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Any Questions from Last Class? 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 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. If you offer a low-value product that is attractive to high-value consumers, you may cannibalize sales of your high-price product. When bargaining with a customer, do not bargain over unit price; instead, bargain over the price of a bundle. 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 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 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 Low-value pays $100; high value pays $150 Option 2: Give away printer and sell cartridges for $100 Low-value pays $100; high-value pays $200 Indirect Price Discrimination Applies if 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 Disadvantages 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 Software manufacturers indirectly discriminate between commercial and home users They design versions of software that appeal to each group Lower price, “disabled” version for more-price-elastic home consumers Full featured version for business users Beware cannibalization threat 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 Example 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 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 50 boys $3 $2 50 girls $2 $3 Discussion: Two movies and two customer types Kung-Fu What is best single price? What is best bundled price? Bundling “flattens” individual demand curve Makes it easier to extract surplus with a single price Alternate Intro Anecdote 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 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.) 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.