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
– Recognize the fact of some odd perceptions by
most people
The Goal: Higher Profits
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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.
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
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 (of day or day of week)
 Language
 Gender (Ladies’ night)
– Prevent resale (and be polite)
 Picture ID (airlines)
 Arbitrage difficult or not worthwhile
(hotels)
Simple example
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)
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 were not buying as much, so
higher quality goods were increased to attract them.
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.
Shoppers send discount coupons for good they are not
now buying but are likely to buy based on patterns.
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.
When entered U.S. market—small stores; fresh produce.
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
Reward Loyal Customers
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Cingular, a large cellphone company, ranks the
value of customers who call to complain, to
change service, etc.
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
based on past history.
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 Mail-Order Company
The best customers buy but do not insist on
extra service. 16% of customer base, but
40% of profits.
The worst customers buy some but impose
high costs on company by returning goods
and other service demands. 25% of
customers but only 15% of 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
Low maintenance customers
impose greater costs on seller.impose fewer costs on seller.
£
Higher cost
customers
£
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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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?
Same Goods to Different
Customers at Different Prices
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Tie the sale of different goods together after
customer agrees to buy one. Based on sales
history, you know what goods are complements.
Example: KFC lists one item (chicken) at $2.29.
Customer buys it but does not order another item
(drink) listed at $1.09. KFC knows those items
are complements. The cash register tells the clerk
to offer the second item for $0.71, so the total
sale would be $3.00.
Where used, sales rise about 5% and profits rise
even more. Must change offer frequently.
Observations about Consumer
Perceptions
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People view magnitudes, not absolutes:
A new radio is being sold for €100 at a store near
you.
You hear it is being sold for 50% less, €50, at a store
15 kilometers away.
Will you go there to buy it and save 50% or €50?
Most people will.
A new car you want to buy is being sold for €20,100
at a dealer near you.
The same car is being sold for €20,050 at a dealer 15
kilometers away.
Will you go there to save 0.25% or €50?
Most people will not.
Exploiting Perception
Buyers more likely to buy an apartment
if first shown a dirty, overpriced
apartment before shown an ordinary
apartment at a fair price compared to
if buyers are first shown a nice
apartment at a higher price and then
an ordinary apartment at a fair price.
Exploiting Perception
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Restaurants encourage customers to
buy more and feel good about
purchases by putting a few expensive
items on the menu, such as a bottle of
wine for $400 or a bowl of bird nest
soup for 400RMB, followed by more
normal price wine and soup.
The normal prices then look like a
bargain compared to reference price.
Perception from Sales
Sales, or the perception of sales, work:
 Identical vacation packages (A and B)
are offered:
A marked down from $600 to $500
B priced at $400 that was on sale the day
before for $300.
 A sells more than B.
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Humans Are Risk Avoiders:
Evidence from Real Experiments
You are given a 50% chance of winning $150
and a 50% chance of losing $100.
What is the expected value of this gamble?
$25 ($75 expected win - $50 expected loss)
But most people refuse this bet. Most will not
accept it until the winning is raised to $200.
Humans are genetically averse to losing or
what is perceived to be losing.
This has odd effects on decision making.
Consumer Preferences
An experiment run on e-bay:
1. Offer certain goods at auction beginning at
$0 with a $4 shipping charge added if
purchased.
2. Offer same goods at auction beginning at
$4 because shipping included (and cost of
$4 shipping is noted).
 More shoppers went to the first auction and
bought more of the good and ran the prices
up higher.
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Perception and Presentation
Side-by-side comparisons matter to
consumer valuation:
Group A consumers bid on new dictionary with
10,000 words. Average: $24
Group B consumers bid on dictionary with
20,000 words and torn cover. Average: $19
Group C consumers shown same dictionaries
side by side: Average bid $19 for 10,000
word version and $27 for 20,000 word
version with torn cover.
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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.