1. Review Own price elasticity Empirical estimation of demand curve
Linear and log-log model
Interpretation of coefficient and computation of price elasticity.

2. Introduction
Price dispersion – different prices for the same product - is prevalent in the marketplace
The “law of one price” is dead
Example: Microsoft software version and upgrade prices
Example: Prices of 1/3 liter Coca-Cola cans in Germany

3. Prices of 1/3 liter Coca-Cola cans
Point of Sale
Price (DM)
Index
1. Large supermarket
0.64
100
2. Grocery store
0.69
108
3. Bakery
0.80
125
4. Vending m/c – university
0.90
141
5. Gas station
1.20
188
6. Vending m/c – street
1.50
243
7. Newsstand - street
1.60
250
8. Newsstand – airport
2.00
312
9. Newsstand – Train station
2.20
344

4. Example: Student Rates
Why do software manufacturers have lower rates for students?
One explanation is that they have lower willingness to pay & higher elasticity than business users.
Charging two prices is more profitable

5. Example: Airline Pricing
Why do airlines have “first class” rates often 2-3 times higher than cabin?
There is a small group of “elite” customers who are less price elastic than “regular” customers
It is more profitable to charge two prices
The “elites” must be “fenced in” from buying cabin seats by making cabin seats uncomfortable

6. Illustration of Benefits of Price Customization
100
Demand curve
Gross Margins
(p-c)*q p
c=10
1000 q

7. Remember the Meaning of Demand Curve
The demand curve is an aggregation of the demands of individual or segment, who have different reservation prices (max. willingness to pay)
Price ($) q
Ideally, charge each customer their reservation price (as long as it is above c) – (i) no profitable customer is excluded from buying and (ii) no money left on table.

8. A Single Price is Inefficient
Money left on the table
Price ($)
100
Profit (p*-c)q*
No trade – deadweight loss p*
c=10 q
1000

9. Calculation The demand function is p = 100 – 0.1q
The profit-maximizing price is
The demand at the profit maximizing price is
The profit (gross margins) is
p* = (a+c)/2 = $55
q* = (a-c)/2b = 450
(p*-c)q* = $20250

10. Demonstration of Benefits Using 2 Price Points
Rule of 1/3 for linear demand functions – 33% higher profits!
100
p1*
p2* c
1000
q1*
q2*

11. Calculation
p = a – bq
q = A – Bp
Assume that we can put a “fence” that prevents higher price customers from paying the lower price, also, c=$10
The demand function is q= D(p) = 1000 – 10p
Profit at prices p1 and p2 are
The profit-maximizing prices are
The maximized profit is
(p1-c)D(p1)+(p2-c)(D(p2)-D(p1))
p2* =$40, p1*=$70
(70-10)*300+(40-10)( )=$27000

12. Calculation
p = a – bq
q = A – Bp
In general, in the case of the linear demand, constant variable cost and two prices, the profit-maximizing prices are
p2* = (2c + a)/3, or p2* = (2cB + A)/3B
p1* = (2a + c)/3, or p1* = (2A + cB)/3B

13. This is Price Discrimination
Charging different prices to different people for the same (or similar) product.
Since “discrimination” has a negative connotation, call it “price customization”
A useful result - Most of the benefit of price customization may be realized with relatively few price points

14. Implementation
Key problem: How do we prevent higher willingness-to-pay customers from paying the price meant for lower willingness-to-pay customers?
Place “fences” that corral customers

15. Methods of “Fence-Building”
Product-line sort
Controlled availability
Sort on buyer characteristics
Sort on transaction characteristics

16. Product-line sort Airlines – first class and economy class seats
Proctor-Silex irons ($54.95 top of line model versus $49.95 same model without a LED light)
Encyclopedia Britannica (Utilitarian cover, $999, Leather bound, $4000)
Cars (same engine Acura $30,000, Accord $25,000)
Based on impatience
Books appear first in hardcover then paperback
Movies appear first in theaters, then in discount cinema, then in video stores

17. Examples Product-Line Sort
Standard SRP $219.99
Professional SRP $299.99
All in Standard +
MS Access
Developer SRP $529.99
Development Tools to Build
Own Applications
Basic SRP $199.95
Pro SRP $279.95
All in Basic +
Create Customized forms,
Tools to Track add’l items
Premier SRP $399.99
All in Pro +
Daily Sales Summary,
Retail Specific Reports

18. Sort on Transaction Characteristics
Airline seats are more expensive closer to the take-off date
CD player purchased with car is more expensive than one installed later
Quantity discounts
Water
Buying clubs
Season discounts
Idea is that users value incremental quantities less. Alternatively, large users have good outside options hence have lower willingness to pay

19. Controlled Availability
Victoria’s Secret offered catalogs with higher discounts to male consumers
GM gave $1500 (nontransferable) coupons only to Oldsmobile consumers who expressed dissatisfaction
Manufacturers frequently negotiate better rates for larger customers
French Telecom gave non-advertised lower prices only when subscribers called and asked, thereby revealing their price sensitivity
Consumers in Japan, UK pay more for identical clothes, cosmetics, electronics than US consumers, but less for pharmaceuticals
Consider arbitrage, gray market issues
Consider fairness considerations
Legal implications

20. Sort on Buyer Characteristics
Kids free/ discount
Families with Kids are willing to pay less per person. Kids age can be easily verified (i.e., at low cost)
Senior citizens discount
Software upgrade discount
Current users have less incentive to renew software
Student discount
Students willing/able to pay less

21. Novell Netware Pricing – An Example of Quantity Discounts
No. of users
Site license fee
Price/user 5
$396
$79.60 10
$796
$79.20 25
$1196
$37.84 50
$1596
$31.92
100
$2236
$22.36
250
$3996
$15.98

22. Price Customization Across Markets
Charge higher prices at places where less price sensitive buyers purchase
Price sensitive and price-insensitive buyers naturally purchase at different locations or…
Insensitive buyers will not change purchase location to take advantage of the price difference

23. Implementation of Price Customization
Devil lies in the details!
Specific steps of price customization
Identify customers who are price-sensitive
Give price discount to them
Reduce stockpiling for those who do get discounts
Make sure that price-insensitive customers do not take advantage of the discount offer
Do not overstep the legal boundaries

24. Identifying the Price-sensitive Customers
Which segments are more price sensitive?
Personal vs. Business Travelers
New to Market vs. Experienced Buyers
Light Users vs. Heavy Users
Students/Retired vs. Employed

25. A department store has the following discounting policy for brand-name quality clothing
The ticket on each item is dated and lists a number of prices.
The first price is the one that a customer pays if the merchandise is bought within the first eleven days after arrival.
The next price is discounted an additional 25% and applies to merchandise that is 12 to 17 days old.
The third price is discounted 50% and applies to merchandise 18 to 23 days old.
The fourth price is discounted 75% and applies to merchandise that is 24 to 29 days old.
On the 30th day, the merchandise is turned over to charity. Since most of the merchandise is surplus, there is generally a limited supply in each style, color, and size.

26. Price Customization - Implementation
What does this strategy accomplish?
Describe the customers whom you suspect make up the different retail segments.
A number of stores in other cities adopted this strategy for surplus merchandise, but no store had adopted it for new merchandise. Can you suggest why?
For what other types of products would you consider this a profitable pricing tactic?

27. Price Customization - Implementation
Peak-load pricing is used to segment markets by the cost of serving them at different times?
Name types of businesses, other than public utilities, that could effectively use peak-load pricing. Describe how a peak-load strategy might be implemented in each case.
Yield management represents a more sophisticated version of peak-load pricing. What kinds of companies use yield management?

28. Price Customization - Implementation
A fancy steak house in a shopping mall offers a 20% discount to employees of other stores in the mall, provided that they eat before 6:00 PM or after 8:00 PM
Can you explain the rationale for this strategy? (Your explanation should both account for why the 20% discount is not offered to everyone and why it is restricted in the hours when it is offered.)

29. Price Customization - Implementation
A deli in a college town has an interesting pricing strategy for students. The dinner specials at the restaurant are normally $ Students, however, can buy weekly "meal tickets" that give them three meals for $13.90, 5 meals for $22.25, or seven meals for $ The tickets expire at the end of each week and they are not transferable.
Can you explain this pricing strategy?

30. Price Customization - Implementation
The local outlet of a fast food chain charges $2.60 for a salad from its salad bar if ordered a la carte. When ordered with a sandwich, however, the salad bar costs only $ In either case, the customers are permitted to fill their bowls just once.
Can you explain this segmented pricing technique?

31. Price Customization - Implementation
Most hotels will lend guests an iron and an ironing board free of charge, despite the fact that this service competes with the hotel's valet service, for which it does charge. Those same hotels usually charge outrageously to supply glasses, ice, and mixers for those who wish to have alcoholic drinks in their rooms.
Can you explain this anomaly?

32. Next Lecture
Pricing and Competition