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Lecture 5 2nd Degree Price Discrimination AEM 4160: STRATEGIC PRICING Prof. Jura Liaukonyte 1 Dyson SECOND DEGREE PRICE DISCRIMINATION 2 Dyson Second-degree price discrimination What if the seller cannot distinguish between buyers? perhaps they differ in income (unobservable) Then the type of price discrimination just discussed is impossible High-income buyer will pretend to be a low-income buyer to avoid the high entry price to pay the smaller total charge 3 Dyson 3 Second-degree price discrimination Essence of second-degree price discrimination • It is “like” first-degree price discrimination – the seller knows that there are buyers of different types – but the seller is not able to identify the different types Seller has to compromise • Design a pricing scheme that makes buyers – reveal their true types – self-select the quantity/price package designed for them 4 Dyson 4 Second-degree price discrimination • Firms typically offer a list of different prices to consumers allowing the consumers to self-select. • Also called VERSIONING pricing strategy: companies sell variations of a product or service at different prices to different groups of customers. • Create versions of a product to appeal to different types of buyers. Customers then choose the version that best meets their needs. • Distribute a physically similar product under different brand names, – E.g. GAP, Old Navy, Banana Republic – Filene’s Basement, TJMaxx, Marshalls 5 Dyson Second-degree price discrimination • Will the monopolist always want to supply both types of consumer? 6 Dyson 6 Second-degree price discrimination • Will the monopolist always want to supply both types of consumer? • There are cases where it is better to supply only highdemand types – high-class restaurants – golf and country clubs 7 Dyson 7 Second-degree price discrimination principles Page 8 • Induce customers to select into high and low price groups themselves. • Key constraint: you can’t make the inexpensive version too attractive to those willing to pay more. • If there aren’t many customers in the low-valuation group, you may want to ignore this group, since selling to it forces you to lower the price to the high valuation group. 8 Dyson Some examples…. 9 Dyson Second-Degree Price Discrimination Example Self Selection • Movies HD vs. SD – Value of high definition • TurboTax Options: Individual with bigger need • Health Clubs Off peak hours discount: busy individual vs. student • Getty Images Resolution – Professional vs Casual Self select price per unit based on quantity • Buy Bulk at Sam’s 10 Dyson Page 11 More types of second degree price discrimination Example Self Selection Intertemporal High Valuation users are less patient Quantity Discounts High valuation consumers pay high price for higher volume Multiple two-part tariff Example: cell phone plans with monthly and per minute fees – Separate between high and low volume users 11 Dyson Bulk Discounts: Second-Degree Price Discrimination In some markets, consumers purchase many units of a good over time Demand declines with increased consumption Price Discrimination: Charge different prices to increase volume Charge different prices per unit for different quantities of the same good 12 Dyson Quantity Discounts Block Pricing: Charge different price for blocks of a good e.g. Electric Power Takeaways Firms would prefer to use perfect (aka first-degree) price discrimination, but this may be impossible. 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. 13 Dyson Page 13 Example: Tablet Industry 14 Dyson Intertemporal pricing • People value things differently depending on the point in time they will receive it – Value now > Value later – eReader and Tablet companies exploit this discrepancy by marking up their product upon introduction – Capture the consumer surplus of early-adopters – They later lower their prices to reflect the reduction in value that occurs when the product leaves the initial market entry stage and more consumers begin to enter the market 15 Dyson Intertemporal Pricing: eReaders 16 Dyson Intertemporal Pricing: eReaders 17 Dyson Intertemporal Pricing: eReaders 18 Dyson Example: Airline Industry 19 Dyson 2nd Degree Price Discrimination • Price Dispersion – Variation in prices for the same item • Versioning – Variations of a product or service at different prices to different groups of customers • First Class vs. Coach seating 20 Dyson Price Dispersion • The expected difference in fares paid is 36% • Airlines likely to have 20 or more different fares on one given flight 21 Dyson Example: Ski Industry 22 Dyson Product Differentiation • A form of second degree price discrimination • Provide customers with many options and they choose what to purchase • Ski resort industry offers a variety of products and services in order to: – Meet consumer needs – Maximize revenue – Maximize producer surplus – Increase customer base 23 Dyson Product Differentiation 24 Dyson Ski Pass Differentiation • Type of ski pass – Full day pass – Half day pass – Night pass • Length of ski time – One day pass – Weekend pass – Week pass – Season pass 25 Dyson Example: Coupons 26 Dyson Coupons Grocery Trends (2009) Coupons Distributed +12% Coupons Redeemed +19% Internet Coupons +83% 75% of coupon users say coupon had at least some influence on their decision to purchase a new product 27 Dyson Coupons • A form of second-degree price discrimination • Enables retailers to attract informed customers by discounting 28 Dyson Coupon Overview 29 Dyson Coupon Usage Distribution 30 Dyson Coupons and Income • Trends relating to newspaper readership provide some explanation for this imbalance. • According to Scarborough Research, better educated and higher income households buy and read the newspaper more than others and newspapers remain a key vehicle for delivering coupons. • Additionally, promotions are generally targeted in areas with more affluent consumers. In essence, the better educated and more affluent consumers are much better at looking for deals as they recognize the value of money. 31 Dyson Summary : Second-degree price discrimination principles • Induce customers to select into high and low price groups themselves. • Key constraint: you can’t make the inexpensive version too attractive to those willing to pay more. • If there aren’t many customers in the low-valuation group, you may want to ignore this group, since selling to it forces you to lower the price to the high valuation group. 32 Dyson Two-Part Tariffs 33 Dyson More types of second degree price discrimination • Multiple two-part tariffs – Examples of two-part tariffs: cell phone plans with monthly and per minute fees. – Idea: separate between low volume users and high volume users. A two-part tariff is a lump-sum fee, p1, plus a price p2 for each unit of product purchased. Thus the cost of buying x units of product is p1 + p2x. Q: What is the largest that p1 can be? 34 Dyson Two-Part Tariffs • p1 + p2x • Q: What is the largest that p1 can be? • A: p1 is the “entrance fee” so the largest it can be is the surplus the buyer gains from entering the market. • Set p1 = CS and now ask what should be p2? The monopolist maximizes its profit when using a two-part tariff by setting its per unit price p2 at marginal cost and setting its lumpsum fee p1 equal to Consumers’ Surplus. 35 Dyson Profit with a Two-Part Tariff • Per-unit charge equals marginal cost • Fixed fee is the consumer’s surplus at that per-unit price • Maximizes aggregate surplus • Leaves the consumer no surplus 36 Dyson 18-36 Two-part pricing • Jazz club serves two types of customer – Old: demand for entry plus Qo drinks is P = Vo – Qo – Young: demand for entry plus Qy drinks is P = Vy – Qy – Equal numbers of each type – Assume that Vo > Vy: Old are willing to pay more than Young – Cost of operating the jazz club C(Q) = F + cQ 37 Dyson Two-Part Pricing $ Vi The entry charge converts consumer surplus into profit Set the unit price equal to marginal cost This gives consumer surplus of (Vi - c)2/2 Set the entry charge to (Vi - c)2/2 c MC MR Vi - c Vi Quantity Profit from each pair of Old and Young is now d = [(Vo – c)2 + (Vy – c)2]/2 38 Dyson