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Lecture 6: 3 rd Degree Price Discrimination AEM 4160: Strategic Pricing Prof. Jura Liaukonyte

Third-Degree Price Discrimination  Consumers differ by some observable characteristic(s)  A uniform price is charged to all consumers in a particular group – linear price  Different uniform prices are charged to different groups  Subscriptions to professional journals [library/student]  Entry prices by age

Third-Degree Price Discrimination  The pricing rule is very simple:  Consumers with low elasticity of demand should be charged a high price  Consumers with high elasticity of demand should be charged a low price

Third Degree Price Discrimination: Example  Harry Potter volume sold in the United States and Europe  Demand:  United States: P U = 36 – 4Q U  Europe: P E = 24 – 4Q E  Marginal cost constant in each market  MC = $4

The Example: No Price Discrimination  Suppose that the same price is charged in both markets  What do we need to find out?

The Example: No Price Discrimination  Suppose that the same price is charged in both markets  What do we need to find out?  Use the following procedure:  Calculate aggregate demand in the two markets  Identify marginal revenue for that aggregate demand  Equate marginal revenue with marginal cost to identify the profit maximizing quantity  Identify the market clearing price from the aggregate demand  Calculate demands in the individual markets from the individual market demand curves and the equilibrium price

The Example United States: P U = 36 – 4Q U Invert this: Q U = 9 – P/4 for P < $36 Europe: P U = 24 – 4Q E Invert Q E = 6 – P/4 for P < $24 Aggregate these demands Q = Q U + Q E = 9 – P/4 for $24 < P < $36 At these prices only the US market is active Q = Q U + Q E = 15 – P/2 for P < $24 Now both markets are active

The Example Invert the direct demands P = 36 – 4Q for Q < 3 P = 30 – 2Q for Q > 3 $/unit Quantity Marginal revenue is MR = 36 – 8Q for Q < 3 MR = 30 – 4Q for Q > 3 Demand MR Set MR = MC MC Q = 6.5 P = $ Price from the demand curve

The Example  Substitute price into the individual market demand curves:  Q U = 9 – P/4 = 9 – 17/4 = 4.75 million  Q E = 6 – P/4 = 6 – 17/4 = 1.75 million  Aggregate profit = (17 – 4)x6.5 = $84.5 million

The Example: Price Discrimination  The firm can improve on this outcome  Check that MR is not equal to MC in both markets  MR > MC in Europe  MR < MC in the US  This requires that different prices be charged in the two markets  Procedure:  take each market separately  identify equilibrium quantity in each market by equating MR and MC  identify the price in each market from market demand

The Example Demand in the US: P U = 36 – 4Q U $/unit Quantity Deman d Marginal revenue: MR = 36 – 8Q U 36 9 MR MC = 4 MC4 Equate MR and MC Q U = 4 Price from the demand curveP U = $

The Example: Demand in the Europe: P E = 24 – 4Q E $/unit Quantity Deman d Marginal revenue: MR = 24 – 8Q E 24 6 MR MC = 4 MC4 Equate MR and MC Q E = 2.5 Price from the demand curveP E = $

The Example  Aggregate sales are 6.5 million books  the same as without price discrimination  Aggregate profit is (20 – 4)x4 + (14 – 4)x2.5 = $89 million  $4.5 million greater than without price discrimination

Some Additional Comments  Suppose that demands are linear  price discrimination results in the same aggregate output as no price discrimination  price discrimination increases profit  For any demand specifications two rules apply  marginal revenue must be equalized in each market  marginal revenue must equal aggregate marginal cost

Price Discrimination and Elasticity  Suppose that there are two markets with the same MC  MR in market i is given by MR i = P i (1 – 1/ η i )  Where η i is (absolute value of) elasticity of demand  From rule 1 (above)  MR1 = MR2  So = P 1 (1 – 1/ η 1 ) = P 2 (1 – 1/ η 2 ) which gives Price is lower in the market with the higher demand elasticity

Takeaways  Firms would prefer to use perfect (aka first-degree) price discrimination, but this may be impossible.  Third-degree PD is one way to approximate perfect PD, but requires that firms can separately identify members different groups.  Second-degree PD induces customers to sort themselves into groups.  Recall the no arbitrage constraint—consumers can’t resell to others.  Price discrimination and other advanced pricing strategies are powerful tools; you now have the economic models to understand them.

BUNDLING AND TYING

Introduction  Firms often bundle the goods that they offer  Microsoft bundles Windows and Explorer  Office bundles Word, Excel, PowerPoint, Access  Bundled package is usually offered at a discount  Bundling may increase market power  GE merger with Honeywell  Tie-in sales ties the sale of one product to the purchase of another  Tying may be contractual or technological  IBM computer card machines and computer cards  Kodak tie service to sales of large-scale photocopiers  Tie computer printers and printer cartridges  Why? To make money!

More Examples of Bundling  Telecommunications  Firms bundle local, long-distance, and mobile telephone services,  Banks  Bundle checking, credit, and investment services  Hospitals bundle an array of medical services

Incentives to Bundle  Bundling may arise in many contexts to sort consumers in a manner similar to second-degree price discrimination.  When consumers have heterogeneous tastes for several products, a firm may bundle to reduce that heterogeneity, earning greater profit than would be possible with component (unbundled) prices.  Bundling—like price discrimination—allows firms to design product lines to extract maximum consumer surplus.

Bundling Advantages  Simplifies consumer choice (as in telecommunications and financial services)  Reduces costs from consolidated production of complementary products  Reduces consumer search costs and product or marketing costs  Bundling to extend market power and/or deter entry  as witnessed by antitrust challenges to Microsoft’s bundling of software applications (e.g. its Internet browser, media player) with its dominant Windows operating system

Cable TV  Crawford’s (2001) empirical study of bundling decisions of cable providers  bundle several networks into a basic bundle service, cable provider increases its profit on average above unbundled sales by 14%  13% less CS than from unbundled sales  bundling together similar networks is less profitable than bundling dissimilar ones

Example: Cable and Satellite TV Industry

Third Degree Price Discrimination  Raw Data Analysis  Collected the price of Comcast Xfinity’s basic cable in 11 cities  Chose Comcast because it has the largest market share  Plotted prices relative to geography  Ran regressions against the number of competitors in the market

Computer Software Suites  Microsoft and others bundle dissimilar programs—word processors and spreadsheets—into a suite  Gandal (2003):  survey of home PC users: 43% use both programs;50% used only one; 7% used neither  survey business PC users: 63% used both, 37% used only one  A lot of users use only one (but not both) pieces of software  consumers with a high value for spreadsheets had a low value for word processors and vice versa: negative correlation in demand

Tie-In Sales  Generally considered to be an ‘extension of monopoly’ by courts. In other words, courts believed it was an attempt to use one monopoly to create a second.  Frequently, tying good is sold very cheaply, while tied good is very expensive. Famous cases: IBM and computer cards, Xerox and toner, Canning machines and tin plate.

Printers and Ink Cartridges  High-intensity usage consumers => high willingness-to- pay  Low-intensity usage consumers => print small volumes => a low willingness-to-pay  Strategy: lower the price of the initial, one-time purchase printer and raise the price of the aftermarket, repeat purchase ink cartridge  Ink cartridge becomes the mechanism by which consumers' intensity of usage is metered:  Inducing high-intensity users to pay a higher overall price  Low-intensity users a lower overall price

Examples cont’d  This basic idea holds for a variety of other aftermarket situations:  Razors and razor blades  Video game consoles and video games  Etc.

Anti-Trust and Bundling  The Microsoft case is central  Accusation that used power in operating system (OS) to gain control of browser market by bundling browser into the OS  Need to show  Monopoly power in OS  OS and browser are separate products that do not need to be bundled  Abuse of power to maintain or extend monopoly position  Microsoft argued that technology required integration  Further argued that it was not “acting badly”  Consumers would benefit from lower price because of the complementarity between OS and browser

And now…  This view gained more force and support in Europe  Bundling of Media Player into Windows  Competition Directorate found against Microsoft  No on appeal

Antitrust and tying arrangements  Tying arrangements have been the subject of extensive litigation  Current policy  Tie-in violates antitrust laws if  There exists distinct products: tying product and tied one  Firm tying the products has sufficient monopoly power in the tying market to force purchase of the tied good  Tying arrangement forecloses or has the potential to foreclose a substantial volume of trade