Chapter 14 Video Lesson
This is Luke Froeb co-author along with Brian McCann of “Managerial Economics: A
Problem-Solving Approach.” This lecture is intended to supplement chapter 14,
“Indirect Price Discrimination.”
Indirect discrimination differs from direct discrimination in that a seller either (i)
cannot distinguish between high and low value buyers, or (ii) low value buyers can
re-sell their purchases to the higher-value consumers. <<ILLUSTRATE THIS
SENTENCE>> Either of these two factors could defeat a direct price discrimination
scheme, so a firm would have to use an indirect scheme instead.
1. Examples of indirect price discrimination <INCLUDE HEADER IN
SLIDES>>
One of the most common methods of indirect price discrimination is the issuance of
coupons. <<ILLUSTRATE WITH COUPONS>> Even though everyone has access to
coupons, high-value customers are far less likely to use them, maybe because their
time is more valuable. Coupons allow stores to offer discounted prices to low-value
consumers and higher prices to the high-value customers don’t clip coupon. As you
might imagine, there are risks involved with this kinds of pricing. If enough highvalue customers start clipping coupons, who would have purchased at the full price,
the scheme will no longer be profitable. This is sometimes called “cannibalization”
because offering the discount coupons “cannibalizes” regular sales. <<ILLUSTRATE
LOW VALUE CONSUMER CLIPPING COUPON, BUT ONLY SOME HIGH VALUE
CONSUMERS CLIPPING COUPONS>>
Another example comes from software companies that offer different versions of
the programs to appeal to different kinds of consumers. Students who use Microsoft
Office are likely to know that Microsoft offers a student version of the program that
is less than half that of the standard version. To discriminate even further, Microsoft
also offers a Professional version that is more than twice the price of the standard
version or four times that of the student version. Each version of the software
package offers users features and functionality that they are most likely to want. By
excluding business functionality from the student package, Microsoft discourages
cannibalization, which in this context means discouraging high-value professional
customers from buying the lower-priced student version.
As demonstrated by the airline pricing example in the last chapter, these kinds of
pricing strategies can be highly profitable but they can also attract competition.
When companies price discriminate against certain groups of customers, new
entrants often find it easy to steal these customers.
1. Discrimination by offering different products to appeal to different
groups
A few years ago, my colleague, Professor Mike Shor, did a study on wine prices at 38
restaurants here in Nashville. He found was that, in many cases, restaurants had
significantly higher markups – about 200-300% above retail – on their least
expensive wines. At the same time, restaurants were selling their more expensive
wines at much lower markups.
By selling low-end wines at high-markups and high-end wines at low-markups,
restaurant owners were implementing a form of what is known as “indirect” price
discrimination. In this case, uniformed, low-value customers were less likely to
recognize the relatively high markup on low-end wines; while the more informed,
high-value customers would not only notice the high markups on the cheap bottles,
but they’ll also recognize the relatively low markups on the more expensive bottles.
By pricing wines this way, high-value customers were encouraged to choose high
end wines, while low value consumers were encouraged to choose low-end wines.
We illustrate this pricing in the Table below.
Wine
High-End
Low-End
Retail Price
(cost)
$50
$15
Restaurant
Price
$75
$30
Markup ($)
Markup (%)
$25
$15
50%
100%
The higher markups on the low-end wine correspond to our intuition about the
relatively inelastic demand of the low-value consumers.
If this were a simple direct price discrimination scheme, the restaurant manager
would price the wines proportionally to the elasticities of the two groups. But
because the high-value consumers can consume the low-end wine, the restaurant
must price the expensive wine cheaply enough so that the high-value customers still
prefer the expensive wine. In other words, the wines must be priced so that the
high value customer gets more consumer surplus (the difference between value and
price), from buying the higher priced bottle.
Even though the restaurant earns more ($25 instead of $15) on the high priced wine
<<CIRCLE THESE FIGURES IN THE TABLE ABOVE>>, the high value consumers still
consume it because it gives them more consumer surplus. To see this, consider the
following table that shows some hypothetical values that the two types of
consumers place on the two types of wine.
Wine
High value
consumer
Low value
consumer
High-End
Low-End
$80
$35
$50
$30
The low-value consumer places a value of only $50 on the high priced wine which is
just equal to its cost. <<ILLUSTRATE THIS SENTENCE BY CIRCLING THE FIGURE>>
What is critical here is that the high-value consumer can buy the lower priced wine
for $30 and gain $5 of consumer surplus <<”SHOW” DIFFERNCE BETWEEN THE $35
Value AND A $30 PRICE IS $5, AND CIRCLE THE $35 VALUE>>. This option limits
the restaurant’s ability to price high on the high-end wine. If the restaurant
manager tries to price the high-end wine at $80, this leaves the high value consumer
with no surplus from consuming the high end wine, which would cause her to
consume the low end wine where she earns $5 worth of surplus ($35 Value-$30
Price). In this case the restaurant finds it more profitable to reduce the price of the
high end wine to just below $75 to give the high value consumer more surplus from
buying the high end wine.
This example illustrates a very important idea in marketing, that of
“cannibalization.” The restaurant must price the high end wine less than the value
consumer’s place on it to avoid “cannibalization,” which in this context means high
value consumers switching to lower priced wine
2. Volume Discounts as Discrimination
Thus far we have been working with aggregate demand curves constructed from a
group of consumers, all of whom wanted one unit of a good, and who placed
different values on the good. In this section, we are going to imagine an individual
consumer who wants to purchase more than one unit of a good. The individual
demand curve shows the value a single customer places on additional units of a
product or service.
Consider a customer buying t-shirts. The customer places a value of $7 on the first
shirt, $6 on the second shirt, $5 on the third, and so on. The individual demand
curve slopes downward, because the value they are willing to pay decreases with
each additional unit.
If you set a single price, there is no difference between profit maximization facing an
aggregate demand curve, or profit maximization facing an individual demand curve.
If we suppose the marginal cost of producing a t-shirt is $1.50, then the optimal
price would be $5. At this price, the buyer would purchase 3 units, and the seller
would make $10.50 profit. <<HIGHLIGHT THE RELEVANT ROW BELOW>>
Price
$7
$6
$5
$4
$3
$2
$1
Quantity
1
2
3
4
5
6
7
Revenue
$7
$12
$15
$16
$15
$12
$7
MR
$7
$5
$3
$1
$-1
$-3
$-5
MC
$1.50
$1.50
$1.50
$1.50
$1.50
$1.50
$1.50
Total
Profit
$5.50
$9.00
$10.50
$10.00
$7.50
$3.00
$-3.50
However, the seller can do better by offering volume discounts. The seller can sell
the first unit at $7, and then offer a $1 discount for each additional unit purchased,
until price reaches marginal cost. The buyer would end up buying 6 units, paying
$27=($7+$6+$5+$4+$3+$2) and the seller would earn $18=$27-($1.50*6)
<<ILLUSTRATE THESE EQUATIONS>>.
There are two other ways to accomplish the same thing. The seller can bundle six
goods together, and sell the bundle for $27=($7+$6+$5+$4+$3+$2), which is exactly
equal to the buyer’s value, <<ILLUSTRATE THIS PRICING>>
Or the buyer can sell the shirts at marginal cost (at this price the buyer would buy
6), plus a fixed fee of $18. <<ILLUSTRATE THIS PRICING>>This is called two part
pricing, and is practiced by the so called “club stores” like Costco and Sam’s Club.
<<PHOTO OF SAMS OR COSTCO SHOWING MEMBERSHIP FEE PLUS PRICE>>
CONCLUSION:
So the bottom line is that when you cannot identify high and low value consumers or
cannot prevent arbitrage, you have to find more indirect ways of price
discriminating. When you do this by offering different products to appeal to
different groups, you have to be mindful of cannibalization.
However, price discrimination against an individual who wants to purchase multiple
units of the same good is much easier. You can do this with volume discounts, by
bundling, or using two part pricing.