Transcript Lecture 19 Price Discrimination

Price Discrimination
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The law of demand tells us that demanders are
different, and so are willing to pay different
amounts (elasticity of demand differs and values
are different—so different willingness to pay)
What it means:
– Charge different prices to different consumers
in an effort to increase market and profits
It Is Done Everywhere
(Especially to Foreigners)
Closer to Home:
P&G products for
upper income &
middle income
customers
The Goal: Higher Profits by
Serving the Customer
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“Whether it’s a deli or SAP, it’s always
about differentiating and serving the
customers so they want to come back to
you.”
Bill McDermott, CEO of SAP Americas
SAP Americas tripled market share in four years by:
segmenting customers into different groups based
on their size, industry, location and needs—by
getting to know their customers better.
The Grand Master
of Price Discrmination!
Google runs a continuous auction where
demanders (advertisers) bid against each
other and Google adjusts price based on
results.
E.g., surfer who googles “digital camera” and
then clicks - $0.75 charge. Surfer who googles
“digital cameras” and then clicks - $1.08.
Based on experience—different likelihood of a
purchase.
A simple example
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Suppose demand for your product
$
is Q = 100 - P
Could be
100
– One demander with
declining willingness
to pay, or
– Different demanders with
50
different willingness to
pay for one unit each
MC is zero (all fixed costs)
The single price solution is
0
P = $50, Q = 50
So that
TR = $2500
D
MR
50
100
Q
The ideal solution
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Charge a different price for each unit (assume MC = $0)
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Thus, P = $100, $99, $98, $97, ……, $1
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Yields an average price of $50 per unit; 100 units sold
– Then, TR = $5000 (think of a real world example)
Suppose there is one demander, then “all or nothing”
pricing
– Take all 100 at a fixed fee of $5000, or take nothing
(a bag of diamonds at de Beers)
In practice, multiple pricing classes are common
– For example, an airplane with 100 seats may have 43
different prices
A common problem…
How to change different prices?
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There are two key issues:
– Correctly identify demanders
 Age (retired or students)
 Appearance (local or not; rich or poor)
 Time (day of week—airline tix cost less
on T,W,Th; iPhone prices cut over time)
 Cookie information
– Prevent resale (and be polite)
 Picture ID (airlines)
 Arbitrage difficult or not worthwhile
(hotel rooms)
Been There; Done That
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Moving a went away from it
does not produce good results
Delta tried “simple fares”—no fare over $499 one
way and most restrictions eliminated. Result:
Delta ended up earning only 86% of industry
average revenue per aircraft mile-seat.
JC Penney went to no coupons, no sales—used “fair
and square” fixed pricing. No 99 cent prices—
round prices at 00. Result: Profits/sales fell, stock
price fell from $42 to $22 in six months.
People say they want clear pricing—not so in
practice.
Example from Belkin
Ethernet cables made in a factory in
China for a U.S. company sold for:
$29.95 with brand name wrapper
$19.95 with chain store wrapper
$15.95 on eBay under no name
Exact same product (purchased for $3)
Cost Is Not Pricing:
iPhone 4S
$188 parts for 16-GB model, $649
$207 parts for 32-GB model, $749
$245 parts for 64-GB model, $849
($30-40 cost differential relates to $100
higher price—other costs assumed same)
* Carriers may cover $450 of price with 2year contract
A Successful Practice
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Tesco, the largest supermarket in UK with 31% share of
grocery sales. Third largest retailer in the world; $91 billion
sales. It uses barcode information from sales to learn how
to improve service and profits.
What goods are complementary? Diapers and beer. High
quality toilet paper and skin care products.
12 million UK customers have “Clubcards.” Six million
versions of a newsletter go to customers based on buying
history and personal characteristics. Each newsletter offers
slightly different discounts. Know your customers.
After annual minimum purchase made, 1% discount
received for using Clubcard.
Tesco: Data Uses
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Location of products on shelves adjusted in each store
and product mix changed.
High-income shoppers wanted higher quality goods.
Asian customers wanted large sacks of rice and certain
spices. The spices attracted non-Asian upper-income
buyers, so were then added in upper-income area
stores.
Database is sold to Tesco suppliers such as Coca-Cola
and Procter & Gamble so they can study data.
Result: Tesco beat Wal-Mart in UK and in South Korea.
How to differentiate in U.S.?
“Big Box Discounts without the Big Box”
Note “fresh” terminology.
2007 launch in Southern California,
Arizona, and Nevada—just as crash hit.
2010—announced plans to open 400
stores by 2013.
Dynamic Pricing:
Follow the Internet Leader
Cost-Side Data Use
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Wal-Mart and other large retailers use sales
data (15 minute increments) from one year to
forecast for the next year when peak customer
loads will occur.
Employee schedules are set based on when
they are likely to be most needed, getting away
from traditional eight hour shifts.
Customers served better; higher output per
employee.
Price Discrimination:
Get Higher Profits
Coke customers can buy one Coke for $1 (the profit
maximizing price) or a pack of six cans for $3. Why
would Coke offer the six cans for $3?
$
$1
D
MC
$0.25
0
Q*
MR
Quantity
Price Discrimination
Why would Coke offer the 6 pack for $3?
It sells to all customers at $1 for one can, but also moves
down the D curve and sells 5 more cans for $0.40 each.
Extra consumer surplus (profit) captured.
$
$1
D
$.40
MC
$.25
0
Q*
Quantity
MR
Potato Chips—Ones focusing on “natural”
and other so-called health claims cost
more, even when identical to regular chips.
Reward and Keep Loyal Customers
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Cellphone companies rank the value of current
customers to decide on price to charge.
Based on history of revenue and problems, loyal
customers are offered better deals on new
phones and more service. Bad customers are
offered no special deals.
The company can predict expected future
revenue (and cost of service) from customers’
history.
Sophisticated customers order over Internet—get
better price than in-store customers.
Dump High Cost Customers?
When we sell products for the same price
to all customers we price discriminate
because some customers cost more to
service. It may be more profitable to
charge higher-cost customers more or
get rid of them.
Does the additional (marginal) revenue
justify the additional (marginal) cost?
Example from website company
Websmith Group develops and maintains
websites for various firms.
Some were “high-maintenance” and
others were chronic late payers.
Eliminating 5% of its clients reduced
time costs by 20%, leading to 10%
growth in 2009 during the recession.
Example from Mail-Order Company
The best customers buy the most. 16% of
customer base, but 40% of profits.
The worst customers buy a little and impose
costs on company by returning goods and
other service demands. 25% of customers
generated minimal profits.
Other customer groups in between these two.
Management must decide—should the worst
(high cost) customers be dropped or made
to bear more of their costs by price
discrimination? Is that possible?
Some Customers More Costly to Serve:
Price Discriminate Between the Two
High maintenance customers
impose greater costs on seller.
£
Higher cost
customers
Low maintenance customers
impose fewer costs on seller.
£
Lower cost
customers
P
MC
MR
P
D
Q/time
Q high
D
MC
MR
Q low
Q/time
Example
Coach, a maker of expensive leather handbags
and other goods, has two methods of sale:
1. Full price at its own stores and at selected
retailers (and on the web). Full price only;
never any discounting. Average age of
shopper is 35; average expenditure is $1,100.
2. Discount outlet stores that sell last season’s
products for less. Stores usually 100 km away
from nearest full-price retailer. Average age of
shopper is 45; average expenditure is $770.
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Example: Jewelry Retailing
Signet Group (U.K.) operates two sets of
jewelry stores in the U.S.:
Kay Jewelers focuses on middle class with
lower price diamonds, etc.
781 stores average $1.65 million sales.
Jared focuses on upper income with
expensive diamonds and Swiss watches.
110 stores with $5.6 million avg. sales.
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Kindle: Price Discrimination
Over Time
Kindle 1, 11/07, $399,
“sold out” instantly
Kindle 2, 2/09, $399;
7/09, $299
10/09, $259
6/10, $189
Kindle 3, 8/10, $139,
sold out instantly,
9/11, $79
Avoiding consumers using
price apps such as RedLaser
Smartphones allow instant price comparisons.
How do politicians see it?
“an attack on Main Street” and “anticompetitive”—Senator Olympia Snowe (Maine)
How to avoid? Private label goods and
variations on a theme from major suppliers.
Computer Jocks Call It
Dyanmic Pricing (Data Mining)
Robert Phillips, Director, Center for Pricing and
Revenue Management, Columbia University,
created a formula that mixes a consumer’s
credit score with his or her likelihood to shop
around. Banks use that score to know whether
to offer that consumer a competitive rate of
interest or a higher one. Bottom line?
Phillips: “It can increase operating profit on
the order of 7-12 percent.”
Be Careful About Internal Competition
Common form of price discrimination—different brands
from same company.
Presume a parent company has three brands of shampoo.
If one is a discount brand, or if discounts offered on one
brand, how much will that cut sales of other brands?
Suppose price is cut 10% on one brand and result is 30%
increase in sales. Is that good? How much does that
add to the net revenue of the parent company? If sales
of two other brands fall as customers move to cheaper
brand, may be a net loss. Know your elasticities.
Bundling
Consumer A will pay $100 a year for the Disney
channel on cable or satellite TV.
Consumer B will pay $10 a year for the Disney
channel on cable or satellite TV.
Consumer A will pay $10 a year for ESPN.
Consumer B will pay $100 a year for ESPN.
Solution: bundle Disney & ESPN for $109 per year
($218 revenue from A&B). If sell Disney and
ESPN for $99 per year, then only $198 revenue.
Does Papa Know Best?
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CEO Robert Nardelli (later at Chrysler)
centralized buying for Home Depot in 2001.
Local managers could not order what they
believed customers wanted. Lock step for
stores: too many snow shovels in Arizona; not
enough power tools. Good managers left;
Lowe’s moved in.
Mixing buying power and standardization with
local interests is tough.
How Do You Want Your Drink?
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Starbucks menu:
Regular coffee
Tall (small) cappuccino
Caffe Mocha
Grande (medium) latte
Venti (large) cappuccino
Venti mocha w/ vanilla
$2.05
$2.55
$2.75
$3.35
$3.60
$3.85
Cost difference to make these different drinks?
Why would they do that?
Travelers, Farmers and others announce
they will discount up to 10% on car
insurance rates for hybrids.
Applauded for being sensitive to the
environment. Are they really?
Coupon Question
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When Disney sells a new DVDs of a
movies, it often has a mail-in coupon
that allows the customer to get a
rebate (price discount). On a $20
DVD, there may be a $5 mail-in
coupon. These are expensive to
process, so why does Disney not just
sell the movies for $15?
Common Mistakes
(Thanks to Peter Drucker)
1. Short term high profit margins.
Remember—the competition is coming. Xerox
dominated copier market in early 1970s.
High prices and profit margins. Canon
entered with simpler, cheaper machines and
swept the market away from Xerox.
High profit margins today do not mean
maximum profits over time. Price elasticity
of demand drops over time due to
alternatives.
Common Mistakes
2. Cost-Driven Pricing.
Many companies derive prices based on cost
recovery plus profit margin.
The goal should be price-led costing. What
will customers pay, given current and future
competition? That is, what is the demand?
Can your costs fit within those prices?
Toyota and Nissan use that model and have
taken larger and larger market shares away
from German and American auto makers.
Common Mistakes
3. Using revenues to feed problems and
starve opportunities.
Many firms incur high costs trying to solve
problems (often assigning the best people to
solve problems). Problems are usually due to
changes in competition and changes in
technology—a sign that demand has
changed. Opportunities should be the focus—
look forward. GE dumps weak products rather
than trying to fix them.