Chapter 13:
Direct Price
Discrimination
Managerial Economics: A Problem Solving Approach (2nd Edition)
Luke M. Froeb, luke.froeb@owen.vanderbilt.edu
Brian T. McCann, brian.mccann@owen.vanderbilt.edu
Website, managerialecon.com
COPYRIGHT © 2008
Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are
trademarks used herein under license.
Slides prepared by Lily Alberts for Professor Froeb
Summary of main points
• 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 group with the lesselastic demand.
• Price discrimination is the practice of charging
different people or groups of people different prices
that are not cost-justified. Typically more people are
served under price discrimination than under a
uniform price.
• Arbitrage can defeat a price discrimination scheme if
enough of those who purchase at low prices re-sell to
high-value consumers. This can force a seller to go
back to a uniform price.
Summary of main points (cont.)
• A direct price discrimination scheme is one in which we
can identify members of the low-value (more price
elastic) 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.
• 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. If you can, keep them
secret.
Introductory anecdote: cell phone
pricing
• In 1997 a global cell phone manufacturer (IRK) was losing sales in the
Philippines because competitors offered a better, lower price.
• The company charged a world-wide uniform price of $120
• It sold most of its phones in wealthy countries
• Important future markets, such as the Philippines, were ignored
because demand was lower in less wealthy countries (“normal good”).
• Competitors were under-pricing IRK in these future markets and were
selling more.
• The Philippine market was quickly approaching the crucial 10%
penetration point.
• At which this Rule of Thumb applies: the firm w/ the largest share
at 10% penetration will grow to 40% w/out marketing when market
penetration grows to 30%
• The company considered charging a lower price in the
Philippines to generate more sales before the 10% point
Cell phone pricing (cont.)
• The company was worried, however, about the consumer
response, and potential fallout, due to discriminatory pricing
Introduction: Pricing schemes
• This chapter looks at ways of (profitably) designing
and implementing price discrimination schemes.
• So that sellers can charge different prices to
different consumers based on differences in
consumer demand.
• This allows sellers to increase profit above the profit
available from setting a single, uniform price.
Pricing tradeoff & discrimination
• Frequently there is a pricing tradeoff based on
simple demand curves:
• Lower price  sell more, but earn less on each unit
sold
• Higher price  sell less, but earn more on each unit
sold
• Marginal analysis tells us how to optimize around this
tradeoff: MR=MC  (P-MC)/P=1/|e|
• Price discrimination allows sellers to avoid the
tradeoff
• Higher prices for some
• Lower prices for others
Why (price) discriminate?
• Example: a simple demand curve
• Seven consumers willing to pay {$7,$6,$5,$4,$3,$2,$1}
• Marginal Cost of the good= $1.50
• Optimal price is $5
• At a price of $5, low-value consumers, {$4, $3, $2,
$1}, don’t purchase
• Even though their values are above the MC
• This leaves unconsummated wealth-creating
transactions!
• If a separate price is set for this group, i.e. price at
$3 and sell 2 extra units, firm profit increases, and more
customers are served.
Price discrimination
• 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 wealth-creating transaction!)
• Definition: Price discrimination is the practice of
charging different prices that are not cost-justified to
different people
• P1/MC1  P2/MC2.
• Price discrimination allows two optimal prices to be set
for two groups with different levels of price elasticity:
• (P1-MC1)/P1=1/|elasticity1|
• (P2-MC2)/P2=1/|elasticity2|
Price discrimination
• The bigger the difference between group elasticities,
the more profit there is in designing a price
discrimination scheme.
• To price discriminate
• ID different groups with different price elasticities or
different values
• Find a way to prevent arbitrage
• Direct Price Discrimination occurs when you can:
• ID members of the low-value group can be identified
• Charge low-value costumers a lower price
• Prevent resale (arbitrage) to higher-value consumers.
Price discrimination (cont.)
• Indirect Price Discrimination occurs when you:
• Cannot ID members of groups; OR cannot prevent
arbitrage
• Instead, discriminate by offering two products, a higherpriced, higher-quality good and a lower-priced, lowerquality good.
Direct or indirect pricing schemes?
• Tickets to a movie theaters (senior citizen discount, student
discount, etc.)
• Grocery stores (discount coupons, in-store or in weekly
newspaper inserts)
• Airlines (business vs. economy tickets)
• Describe a price discrimination opportunity facing your
company
The Robinson-Patman Act (US)
• Robinson-Patman Act
• Prohibits providing a price discount on a good sold to
another business
• The Robinson-Patman act was designed to protect
independent retailers from chain-store competition by
preventing the chains from receiving supplier discounts.
• Defenses against a Robinson-Patman lawsuit are:
• That the price discount was cost-justified; or
• The price discount was given to meet the competition
• Europe has similar, and stronger, laws
• Promotional allowances or vertical integration may
avoid Robinson-Patman liability
Pricing for laptops
• Computer companies often sell to a wide variety of
users with a wide variety of price sensitivities.
• To identify the price sensitivity of on-line customers Dell’s
website has different categories in which users can shop
(such as home & home office, small & medium business,
large business, etc.)
• Under the “Small and Medium Business” category, a laptop
was listed as $1,197
• Under the “Large Business” category, the same computer
was $1,339 a 12% increase
• This pricing scheme allows Dell to sell identical computers
at different prices based on the consumers’ price
sensitivity.
Back to cell phone pricing
• The cell phone manufacturer, IRK, reduced prices in
Philippines to $90
• PROBLEM: the Philippine phones used the same
standard (GSM) as higher-priced European phones
• Thus, arbitrage threatened sales in other countries (15
million units annually)
• To prevent this, the company sold models with SIM-locks,
which allow calls only in the local operators’ networks
• Turkish hackers broke the SIM-lock
• 15,000 phones were sold to Western Europe by the
hackers before IRK changed the SIM-lock algorithm and
again prevented arbitrage
IRK’s cell phone pricing (cont.)
• In 1998, IRK sold 200,000 phones to Philippines –
much better than the 50,000 units they would have
sold without price discriminiation
• IRK’s market share went from 10% to 25% in one
year
• 1999, IRK returned to global uniform pricing
• Competitors followed, and raised prices as well.
• In 2000, the Phillipines cell phone penetration
reached 12% and IRK market share rose to 34%
Warning: only schmucks pay retail
• Consumers do not like knowing they are paying higher
prices than others.
• For example, when shown a box for a promotional code
on a website, click-through rates decline.
• Online shoppers were less likely to complete their transactions
once they realized a coupon existed that they didn’t have.
• People don’t like knowing they are schmucks
• So, if you are price discriminating, it is important to
keep the scheme secret if you can.
Alternate intro anecdote:
medical test strips
• In Northern Europe (Ger., Holland and Scandinavia)
• Machines sell for $25
• 50 test strips sell 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
• Potential market for test strips is $200 million per year
• If they acquire 30% of the market, they can make an
additional $60 million in revenue
North/South Europe price
discrimination implementation
• Lower prices to Southern Europe
• Test strips at $11
• Measurement devices at $12.50
• To prevent arbitrage
• ROM key ensures north/south incompatibility
• Also reduce the measurement speed of the
Southern devices from 11 to 25 seconds. It is
important that these slower devices cost less, so
that the price difference has some cost justification
(so it wont violate antitrust laws).
Anecdote: conference pricing
• The American Association for Clinical Chemistry (AACC)
sponsors 3-day conferences
• 90% of the attendees from same city or surrounding region
• Foreign participants
• Greater travel costs
• Longer travel times
• Applying and interviewing for travel visas
• The majority attend conferences in own countries
• To increase attendance, the AACC proposed reducing price to
foreign participants
• QUESTION: HOW DID THEY PREVENT ARBITRAGE?
20
1. Introduction: What this book is about
Managerial Economics 2. The one lesson of business
3. Benefits, costs and decisions
Table of contents
4. Extent (how much) decisions
5. Investment decisions: Look ahead and reason back
6. Simple pricing
7. Economies of scale and scope
8. Understanding markets and industry changes
9. Relationships between industries: The forces moving us towards long-run equilibrium
10. Strategy, the quest to slow profit erosion
11. Using supply and demand: Trade, bubbles, market making
12. More realistic and complex pricing
13. Direct price discrimination
14. Indirect price discrimination
15. Strategic games
16. Bargaining
17. Making decisions with uncertainty
18. Auctions
19. The problem of adverse selection
20. The problem of moral hazard
21. Getting employees to work in the best interests of the firm
22. Getting divisions to work in the best interests of the firm
23. Managing vertical relationships
24. You be the consultant
EPILOG: Can those who teach, do?