Pop-corn Pricing Why does pop-corn cost more at movie theaters?

Pop-corn Pricing Why is the obvious answer wrong? E.g. Toilet Do you pay for using toilet in movie theaters? Monopoly does not imply high prices The ticket price & pop-corn price are related.

Pop-corn Pricing UtilityHigh TypeLow Type Movie106 Movie + popcorn 12 (2)8 (2)

Pop-corn Pricing Let us compare the following two strategies: (For simplicity, there is no production cost) 1) charging monopoly price for pop-corn T=6, P=2Revenue=6*2+2*2=16 2) supplying pop-corn at competitive market price T=8, P=0Revenue=8*2=16

Pop-corn Pricing 2 strategies: 1) T=$6, P=4Rev=$6*2+$4=16 2) T=$7, P=0Rev=$7*2+$0=14 Only high type buys pop-corn under strategy 1. UtilityHigh TypeLow Type Movie106 Movie + popcorn 14 (4)7 (1)

Pop-corn Pricing UtilityHigh TypeLow Type Movie106 Movie + popcorn 8 (-2)7 (1) T=9, P=-2

Pop-corn Pricing Summary What do you learn from the pop-corn pricing?

Digression How to defense your company?

Price discrimination vs. cost difference MA laundry services: They charge a higher price for female customers. Usually female customers are willing to pay more than male customers. Is it price discrimination? How can you defense it?

A two parts tariff A firm produces a main product and complementary goods. Polarod example: camera and film Sony Camera and Memory Sticks IBM example: IBM computer and input card.

A fixed monthly fee + variable fees Taxi fares Telecom. Services Entry fee and Popcorn prices. Durable goods and replacement parts or repair services

The optimal two-part tariff What is your optimal structure of (T, t) in terms of profit maximization? Your profit consists of two parts, T+(t-c)Q(t)- c H. What are the optimal T and t?

A review of Demand Curve Utility maximization Price = marginal utility Two interpretations Total utility/Marginal utility Consumer surplus

How can a firm maximize its profit? Example: marginal utility from complementary goods, mu = 10-q P Q CS (t=1)

Consumer Side What is the optimal consumer ’ s consumption decision, given (T, t)? What is my optimal consumption of software if I have already bought hardware? Suppose t=1, the optimal software variety is 9. t=2, the optimal software variety is 8

Consumer Side What is your satisfaction from the software market? The size of your satisfaction from the software market is represented by the consumer surplus from the software market. If t=0, q=10, CS=(10*10)/2 =50 If t=1, q=9, CS=(9*9)/2 =40.5 If t=2, q=8, CS= (8*8)/2 =32 As you see, the consumer surplus from the software side decreases with a higher software price.

Consumer Side Given t, we can obtain some amount of consumer surplus. If CS(t) is less than T, consumers will not buy. If CS(t) is more than T, consumers will buy.

Given t, the firm ’ s optimal T is cs(t). The firm ’ s profit is cs(t)+Q(t)(t-c)-c H.

Suppose that marginal production cost of complementary good is c. Claim: the optimal t=c. How to prove it?

Profit when t=1 Q=10-P MC=1 P 10 Q P Profit from complementary goods =0 Profit from a main product is the triangle.

What would happen if t is above 1? P’P’ Q=10-P MC=1 P 10 Q P Profit from complementary goods is the red rectangular. How about Hardware Price? DWL (Deadweight loss)

What would happen if t is below mc? 10 Q=10-P MC=1 P 10 Q P Profits from complementary goods? Hardware price?

Conclusion: Firms can maximize its profit by setting the complementary good price at its MC (equal to 1 in the above case) and setting the main product price equal to the consumer surplus at that price. Maximize consumer surplus and extract it by a main product price. All consumers have the same preference for the complementary goods. N[cs(t)+Q(t)(t-c)-c H ]

Two Types of Customers If there are 2 types of customers, how can the firm extract the surplus of high type customers? E.g: Q = 10-P Q = 8-P P 10 Q Q=10-P Q=8-P 8 8

Two Types of Customers Gain from setting t> c t > c t = c

Two Types of Customers If t = c: Profits from complementary goods = 0 Profits from a main product = 2*T If set t > c:

h Gain from setting t> c t > c t = c

T(t>c) is (triangle) gets smaller Profit generated by low type in software market: Profit generated by high type in software market: The total profit generated by low type decreases However, the total profit generated by high type increases Therefore, when there are multi types, it can be an optimal choice for the firm to charge t above c.

Tie In sales The firm with a main product wants to charge a high price for a complementary good for price discrimination. Higher consumption of the complementary goods signals higher valuation of the good. The sales of complementary goods serves as a counting device.

Examples Low hardware price and high software price: discrimination tools. SCM, a copy machine firm, used a process that required special coat paper. SCM charged high margin on paper (about 200 percent) and low ones on machines (around 25 percent).

The firm requires that consumers buy complementary goods from it. IBM punch cards. Xerox Copy Machine: high profit margin on papers, low profit margin on the machines

Versioning Price discrimination requires knowledge about individual customers How to get the information? Customers have best information for themselves Offering menu of product for them to choose

Versioning Get the customers to sort themselves into different groups according to their willingness to pay by emphasizing customer differences Self-selection

Some example of Versioning PAWWS Financial Network: Charge $8.95 for 20 min delay, $50 for real-time quotes Even willing to incur an extra cost to get customers self-selected

Numerical Example 1 Willingness-to-pay for immediate or delayed information 2940Low version 49 (+20)100 (+60)High version Low typeHigh type

Numerical Example 1 Perfect Information: Sell the high version to both, charging $100 for the high type and $49 for the low type; TR = $100+$49=$149 Problem: you cannot decide whether each particular customer is high or low

Numerical Example 1 If sell only high version:P=$100, R=$100 If sell high version to high type & low version to low type: P L =$29,

We must be careful because the high type can buy the low version. If a high type buys the low version, her net surplus is 40-29=11. Thus, in order to sell the high version to the high type, the high type must get at least 11 net surplus from buying the high version. P H =$89. R=$89+29 = 118.

Numerical Example Low version 49 (+20)100 (+20)High version Low typeHigh type

Numerical Example 2 If you sell only the high version, P=$100, R=$100 If you sell the high version to high type & the low version to low type: P L =$29 If a high type buys the low version, her net surplus is 80-29=51. Thus, in order to sell the high version to the high type, the high type must get at least 51 net surplus from buying the high version. P H =$49 R=$78

Product Cannibalization Cannibalization (in marketing) occurs when the sales of one product reduce the demand for another product with a higher incremental margin.

Practical Implication Make sure that your design the product so that it can be versioned Design the high end first, and then downgrade the product to get the lower version

Some examples of Versioning IBM LaserPrint series E: Standard one prints 10 pages a second. This one is identical to the standard one, but prints 5 pages a second. They put a chip which induces wait states Federal Express: The next day service Vs. The next 10 am service. They arrive in a destination at the same time !!!

Practical Implication Make sure that your design the product so that it can be versioned Design the high end first, and then downgrade the product to get the lower version

Goldilocks Pricing Develop 3 versions instead of 2 “ Adding a premium product to the product line may not necessarily result in overwhelming sales of the premium product itself. It does, however, enhance buyers ’ perceptions of lower-priced products in the product line and influences low-end buyers to trade up to higher-priced models. ” Psychological phenomenon known as Extremness Aversion.

Experiment McDonald: soft drink If only small & large: If small, large & Jumbo: 45%55% LargeSmall 65% JumboLargeSmall

Experiment Microwave oven case If only bargain-basement & mid-range: If add a high-end oven to the both: 45%55% mid-rangeBargain- basement 60% High-endmid-rangeBargain- basement

Experiment Wine story: Best selling wine: wine with 2 nd lowest price in the menu Offer an obviously low quality wine at the bottom end, and set the price of the next wine up to be only slightly higher This makes it seem like a really good deal, virtually guaranteeing significant sales

Promotional Pricing Sale, coupons, rebates Impose inconvenience cost on consumers Why?

Firm can provide coupons (which require the customer to bring in pieces of paper that then allow them discounts), or rebates (in which customers must mail in a piece of paper to get some money back). All of these marketing techniques have one feature in common they impose some inconvenience cost to the consumer.

Coupons wouldn't be a worthwhile marketing strategy if everybody used them, the seller may as well cut the price and eliminate the cost of dealing with the coupons.

Promotional Pricing 60 (-20)70 (-30)Good X with searching for coupon 80100Good X Low typeHigh type

They wouldn’t be a worthwhile marketing strategy if everybody used them I’m a price-sensitive consumer. You know that’s true since I went to all this trouble to collect the coupons. They are worthwhile only if they segment the market into price sensitive and non price sensitive components.

Bundling MS-Word & Excel are separate product But there are usually sold as package:MS- Office Why would Microsoft do this?

Bundling Suppose there is two types of consumer: A & B. What is the difference between selling separately or as a bundle? WordExcel A124 B103

Bundling Selling separately: P x =$10, Rev=$20 P y =$3, Rev=$6 TR=$26 Sell as bundle: P b =$13, TR=$13*2=$26 No difference!

Bundling Suppose there is two types of consumer: A & B. What is the difference between selling separately or as a bundle? WordExcel A123 B104

Bundling Selling separately: P x =$10, Rev=$20 P y =$3, Rev=$6 TR=$26 Sell as bundle: P b =$14, TR=$14*2=$28 Bundling is profitable in this case

Bundling WordExcelBundle A12 (2)315 (1) B104 (1)1414

Dispersion in customer value The willingness to pay for the bundle is less dispersed than the willingness to pay for the components. This will happen when the consumers with a high value for one component tent to have low value for another component

Red shoes/Blue shoes Red shoesBlue shoes R53 B35 1 st pair of shoes at a regular price 5 2 nd pair of shoes at a discounted price 3, 40% discount

Examples of Bundling MS-Office New York Times (single issue) Subscribing to Times for 1 year, Dec, Jan.. Music CD album Advanced booking (reservation)

Mixed Bundling Why are mixed bundling good for the company? 1090D 4060C 50 B 9010A Good YGood XSatisfaction Cost of X=$20 Cost of Y=$30

Mixed Bundling Selling separately: Px=$50, Rev=$(50-20)*3=$90 Py=$90, Rev=$(90-30)*1=$60 TR=$90+$60=$150 Selling as pure bundle: P b =$100, TR=$(100-50)*4=$200

Mixed Bundling Selling as mixed bundling Px=Py=$89.99 P b =$100 In this case: A will buy Y only B & C will buy bundle D will buy X only TR=$(89-30)+$(100-50)*2+$(89-20)=$228