product generates in excess of your cost going to the consumer P*   D Q P MC MR Un-captured Consumer Value

Price discrimination is a way to try to capture this Capturing Value Price discrimination is a way to try to capture this P*   D Q P MC MR Un-captured Consumer Value

Capturing Value With perfect price discrimination, you would charge all N customers a different price and capture it all Not possible but is the limiting case we aim for P*   D Q P MC MR Un-captured Consumer Value

Modified Simple Pricing Econ 5313 Modified Simple Pricing Simple rule for different groups Set contribution margins to the inverse of their respective elasticities (P1-MC1)/P1=1/|e1| (P2-MC2)/P2=1/|e2| So if you know demand for cowboy boots is less elastic in Boston (luxury good, few competitors), set prices higher

Price Discrimination Online Econ 5313 Price Discrimination Online Computer companies often sell to a wide variety of users with a wide variety of price sensitivities To identify the price sensitivity of on-line customers Dell’s website has different categories in which users can shop (such as home & home office, small & medium business, large business, etc.) Under the “Small and Medium Business” category, a laptop was listed as $1,197 Under the “Large Business” category, the same computer was $1,339 a 12% increase This scheme allows Dell to sell identical computers at different prices based on the consumers’ price sensitivity

When is it Illegal? Robinson-Patman Act Econ 5313 When is it Illegal? Robinson-Patman Act Prohibits providing a price discount on a good sold to another business The Robinson-Patman act was designed to protect independent retailers from chain-store competition by preventing the chains from receiving supplier discounts Defenses against a Robinson-Patman lawsuit are: That the price discount was cost-justified; or The price discount was given to meet the competition Europe has similar, and stronger, laws Promotional allowances or vertical integration may avoid Robinson-Patman liability

Blood Tests In Northern Europe (Ger., Holland and Scandinavia) Econ 5313 Blood Tests In Northern Europe (Ger., Holland and Scandinavia) Medical blood test machines sell for $25 50 test strips sell for $22 12 million boxes of test strips Southern Europe Italy and Spain: insurance companies’ reimbursement rates are 50% lower Firm has capacity to produce additional 6 million Potential market for test strips is $200 million per year If they acquire 30% of the market, they can make an additional $60 million in revenue

Blood Tests Lower prices to Southern Europe To prevent arbitrage Econ 5313 Blood Tests Lower prices to Southern Europe Test strips at $11 Measurement devices at $12.50 To prevent arbitrage ROM key ensures north/south incompatibility Also reduce the measurement speed of the Southern devices from 11 to 25 seconds It is important that these slower devices cost less, so that the price difference has some cost justification (so it wont violate antitrust laws)

Econ 5313 Distribution Your family business produces a secret recipe salsa and distributes it through both smaller specialty stores and chain supermarkets. The chains have been demanding sizable discounts but you do not want to drop your prices to the specialty stores. How can you legally accommodate the chains without losing profits from the specialty stores? Must alter it somehow to justify differences in prices High volume implies full pallets which are cheaper to distribute

Econ 5313 Customer Perceptions Consumers do not like knowing they are paying higher prices than others “Only Schmucks pay Retail” For example, when shown a box for a promotional code on a website, click-through rates decline Online shoppers were less likely to complete their transactions once they realized a coupon existed that they didn’t have People don’t like knowing they are schmucks So, if you are price discriminating, it is important to keep the scheme secret if you can

From the Blog Chapter 13 Cable Car in Barcelona Econ 5313 From the Blog Chapter 13 Cable Car in Barcelona Weekend airline purchases Women’s Haircuts? Price Discrimination at the FTC!

Econ 5313 Main Points Price Discrimination is charging different markups to different groups of customers Must be able to identify differences in WTP (elasticity) Must be able to limit arbitrage Engage in “simple pricing” for each group Typically additional customers are served than would be under simple pricing