Strategic Pricing:
Theory, Practice and Policy
Professor John W. Mayo
mayoj@georgetown.edu
Nonlinear Pricing
So far, Uniform /nonuniform pricing
Cantaloupes
Price Quantity Expenditures
.90
1
$.90
.90
2
$1.80
.90
3
$2.70
.90
4
3.60
Exp.
Q
Q
Linear and Nonlinear Pricing
• Linear Pricing – expenditures increase
proportionately with consumption
• E.g., Beer: P = $5 per beer
• Nonlinear Pricing – expenditures rise
disproportionately with consumption
• E.g. Redskins tickets:
• Exp = Personal Seat License + X per game
Two-part Tariffs
• Two-part Tariff involves a fixed fee plus a per unit
price
• Examples:
• Restaurants (á la carte v buffet)
• Nightclubs: cover plus drinks
• Country clubs: monthly charge plus greens fees
• Important Features of nonlinear pricing
• Requires ability to prevent resale
• Creates vehicle for extracting consumer surplus that is
otherwise unattainable
Single-type consumers
P/Q
Optimal linear price: pm
Optimal two-part tariff:
B
= (A+B+C) + m*q
pm
A
C
MC = m
qm
Q
Multiple-type consumers
P/Q
pm
MC = m
qm
Q
Multiple (optional) two-part tariffs
P/Q
If knew customer types and can prevent
resale, then charge two tariffs,
pm
But suppose that all you know
is that there are different customers,
Not their identity?
MC = m
qm
Q
Multiple (optional) two-part tariffs
Exp.
F2
F1
Consumers will tend
To minimize expenditures
(absent insurance considerations)
Receipts will tend to be
Defined by the lower
Envelope of the curves
Q
Optional Two-part Tariffs in Practice:
Telephone Pricing in the United States
• Unlimited (Flat-rate) service $17.01/month
• Limited Per Call Service
• $10.16 + .10* Calls (for calls > 65/month)
• Economy Call Service
• $5.92 +.10*Calls
Source: Verizon, Montgomery County White pages
Telephone Expenditures with Nonlinear Pricing
What is the “logical” consumer response?
What is the actual consumer distribution among the calling plans ?
$
$17.01
$10.16
$5.92
42
110
134
Calls
Nonlinear pricing in practice
• Is the pricing of electricity in Basel (Washington)
(elsewhere) linear or nonlinear? What are the
economic and societal implications of such
pricing?
• Why would such a firm ever set a price to encourage
conservation?
• What is the structure of mobile telephone pricing?
What competitive and economic dynamics have
led to this pricing structure?
Discussion:
Paying by the Gig
• What is the current pricing model for Internet
usage?
• What is being trialed by Time Warner Cable?
• What are the business drivers of the pricing
scheme?
Minimum quantity pricing
• Consider a good or service with a highly
fluctuating intertemporal demand
• The demand for hotel rooms in Washington during the
Inauguration activities versus a normal demand
• The demand for hotel rooms in Basel during Fachnacht
• Option one: Charge the linear price consistent with the
extent of market power or impose minimum stay
Minimum Quantity Pricing
$/Day
Monopoly
Pricing
A
Pm
C
B
B+E
A
A + B +C - D
Net
B+C>D?
E F D
mc
2
Consumer
Surplus
Minimum Stay E+F+D
Pstay
1
Profit
Days
F+D>B?
Price Discrimination
• Price discrimination – practice of charging
consumers prices that differ by more than
differences in the cost to produce the good
• (Pi/mci) ≠ (Pj/mcj ) [George Stigler]
• (cost-based differences are not considered price
discrimination)
Profit Maximization with Market Power
$
MC(Q)
Is Q*, P* profit max?
P*
Why not sell these units?
MR(Q)
Q*
D=Q(P)=P(Q)
Q
Market Power and Price Discrimination
$
“Consumer Surplus”
P
MC(Q)
Unrealized Sales
What would be ideal
for the firm?
MR(Q)
D=Q(P)=P(Q)
Q
Market Power and Price Discrimination
$
“Consumer Surplus”
P
MC(Q)
Unrealized Sales
Is this a violation of
our MR=MC rule?
MR(Q)
D=Q(P)=P(Q)
Q
Effects of price discrimination
• Producer increases revenue and profits
• Low willingness-to-pay consumers typically gain
as they would be under-served otherwise
• High willingness-to-pay consumers typically
worse off
Forms of Price Discrimination
• First Degree – practice of charging each
consumer her individual reservation price
• Second Degree – Practice of charging
consumers a volume-sensitive price that is
noncommensurate with cost charges
• Third Degree – practice of sorting consumers
into different groups based on observable
characteristics and charging different prices
Price Discrimination
$/Q
First Degree Price Discrimination
Allows firms to extract all consumer surplus
pm
mc
mr
D
Q
First-Degree (Perfect) Price Discrimination
• Hard to achieve in reality, but some strategies come close
• Examples ?
•
Amazon.com “dynamic pricing” (more later)
•
•
•
•
Used car dealers, mechanics, contractors, any
negotiated price
Haggling in the bazaar
Capital One
1990s - Pricing long-distance telephone calls
First-degree price discrimination
• Advantages:
•
Extracts the most consumer surplus
• Disadvantages:
• Difficult (costly) to do - Determining willingness
to pay is exceedingly hard
• Risk consumer backlash (Amazon.com)
Second-Degree Price Discrimination
• Practice of charging consumers a volumesensitive price that is noncommensurate with cost
charges
M&Ms 1.74 oz. P = .89 or $8.18/lb
M&Ms 14 oz P=$2.50 or $2.85/lb
Second Degree Price Discrimination
Example: Electricity Pricing
Electricity pricing
First 1000kwh P= .10
Next 10000 kwh P = .08
Kwh > 11,000, p= .07
$/kwh
.10
.08
.07
1,000
11,000
kwh
Second-degree price discrimination
• Advantages:
• Can target consumers with particular volume preferences
• Can encourage or discourage consumption by pricing for
marginal customers
•
• Disadvantages:
•
Lower total revenue than 1st degree
•
Risk confusing consumers
Third Degree Price Discrimination
• Occurs when firm charges different consumers
different prices for the same good
• Consider a firm selling to two distinct customer
groups, so…
Third Degree Price Discrimination
π = P1Q1 + P2Q2 – C (Q)
mr1 = p1(1 + 1/ε1) and mr2 = p2(1 + 1/ε2)
And profit maximization requires:
mr1 = mc and mr2 = mc, so
p1(1 + 1/ ε1) = p2(1 + 1/ ε2) = mc , or
p1/p2 = (1 + 1/ ε2) / (1 + 1/ ε1)
So, say ε1=-6 and ε2 = -4
Third-Degree Price Discrimination
• Practice of sorting consumers into groups based
on observable characteristics associated with
willingness to pay and charging different prices
(a.k.a. group pricing)
• Examples of 3rd degree p.d.:
•
Senior/student discounts
•
Drycleaners and haircuts
•
AAA and AARP discounts
•
Spatial groupings
• (Canadians at DisneyWorld)
Implications
• If it is possible to identify separate elasticities, it is
desirable to set different prices.
• How might firms identify elasticities?
• Travelling tomorrow?
• Number of substitutes
• Self-identify (coupons)
Third-degree price discrimination
• Advantages:
•
Generally produces higher total revenue than
a one price constraint
•
Sorting mechanism is observable/verifiable
• Disadvantages:
•
Lower total revenue than 1st degree
•
Risk consumer backlash
The Policy of Price Discrimiation
• Price Discrimination [Clayton Act, Sec. 2]
• It shall be unlawful for any person engaged in commerce, … to
discriminate in price between different purchasers of
commodities of like grade and quality, …where the effect of such
discrimination may be substantially to lessen competition or tend
to create a monopoly in any line of commerce, or to injure,
destroy, or prevent competition with any person who either grants
or knowingly receives the benefit of such discrimination, or with
customers of either of them:
• Provided that nothing herein contained shall prevent differentials
which make only due allowance for differences in the cost of
manufacture, sale, or delivery resulting from the differing
methods or quantities in which such commodities are to such
purchasers sold or delivered:
• Section 2(b) permits “good faith” meeting of competition
Peak Load Pricing
• Suppose that demand is predictably volatile
• Variation may be daily, seasonal
• Pricing response?
Intertemporal Price Discrimination:
Peak Load Pricing
P
mc
p2
D2
p1
mr2
D1
mr1
q1
q2
Pizza for $2.99???
Examples of Peak-load pricing
• Pricing power by the hour
• Average rate = $.11/kwh
• Peak rate = $.81/kwh
• Off Peak =$.09/kwh
• Reservations?
• How is this different than ‘paying by the gig’ for Internet
downloads?
Necessary conditions for Price discrimination
• 1. Monopoly power
• 2. Ability to identify different customers
• 3. Ability to prevent arbitrage
European Commission Finds against Topps
• Facts?
• Should government concern itself with something
as trivial as trading cards?
• Is Topps pricing policy consistent with the
establishment of the EU?
The Economics of Price Discrimination
Finland
Portugal
€/Q
€/Q
€/Q
Combined Market
PF
D
P
PP
mc
mr
QF
mr
d
Q
d
Q
QP
With linear demand and costs, price discrimination fails to benefit consumers
MR
Q
Q
Dynamic Pricing
• “Dynamic pricing”
• is sometimes meant to connote price changes over
time for the same commodity or service
• E.g., Caps’ pricing within a season
• Coca-cola vending machines that adjust price depnding on
temperature
• Is sometimes meant to connote third degree price
discrimination
• E.g., Amazon.com (setting different prices to different
consumners for the same commodity (e.g. book or CD)
• Orbitz has discovered that Mac users pay on average 30 %
more for hotel rooms per night than PC users – modify
showing
41
Orbitz Pricing : PC Search (July 6, 2012)
1:PC: $103
3:PC:$129
2:PC: $134
4:PC:$159
42
But if Mac-based search???
Hyatt Regency Crystal City
October 19- Oct 21
$103 per night
Hyatt Regency Crystal City
October 26- Oct 28
$169 per night
43
Takeaways
• When firms have market power, simple pricing
can leave a lot of value “on the table”
• Price discrimination strategies can help firms
increase profits
• Extract consumer surplus from existing high
willingness-to-pay customers
• Make additional profitable sales to low willingness-topay consumers
• Be aware of legal restrictions