Transcript lecture 1 - Vanderbilt University

Any Questions from Last
Class?
Chapter 11
Direct Price Discrimination
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herein under license.
Chapter 11 – Take Aways
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If a seller can identify two groups of consumers with different demand
elasticities, and it can prevent arbitrage between two groups, it can increase
profit by charging a higher price to the low-elasticity group.
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Price discrimination is the practice of charging different people or groups of
people different prices that are not cost-justified.
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A direct price discrimination scheme is one in which we can identify
members of the low-value group, charge them a lower price, and prevent them
from reselling their lower-priced goods to the higher-value group.
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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.
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Price discrimination schemes may annoy customers who know they’re paying
more than others and can make them less willing to buy because they know
someone else is getting a better price.
Review of Chapter 10
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After acquiring a substitute product
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After acquiring a complementary product
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Reduce price on both products to avoid cannibalizing each other’s sales.
If fixed costs are large relative to marginal costs, and capacity is fixed,
you should price to fill available capacity.
Price-related promotions (coupons, end-of-aisle displays, etc.) tend to
make demand more elastic.
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Raise price on both products to avoid cannibalizing each other’s sales.
Raise price by more on the low-margin (more elastic demand) product.
Reposition the products so that there is less substitutability between them.
If you are making demand more elastic, it makes sense to reduce price
concurrently
Product-related promotions (quality advertising, celebrity endorsements,
etc.) tend to make demand less elastic.
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If you are making demand less elastic, it makes sense to raise price
concurrently
Anecdote: Conference Pricing
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The American Association for Clinical Chemistry
(AACC) sponsors 3-day conferences
90% of the attendees from same city or surrounding
region
Foreign participants
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Greater travel costs
Longer travel times
Applying and interviewing for travel visas
Choose to attend conferences in own countries
To increase attendance, the AACC proposed
reducing price to more distant participants while
maintaining prices to local attendees
Anecdote: Cell Phone Pricing
Global cell phone manufacturer in 1997
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World-wide uniform price of $120
Most sales in wealthy countries
Important future markets, like Philippines, ignored
Competitors underpricing in these future markets
10% penetration point is crucial
 The largest market share will grow 40% w/out marketing
when market penetration grows to 30%
Considering charging different price in Philippines
Mobile phone penetration .
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100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Philippines in
1997
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2
3
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5
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7
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9 10 11 12
Time in years from opening of first digital network
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Pricing Tradeoff & Discrimination
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Remember the tradeoff from the pricing
chapter
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Lower pricesell more, but earn less on each unit
sold
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Higher pricesell less, but earn more on each
unit sold
Price discrimination avoids the tradeoff
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Higher prices to some
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Lower prices to others
Why (Price) Discriminate?
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Example
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At price of $5, low-value consumers, {$4, $3,
$2, $1}, don’t purchase
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Demand= {$7,$6,$5,$4,$3,$2,$1}
Marginal Cost= $1.50
Optimal price is $5
Even though their values are above MC
Unconsummated wealth-creating transactions!
Set separate price for this group
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Price at $3; sell 2 extra units
Direct Price Discrimination
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Motivation: price discrimination allows a firm to sell items to
low-value customers who otherwise would not purchase
because the price is too high (the firm consummates a wealthcreating transaction!)
Definition: Price discrimination is the practice of charging
different prices that are not cost-justified to different people
 P1/MC1P2/MC2.
Optimal prices for two groups
 (P1-MC1)/P1=1/|elasticity1|
 (P2-MC2)/P2=1/|elasticity2|
Direct Price Discrimination
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The more unique, innovative and useful is the product, and the fewer
substitutes, the more profit there is in designing a price discrimination
scheme.
3 conditions
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Market power
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ID different groups with different elasticities
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Prevent arbitrage
Direct Price Discrimination
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Can identify members of low-value group
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Charge them a lower price
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Prevent resale
Indirect
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When cannot ID consumer groups
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ID high-value consumers by willingness to buy high-priced good
Direct or Indirect?
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Discussion: Movie theaters
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Discussion: Grocery stores
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Discussion: Airlines
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Discussion: Describe a price discrimination
opportunity facing your company
Robinson-Patman Act
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Robinson-Patman Act
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Prohibits providing price discount to a good sold to another
business
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Defenses
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Cost-justified; or
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Meet the competition
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Europe has similar and stronger laws
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Promotional allowances or vertical integration may
avoid Robinson-Patman liability
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Discussion: Herbicide that has both farming and home uses
Conference Price Discrimination
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More distant consumers have more elastic demand
for the conferences.
Adopt policy of lower prices for traveling attendees
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Local: $800
National: $600
International: $400
Implementation ideas
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Mail regional editions of conference brochures containing
different prices to different customers.
Require a foreign mailing address to get international rate
Cell Phone Discrimination
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Manufacturer reduced price in Philippines to $90
Same standard (GSM)
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Turkish hackers broke SIM lock
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15,000 phones to Western Europe
1998, Firm X sold 200,000 phones to Philippines
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Arbitrage threatened sales in other countries (15 million units
annually)
SIM-locks allow calls only in local operators’ networks
Share went from 10% to 25% in one year
1999, Firm X returned to global uniform pricing
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Competitors followed
2000, penetration reached 12%
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Market share rose to 34%
Warning: Only Fools Pay Retail
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Consumers do not like knowing they are
paying higher prices
For example, when shown a box for a
promotional code on a website, click-through
rates dramatically dropped
People don’t like knowing they are fools
So, if you are price discriminating, it is
important to keep the scheme secret if you
can
Alternate Intro Anecdote: Medical Test
Strips
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In Germany, Holland and Scandinavia
 Machines for $25
 50 test strips sells for $22
 12 million boxes of test strips
Southern Europe
 Italy and Spain: insurance companies’ reimbursement
rates are 50% lower
 Firm has capacity to produce additional 6 million
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Potential market for test strips is $200 million per year
If acquire 30% of the market, the opportunity cost of
not entering the southern markets is about $60 million
in revenue
North/South Europe Price
Discrimination Implementation
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Lower prices to Southern Europe
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Arbitrage prevention
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Test strips at $11
Measurement devices at $12.50
ROM key ensures north/south incompatibility
EC antitrust laws reduce the measurement speed of
the devices from 11 to 25 seconds. It is important
that these slower devices cost less, so that the price
difference has some cost justification.