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Lecture 4: Price Discrimination
AEM 4160: Strategic Pricing
Prof. Jura Liaukonyte
2
Price Discrimination
Examples
Industry
Paper towels, soft drinks in
supermarket
Discrimination

Mass discount

Business class

Economy class

US. 10$ per pack

China 1$ per pack

Microsoft office $750

buy Microsoft office’s each
component individually $2060
Air fares
Marlboro sold in different
countries
Software
Price Discrimination
Definition

Oxford Dictionary


the action of selling the same
product at different prices to
different buyers, in order to
maximize sales and profits
Suppliers try to steal consumer
surplus by pricing as close as
possible to their willingness to
pay
Conditions
Price Discrimination
Definition

Oxford Dictionary


Conditions

the action of selling the same
product at different prices to
different buyers, in order to
maximize sales and profits
Suppliers try to steal consumer
surplus by pricing as close as
possible to their willingness to
pay

Four Conditions
1.
Monopoly Power
2.
Identifiable submarkets
3.
Different price elasticities of demand
4.
Prevention of arbitrage
Arbitrage Definition: Buy a good and sell
it for a higher price to
someone/somewhere else
3 Types of Price Discrimination
First Degree

Charge different price for every unit sold

Most effective – capture all Consumer Surplus
Second Degree

Provide choices and let consumers self-select different prices depending
on volume and usage
Third Degree

Easily segmented market E.g:

Geography

Senior Citizen
First Degree PRICE DISCRIMINATION
First Degree Price Discrimination
P
The first unit has the
highest price
P
MC
P1
D
Q1
The price drops for every
additional unit based on
each buyers willingness
to pay
MC
P1
P2
P3
Q
D
Q1 Q2 Q3
Q
First Degree Price Discrimination
P
P1
P2
P3

Consumers pay exactly what they are
willing to pay

Consumer Surplus = WTP-P = 0

Producer Surplus = P-MC │P=WTP

Consumer Surplus in perfect
competition = Additional producer
surplus in case of first degree price
discrimination
MC
+PS
P4
D
Q1 Q2Q3 Q4
Q
Slide
11
Price Discrimination

First Degree Price Discrimination: Summary

Charge a separate price to each customer: the maximum or
reservation price they are willing to pay.
Additional Profit From Perfect First-Degree
Price Discrimination

Question

Why would a producer have difficulty in achieving firstdegree price discrimination?
Slide
12
Additional Profit From Perfect First-Degree
Price Discrimination

Question


Why would a producer have difficulty in achieving firstdegree price discrimination?
Answer
1) Too many customers (impractical)
2) Could not estimate the reservation price for each
customer
Slide
13
Slide
14
Price Discrimination

First Degree Price Discrimination

Other examples of imperfect price discrimination where
the seller has the ability to segregate the market to some
extent and charge different prices for the same product:
 Lawyers, doctors, accountants
 Car salesperson (15% profit margin)
 Colleges and universities
Example: Credit Card
Industry
How The Industry Works


Credit agencies keep track of consumer credit
history.
Banks originate credit lines and determine terms.



Banks lend consumers lines of credit
Fixed amount of money based primarily on income
and FICO score
Terms, including interest rates, are determined based
on FICO score
Credit Agencies
Agencies
Experian, TransUnion, Equifax Collect
Data
Social Security Number
Risk
Factor
Payment
History
Account
History
Debt-to-Credit Ratio
Age of
Account
Average Account
Coverage
Debt
Available
Credit
Accounts 30 days, 60
days, 90 days late
Understanding the FICO Score
First Degree Pricing Using FICO Score



FICO scores provide a snapshot of the consumer's credit
worthiness, and companies price on an individual basis
Less risky consumers are worth more in the long run
 More responsible spending, payments on time
High risk consumers are less desirable, but can be highly
profitable.
 Higher risk means higher APRs, worse terms for
consumer
First Degree Price Discrimination
 However,
first-degree price discrimination has found a place on
the Internet in the form of reverse auctions.
 In a
reverse auction, a customer names the price he is willing to
pay, and the seller decides whether or not to offer him that
price.
 (Customers are
restricted from bidding on the same item
multiple times within a certain amount of time, eliminating their
ability to start out low and increase the bid until it is accepted).
 Priceline is
the most commonly cited example of a reverse
auction. http://www.priceline.com/
Google’s IPO was the first hybrid-Dutch
Auction
First-degree price discrimination



Suppose that you own five antique cars
Market research indicates that there are collectors of different
types
keenest is willing to pay $10,000 for a car, second keenest
$8,000, third keenest $6,000, fourth keenest $4,000, fifth
keenest $2,000





Contrast with linear pricing: all cars sold at the same price



22
sell the first car at $10,000
sell the second car at $8,000
sell the third car to at $6,000 and so on
total revenue $30,000
set a price of $6,000
sell three cars
total revenue $18,000
Informational Requirements
 Are
1.
2.
3.
4.
four criteria satisfied?
Monopoly Power
Identifiable submarkets
Different price elasticities of demand
Prevention of arbitrage
 Do you think
first degree price discrimination is
common?
 What are the informational requirements for the
seller?
24
Conclusions

The information requirements for first degree price discrimination appear
to be insurmountable

but not in particular cases
tax accountants, doctors, students applying to private universities
First-degree price discrimination is highly profitable but requires






detailed information
ability to avoid arbitrage
Leads to the efficient choice of output: since price equals marginal revenue
and MR = MC
no value-creating exchanges are missed
SECOND Degree PRICE DISCRIMINATION
26
Second-degree price discrimination
 What
if the seller cannot distinguish between buyers?
 perhaps they differ in income (unobservable)
 Then
the type of price discrimination just discussed is
impossible
 High-income buyer
will pretend to be a low-income buyer
 to avoid the high entry price
 to pay the smaller total charge
Second-degree price discrimination




Firms typically offer a list of different prices to consumers
allowing the consumers to self-select.
Also called VERSIONING pricing strategy: companies sell
variations of a product or service at different prices to
different groups of customers.
Create versions of a product to appeal to different types of
buyers. Customers then choose the version that best meets
their needs.
Distribute a physically similar product under different brand
names,


E.g. GAP, Old Navy, Banana Republic
Filene’s Basement, TJMaxx, Marshalls
Second-Degree Price Discrimination
Example
Self Selection

HD vs. SD – Value of high definition

Movies Link
TurboTax Link

Options: Individual with bigger need

Health Clubs

Off peak hours discount: busy individual vs.
student

Getty Images

Resolution – Professional vs Casual

Buy Bulk at Sam’s

Self select price per unit based on quantity

Second-Degree Price Discrimination
In some markets, consumers purchase
many units of a good over time
Demand declines with increased
consumption
Price Discrimination: Charge different
prices to increase volume
Charge different prices per unit for
different quantities of the same good
Quantity
Discounts
Block Pricing:
Charge different
price for blocks of
a good e.g. Electric
Power
30
Second-degree price discrimination
Essence of second-degree price discrimination

It is “like” first-degree price discrimination


the seller knows that there are buyers of different types
but the seller is not able to identify the different types
Seller has to compromise

Design a pricing scheme that makes buyers


reveal their true types
self-select the quantity/price package designed for them
31
Second-degree price discrimination

Will the monopolist always want to supply both types of
consumer?

There are cases where it is better to supply only highdemand types


high-class restaurants
golf and country clubs
Second-degree price discrimination
principles



Page
32
Induce customers to select into high and low price
groups themselves.
Key constraint: you can’t make the inexpensive version
too attractive to those willing to pay more.
If there aren’t many customers in the low-valuation
group, you may want to ignore this group, since selling to
it forces you to lower the price to the high valuation
group.
More types of second degree price
discrimination
Example
Page
33
Self Selection

Intertemporal

High Valuation users are less patient

Quantity Discounts

High valuation consumers pay high
price for higher volume

Multiple two-part
tariff

Example: cell phone plans with monthly
and per minute fees – Separate
between high and low volume users
Page
34
Takeaways

Firms would prefer to use perfect (aka first-degree) price
discrimination, but this may be impossible.

Second-degree PD induces customers to sort themselves into
groups.

Recall the no arbitrage constraint—consumers can’t resell to
others.

Price discrimination and other advanced pricing strategies
are powerful tools; you now have the economic models to
understand them.
35
Feasibility of price discrimination

Two problems confront a firm wishing to price discriminate
1 identification: the firm is able to identify demands of different types of
consumer or in separate markets
 easier in some markets than others: e.g tax consultants, doctors
2 arbitrage: prevent consumers who are charged a low price from
reselling to consumers who are charged a high price
 prevent re-importation of prescription drugs to the United States

The firm then must choose the type of price discrimination



first-degree or personalized pricing
second-degree or menu pricing
third-degree or group pricing
Example: Tablet Industry
Intertemporal pricing

People value things differently depending on the point in
time they will receive it


Value now > Value later (Hyperbolic Discounting)
eReader and Tablet companies exploit this discrepancy by
marking up their product upon introduction


Capture the consumer surplus of early-adopters
They later lower their prices to reflect the reduction in value
that occurs when the product leaves the initial market entry
stage and more consumers begin to enter the market
Intertemporal Pricing: eReaders
Intertemporal Pricing: eReaders
Intertemporal Pricing: eReaders
Example: Airline Industry
2nd Degree Price Discrimination

Price Dispersion


Variation in prices for the same item
Versioning

Variations of a product or service at different prices to
different groups of customers

First Class vs. Coach seating
Price Dispersion


The expected difference in fares paid is 36%
Airlines likely to have 20 or more different fares on one
given flight
Example: Ski Industry
Product Differentiation



A form of second degree price discrimination
Provide customers with many options and they choose
what to purchase
Ski resort industry offers a variety of products and
services in order to:




Meet consumer needs
Maximize revenue
Maximize producer surplus
Increase customer base
Product Differentiation
Ski Pass Differentiation

Type of ski pass




Full day pass
Half day pass
Night pass
Length of ski time




One day pass
Weekend pass
Week pass
Season pass
Ski Lift Ticket Prices: Bristol Mountain
Adult Prices
Price (in dollars)
All Day and Night (Opening10pm)
8-hours (starting anytime)
57
4-hours (starting anytime)
51
Twilight (4pm-10pm)
36
Evening (7pm-10pm)
30
54
Variations in Ski Pass Options


As the number of days purchased at one time increases,
the price per day of the ticket decreases
Resorts do this to encourage customers to buy more
days worth of tickets