MBA201a: Price Discrimination * * Note for pricing projects: This is the beginning of the “advanced pricing” material.

Professor WolframMBA201a - Fall 2009 Page 1 Basic price discrimination Definition: A firm is price discriminating if it is selling goods at prices that differ by more than the firm’s marginal costs of producing the goods. –One important example is selling the same good for different prices. –Cost-based price differences are not considered price discrimination (e.g. price differences based on transportation costs).

Professor WolframMBA201a - Fall 2009 Page 2 When can a firm price discriminate? A firm’s ability to price discriminate is hampered if: –Consumers can arbitrage price differences, for instance by reselling the good to other consumers. –It faces competition from other firms providing perfect or near-perfect substitutes. –It faces legal restrictions (more on this later).

Professor WolframMBA201a - Fall 2009 Page 3 One type of price discrimination - Often done through negotiation. - Called “perfect” or “first-degree” price discrimination. Q D MC P - Each consumer is charged his or her willingness to pay.

Professor WolframMBA201a - Fall 2009 Page 4 The effects of perfect price discrimination Q D MC P MR

Professor WolframMBA201a - Fall 2009 Page 5 The effects of perfect price discrimination Q D MC P Profits at monopoly price * MR *Assuming no fixed costs

Professor WolframMBA201a - Fall 2009 Page 6 The effects of perfect price discrimination Q D MC P MR Profits from perfect price discrimination

Professor WolframMBA201a - Fall 2009 Page 7 Effects of price discrimination in general –The seller gains: revenue and profits go up. –The low-price buyer often gains, since under monopoly pricing he would have been priced out of the market. –The high-price buyer often loses, since he is charged a higher price. –On net, it is not clear whether this is good or bad for society as a whole. It depends!

Professor WolframMBA201a - Fall 2009 Page 8 Types of price discrimination 1.First-degree PD: charge every consumer his or her willingness to pay. 2.Third-degree PD: sort customers into several groups based on observable, exogenous characteristics. 3.Second-degree PD: present all customers with a menu of prices and allow the customers to self-select.

Professor WolframMBA201a - Fall 2009 Page 9 Discrimination among groups: 3 rd degree PD –Firm must be able to identify the different segments (e.g. require student id for student discount, driver’s license for senior-citizen discount). –Rule: different elasticities  different prices Recall the “elasticity rule” from our discussion of monopoly prices. Here it means that the firm should set higher prices in less elastic market segments.

Professor WolframMBA201a - Fall 2009 Page 10 Markups on European cars Renault Ford Escort Fiat Tipo Fiat Uno UKItaly Germany FranceBelgiumModel

Professor WolframMBA201a - Fall 2009 Page 11 Second-degree price discrimination Basic idea: Present consumers with a menu of (price, quality) pairs and let them sort themselves into groups. –A consumer’s willingness to pay for quality should be correlated with his or her willingness to pay a high price for the underlying good. –Examples: Retail: Old Navy, Gap and Banana Republic jeans. Airlines: first class and coach seats.