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Chapter 12
Indirect Price Discrimination
COPYRIGHT © 2008
Thomson South-Western, a part of The Thomson Corporation. Thomson, the
Star logo, and South-Western are trademarks used herein under license.
Chapter 12 – Take Aways
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When a seller cannot identify low- and high-value consumers or cannot
prevent arbitrage between two groups, it can still discriminate, but only
indirectly, by designing products or services that appeal to groups with
different price elasticities of demand, who identify themselves based on
their purchase patterns.
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If you offer a low-value product that is attractive to high-value
consumers, you may cannibalize sales of your high-price product.
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When bargaining with a customer, do not bargain over unit price;
instead, bargain over the price of a bundle.
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Bundled pricing can allow a seller to extract more consumer surplus if
willingness to pay for the bundle is more homogeneous than willingness
to pay for the separate items in the bundle.
Review of Chapter 11
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Price discrimination is the practice of charging different prices that are not
cost-justified to different people or groups of people
Profits are increased by charging higher price to the low-elasticity group.
Conditions
 Market power
 ID different groups with different elasticities
 Prevent arbitrage
A “direct” price discrimination scheme is one where we can directly identify
members of the low-value group, charge them a lower price, and prevent
them from re-selling their lower-priced goods to the higher-value group.
It can be illegal for business to price discriminate when selling goods (not
services) to other businesses unless
 Price discounts are cost justified; or
 Discounts are offered to meet competitors’ prices
Only fools pay retail
Anecdote: HP Printers and Ink
Cartridges
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Printers and ink cartridges bring in roughly same amount of
revenue, cartridges are 3x more profitable
Not possible for HP to directly identify low- and high-value
consumers
Example: Low-value consumers want printer and one
cartridge and are willing to pay $100; high-value consumers
want printer and two cartridges and are willing to pay $200
 Option 1: Sell printers and cartridges for $50 each
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Low-value pays $100; high value pays $150
Option 2: Give away printer and sell cartridges for $100
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Low-value pays $100; high-value pays $200
Indirect Price Discrimination
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Applies if
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Seller cannot identify low- and high-value
consumers; or
Cannot prevent arbitrage between two groups
Can still price discriminate by designing
products or services that appeal to
different consumer groups
Groups reveal themselves by the choices
they make
Indirect Price Discrimination
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Disadvantages
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Typically less profitable than direct price
discrimination
May not be a clear way to get consumers to
identify themselves as high- or low-value
Potential of cannibalization
Can create profitable entry opportunities for
rival firms
Software Example
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Software manufacturers indirectly discriminate
between commercial and home users
They design versions of software that appeal to
each group
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Lower price, “disabled” version for more-price-elastic home
consumers
Full featured version for business users
Beware cannibalization threat
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Full-featured version must be priced low enough so highvalue business consumers prefer it to the disabled version
Software Example (cont.)
Home
Users
Commercial
Users
Home Version
$150
$200
Commercial
Version
$175
$500
Strategy
Implementation
Total Profits (assume
only two customers,
one of each type)
Sell to only commercial Price commercial
users
version at $500; do not
sell home version
$500
Sell to all users at same
price
$175+$175=$350
Price commercial
version at $175.
Price discriminate:
Price home version at
price high to the
$150; price commercial
commercial users; price version at $450
low to the home users
$150+$450=$600
Volume Discounts
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Example
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Demand= {$7,$6,$5,$4,$3,$2,$1}
Marginal Cost= $1.50
Demand is from a single individual for seven units
Three ways to discriminate
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Volume discounts: first unit for $7, second for $6, etc.
Two part pricing: price=$1.50, bargain over fixed
“entry” fee
Offer six units for $27=$(7+6+5+4+3+2)
Bundling
Dinosaur
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50 boys
$3
$2
50 girls
$2
$3
Discussion: Two movies and two customer
types
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Kung-Fu
What is best single price?
What is best bundled price?
Bundling “flattens” individual demand curve
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Makes it easier to extract surplus with a single price
Alternate Intro Anecdote
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International Expeditions, Inc. (IEI) provides trip
cancellation insurance for international travelers
IEI currently utilizes uniform pricing based on trip
duration, but with this pricing strategy, they can not
differentiate between high- and low-risk travelers
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Low-risk travelers are declining insurance cutting off a
profitable stream of business
If IEI could discover a way to price discriminate
between high- and low-risk clients, it could transact
with the low-risk travelers at a different price
Question – why not directly discriminate?
Alternate Intro Anecdote (cont.)
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By studying its customer histories, the company found
that frequent international travelers are low-risk for
cancellation
By offering a frequent traveler discount, the company
gets travelers to identify themselves by their purchasing
activities
 A high-risk traveler is unable to profitably mimic the
low-risk traveler with this program
This price discrimination scheme helped drive a nearly
100% revenue increase in 2003.