PowerPoint Slides © Michael R. Ward, UTA 2014
Econ 5313
Bagel Shop
• You run a small bagel shop. You have engaged in a market
study to categorize your customers’ willingness to pay for
a meal (coffee & bagel) into 8 equal sized groups: ($5.00,
$4.50, $4.00, $3.50, $3.00, $2.50, $2.00, $1.50). All of
your costs are fixed except labor and materials, which cost
$2.25 per meal sold.
• What price should you charge for a meal?
Econ 5313
Bagel Shop
• Sort them from highest WTP to lowest
• If you charge them their WTP or lower, they purchase
• So this generates a demand curve
Price
$5.00
$4.50
$4.00
$3.50
$3.00
$2.50
$2.00
$1.50
Quantity
1
2
3
4
5
6
7
8
Total Rev
MR
MC
Profit
Econ 5313
Bagel Shop
• Multiply price times quantity to get total revenue
Price
$5.00
$4.50
$4.00
$3.50
$3.00
$2.50
$2.00
$1.50
Quantity
1
2
3
4
5
6
7
8
Total Rev
$5.00
$9.00
$12.00
$14.00
$15.00
$15.00
$14.00
$12.00
MR
MC
Profit
Econ 5313
Bagel Shop
• Multiply price times quantity to get total revenue
• Calculate the MR from the change in total revenue
Price
$5.00
$4.50
$4.00
$3.50
$3.00
$2.50
$2.00
$1.50
Quantity
1
2
3
4
5
6
7
8
Total Rev
$5.00
$9.00
$12.00
$14.00
$15.00
$15.00
$14.00
$12.00
MR
$5.00
$4.00
$3.00
$2.00
$1.00
0
($1.00)
($2.00)
MC
Profit
Econ 5313
Bagel Shop
• Multiply price times quantity to get total revenue
• Calculate the MR from the change in total revenue
• Compare this with the MC
Price
$5.00
$4.50
$4.00
$3.50
$3.00
$2.50
$2.00
$1.50
Quantity
1
2
3
4
5
6
7
8
Total Rev
$5.00
$9.00
$12.00
$14.00
$15.00
$15.00
$14.00
$12.00
MR
$5.00
$4.00
$3.00
$2.00
$1.00
0
($1.00)
($2.00)
MC
$2.25
$2.25
$2.25
$2.25
$2.25
$2.25
$2.25
$2.25
Profit
Econ 5313
Bagel Shop
• Verify by calculating the profits at each price
Price
$5.00
$4.50
$4.00
$3.50
$3.00
$2.50
$2.00
$1.50
Quantity
1
2
3
4
5
6
7
8
Total Rev
$5.00
$9.00
$12.00
$14.00
$15.00
$15.00
$14.00
$12.00
MR
$5.00
$4.00
$3.00
$2.00
$1.00
0
($1.00)
($2.00)
MC
$2.25
$2.25
$2.25
$2.25
$2.25
$2.25
$2.25
$2.25
Profit
$2.75
$4.50
$5.25
$5.00
$3.75
$1.50
($1.75)
($6.00)
Econ 5313
Bagel Shop
• Does your profit maximizing price depend on the total
number of consumers?
• Not if the groups are equally sized
• Suppose your market research tells you that the four
lowest value groups are all students. Should you offer a
student discount?
• If so, how much?
Econ 5313
Student Discounts
• Separate the last four students from the rest
• Prices charged to them do not affect the revenues from
non-students
• Like a whole new demand curve
• Maximize profits here yield a different “student” price
• Implement with a $1.00 student discount
Price
$3.00
$2.50
$2.00
$1.50
Quantity
1
2
3
4
Total Rev
$3.00
$5.00
$6.00
$6.00
MR
$3.00
$2.00
$1.00
($0.00)
MC
$2.25
$2.25
$2.25
$2.25
Profit
$1.00
$0.50
($0.75)
($3.00)
Econ 5313
Student Discounts
• You earn $5.25 in profit from the $4.00 price
• You earn an additional $1 from the students at a $3.00
price
• You have increased profits through “price discrimination”
• That is, P1/MC1  P2/MC2
• What did we need for this to work?
1.
2.
Need to be able to identify the groups which are less demand
elastic from the groups which are more demand elastic (high
WTP versus low WTP)
Need to prevent arbitrage
Econ 5313
Price Discrimination
• Identifying demand segments is more common than you
might imagine
• Could be due to differences in demand
• Ex Student or senior citizen discounts
• Ex Household services (e.g., maid, yard, plumber) in Park Cities
versus South Dallas
• Ex Early bird special or matinee pricing
• Ex Air travel with a Saturday stay-over
• Ex Air travel booked a month in advance versus ‘week of’
• Ex McDonalds on Cooper versus Champs d'Elise
• Ex Patented pharmaceutical product in US versus Canada versus
Mexico versus Haiti
Econ 5313
Differences in Demand
• Could be due to differences in rivalry
• Ex Cowboy boots in Texas versus Boston
• Ex Pharmaceutical product in US pre-patent expiration versus in
Brazil with price regulation
• Ex Mobile phone service in US with many carriers or in the
Philippines with few carriers
• Always indicates difference in demand elasticity across
groups
• Direct = observe group membership
• Indirect = infer group membership
Econ 5313
Limiting Arbitrage
• Limiting Arbitrage can be tricky
• What if group 3 could pass for students?
• They get the lower price and your whole scheme falls apart
• What if business travelers can book months in advance?
• What if Florida retirees can travel to Canada for their
medicines?
Econ 5313
Limiting Arbitrage
• Need a cost to arbitrageurs that you do not face to
prevent reselling product
• High transportation costs
• Shipping boots from Texas to Boston
• High transactions costs
• Prosecuted for re-importing possibly counterfeit drugs
• Services versus products
• Hard to resell a haircut or dry cleaning
• No price discrimination scheme will work perfectly
• You usually just need that there is not ‘too much’ arbitrage
Econ 5313
Limiting Arbitrage
• 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.
Econ 5313
Limiting Arbitrage
• Once sales hit 10%, diffusion from luxury to mass market
happens very quickly
Econ 5313
Limiting Arbitrage
• The Philippine market was quickly approaching the crucial
10% penetration point
• At which this Rule of Thumb applies: the firm with 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
• IRK reduced prices in Philippines to $90
• Problem: the Philippine phones used the same standard
(GSM) as higher-priced European phones
Econ 5313
Limiting Arbitrage
• 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
• Have to change the algorithm every few years in a neverending “arms race”
Econ 5313
Capturing Value
• Our typical profit maximizing situation from simple pricing
P
P*
MC
MR
D
Q
Capturing Value
• What do the Blue regions represent?
P
P*
MC
MR
D
Q
Capturing Value
• These are part of the value that the product generates in
excess of your cost going to the consumer
P
Un-captured
Consumer
Value
P*
MC
MR
D
Q
Capturing Value
• Price discrimination is a way to try to capture this
P
Un-captured
Consumer
Value
P*
MC
MR
D
Q
Capturing Value
• With perfect price discrimination, you would charge all N
customers a different price and capture it all
• Not possible but is the limiting case we aim for
P
Un-captured
Consumer
Value
P*
MC
MR
D
Q
Econ 5313
Modified Simple Pricing
• Simple rule for different groups
• Set contribution margins to the inverse of their respective
elasticities
• (P1-MC1)/P1=1/|e1|
• (P2-MC2)/P2=1/|e2|
• So if you know demand for cowboy boots is less elastic in
Boston (luxury good, few competitors), set prices higher
Econ 5313
Price Discrimination Online
• 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 scheme allows Dell to sell identical computers at
different prices based on the consumers’ price sensitivity
Econ 5313
When is it Illegal?
• 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
Econ 5313
Blood Tests
• In Northern Europe (Ger., Holland and Scandinavia)
• Medical blood test 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
Econ 5313
Blood Tests
• 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)
Econ 5313
Distribution
• Your family business produces a secret recipe salsa and
distributes it through both smaller specialty stores and
chain supermarkets. The chains have been demanding
sizable discounts but you do not want to drop your prices
to the specialty stores. How can you legally accommodate
the chains without losing profits from the specialty stores?
• Must alter it somehow to justify differences in prices
• High volume implies full pallets which are cheaper to distribute
Econ 5313
Customer Perceptions
• Consumers do not like knowing they are paying higher
prices than others
• “Only Schmucks pay Retail”
• 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
Econ 5313
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•
•
•
•
From the Blog
Chapter 13
Cable Car in Barcelona
Weekend airline purchases
Women’s Haircuts?
Price Discrimination at the FTC!
Econ 5313
Main Points
• Price Discrimination is charging different markups to
different groups of customers
• Must be able to identify differences in WTP (elasticity)
• Must be able to limit arbitrage
• Engage in “simple pricing” for each group
• Typically additional customers are served than would be
under simple pricing