ECON 325
Pricing Theory and Strategies
Outline Four: Price Structures
Sources: Confessions of the Pricing Man: How Price Affects Everything by Hermann Simon; Pricing Strategy by Tim J. Smith (more will be added)
What is a Price Structure?
Determines the method by which total transaction prices are determined.
Price structures are a strategic means to price-segment the market. In other words – it allows a firm to try to structure prices such that the total price paid will be proportional to a customer segment’s willingness to pay.
If a firm has two customer segments – it can adjust the structure to capture both markets.
This is not an easy pricing strategy. It is far more difficult to change a price than to change a price structure.
Price structures tend to define an industry. However, new entrants can try new price structures to try to break into a market and even displace the old guys. So it can be a very competitive move.
Example: Southwest airline’s initial pricing of individual legs on trips in comparison to airline industry pricing roundtrips.
The structure of the price allowed customers to pay for each leg separately instead of having to buy a round trip ticket.
How did this segment their market?
So when a firm considers a different way of calculating the transaction price, it is considering a different price structure.
Rethinking the “Unit”
Remember – customers are meeting ends that they value with the products or services they buy. Different customers have different ends – and customers value ends differently.
So because they have different ends – they seek different benefits from a product or service, and therefore they will have different willingness to pay for that product or service.
If a company can discover some information about the different “drivers” that lead to willingness to pay, it can build its pricing structure to capture more customers.
So ask two things (review):
1. What drives the value that customers place on the products or services?
2. How can the firm structure prices in proportion to the value that customers perceive?
Demand Heterogeneity:
Different customers, different values, different situations.
This can come from differences between customers or differences within a single customer’s willingness to pay depending upon the situation, timing, urgency, or a host of other factors.
Pricing structures that closely match demand heterogeneity can increase profits.
Wider market is captured.
So basically a firm should redefine what they see as the “unit” they are selling. As Southwest redefined the unit it was selling from just offering a round trip to also offering one leg of the trip.
a. They created different products for different customer segments.
b. Another way of redefining the unit is to change the unit from that of the sale of a product to that of the ability to use a product.
Examples: Rental agreements and subscription-based services redefine the unit away from the units of product sold to units of agreement sold that enable customers to use a product.
c. A third way of redefining the unit may focus more on actually changing the product sold.
Add-ons: a la carte pricing - example. The customers can choose to add on or not. So a la carte items on a menu.
Versions: different versions of the same product (at different prices). A drill for home use vs. a drill for industrial use.
Bundles: products are bundled together. Must buy the bundle. Although in some cases the same place will offer both a bundle and add-ons. A Mexican restaurant offers bundled meals but also offers a la carte items. The bundled item is usually cheaper.
The seller likes bundles because they can sell consumers things they otherwise would not buy. However, be careful -- the customer might prefer add-ons and therefore a bundle can make them angry! Offering both is really a way to segment the market and price accordingly.
Examples: Hotels, airlines, even manufacturers who offer professional versions and household versions.
d. A fourth way is multi-part pricing. The transaction price is calculated from using two or more metrics rather than just one.
Example: Zipcar sells drivers a contract that grants the right to use its cars and charges a per-hour fee for actually driving their cars.
Let’s look deeper into this.
Multi-Part Pricing
The most common economic example of a price structure beyond unit pricing is called a:
Two-part Tariff:
Basically it can be described such that the “entrance fee” provides the privilege of purchasing the metered component.
Example: A Jazz club charges a $25 entrance fee at the door and $7 per beverage bought in the club.
Can you think of other examples?
How the fee versus the metered component are priced, however, varies depending upon the market.
But the firm will generally try to obtain profits from both parts.
From a customer perspective, two-part tariffs charge different prices to customers in proportion to consumption. For low-consuming customers, the total price calculated from a two-part tariff is small; for a high-consuming customer, the total price is large or at least larger.
Typically (but not always) – firms will price the entrance fee relatively high to contribute a majority of the profits while pricing the metered unit relatively low to contribute only a fraction of the firm’s profits.
Consider this price structure as a strategy to capture and keep customers.
If customers are more sensitive (elastic) to the price of the metered good than the entrance fee, the entrance fee will tend to be priced relatively high while the metered good may be priced relatively low.
Example: Amusement parks.
If customers are more sensitive (elastic) to the price of the entrance fee than the price of the metered good, then the entrance fee will tend to be priced relatively low while the metered fee is priced relatively high.
Example: Jazz club example. $25 to see a live band is pretty low - $7 per drink not so much.
Question: Explain why the average price paid per half hour decreases as a customer spends more time at the jazz club. Assume that a customer buys a drink every half hour. Does this relate to a demand curve for listening to jazz? Your axes should be: Price per Half Hour/Jazz and Quantity of listening to Jazz (minutes).
Graph:
Qualifications:
Two-part tariffs require products that cannot be easily resold or stored for later use. Why?
As competition increases in the market, firms find their ability to charge an entrance fee decreases, and they raise the price of the metered component within their price structure. Sometimes the entrance fee has to be dropped all together and the two-part tariff no longer exists.
Refining the Entrance Fee and Metered Price
What if the market segments are low use customers and high use customers?
Block Tariff:
The price of the metered service is changed with different levels of consumption.
First block of consumption will be priced somewhat higher than subsequent blocks. After the customer consumes that block, the price will decrease again, etc.
Example: metered part of electric power.
Why is it profitable? The firm captures higher prices from low users (electricity for lighting), and it also captures profits from higher users who require electricity for heating as well (as an example).
Block Tariff Graph: Electricity (price per kilowatt hour)
Inclined Tariff:
Pressure from certain groups that discourage consumption instead of encourage it have tried to get regulators to require this pricing structure. For example, water usage or electricity, etc.
Note: this pricing structure is not designed to increase profits. It is designed to discourage consumption and also “ensure that residential customers can afford a basic amount of service.”
Inclined Tariff Graph: Electricity (price per kilowatt hour)
Tying Arrangements
Similar to a two-part tariff.
Tying arrangements use two prices for selling multiple products that function together to deliver value to customers.
Unlike the two-part tariff though, a tying arrangement is designed to create profits primarily through the sale of the second good, not the first good (or entrance fee).
Customers may be able to derive some value from the products independently, but most of the value that a customer derives is from the joint use of the two products.
Classic use: the first product is a durable good and the second product is a consumable good that is used in conjunction with the durable good. When the durable good is bought – a consumable good is included in the purchase but must be purchased after that is “consumed.”
Example: Razor handles and razor blades.
Can you think of other examples?
Different from a two-part tariff –
the first product is priced relatively low (sometimes even below marginal cost) – but the consumable product is priced relatively high and contributes the main portion of the profits earned. Sometimes the profits from the consumable product are used to subsidize the loss from the durable products sales.
Tying arrangements are common in industries where competitors are trying to bring customers in and keep them.
A long-term relationship with the customer is the goal.
Low price for the durable good (capture the customer) – but then the customer pays long term for the consumable good.
The repeat purchase of long term customers is what makes this profitable.
Customers often have a tendency to select products based the price of the first sale (the durable good) and routinely underestimate the future costs of future sales (the consumable good).
Customer defections – or the creation of other markets where customers can purchase the consumable goods through an alternative supplier, destroy the ability of tying arrangements to generate profits.
So how do firms try to stop this from happening?
Switching barriers:
Examples:
1. Patented interface between the durable good and the consumable good. If the durable good and the interaction with the consumable good are patented – then the consumer will have to purchase it as long as the patent is in effect.
2. Contractual arrangements:
Free phone with a long-term service contract.
Classic Examples of Multipart Price Structures in Industry
1. Utilities: two-part tariff.
2. Partial Ownership: two-part tariff.
Time-share vacation homes, etc.
3. Healthcare Insurance: two-part tariff.
Purchase insurance but then pay a fee per doctor’s visit.
This is also designed to decrease moral hazard:
4. Ink: Tying Arrangement.
Price Structuring Continued - Price Discrimination
What is it?
Two different definitions or ways to price discriminate:
1.
2.
Why do it?
Because you can increase your profits (of course). Through segmentation and pricing accordingly the firm can broaden their consumer base and price to the value of the customer segment – thereby capturing more consumer surplus.
Review of Consumer Surplus:
Necessary Conditions for Price Discrimination (general speaking):
1.
2.
We can classify price discrimination in two different ways: By degree or other.
Price Discrimination by Degree:
First Degree Price Discrimination (also called Perfect Price Discrimination):
Reservation Price:
So those consumers that value the product more are charged more.
Graph:
Why profitable? Notice that all of the consumer surplus is taken by the seller.
Is this Practical?
Although in reality a firm might not be doing first degree price discrimination exactly – many firms try to capture each customer’s reservation price as best they can. Sellers can't have perfect knowledge about what each consumer would be willing and able to pay -- and even if they could, the cost would be prohibitive in getting the information.
However, as stated, it doesn’t stop firms from trying.
Example: An auction. Each buyer submits a sealed bid. There's a minimum bid set -- and all customers above that bid pay what they bid.
Other Examples?
What about what the reading said? Is the data gathered from on-line shopping enough to enable online sellers to really do first degree price discrimination?
Third Degree Price Discrimination:
The firm only knows demand characteristics for different groups of consumers - groups differ in their price responsiveness.
Cannot distinguish between consumers in each group: So need to try to determine who is in each group before the sale.
Examples: Student vs. Adult tickets (show identification)
Journal subscriptions: personal vs. institution
Main ideas:
Charge different price to different group, according to inverse-elasticity rule.
Group with more elastic demand gets lower price.
This can increase consumer welfare: group with more elastic demand gets lower price.
EC
There are many ways to separate the groups:
1. Geographically
2. Nature of use
3. Personal characteristics of consumers.
Examples of each:
1. Books outside the U.S. – outside consumers are more elastic.
2. Telephone customers - residential or business. Business more inelastic.
3. Movie theatres, etc. Students more elastic.
Is it Practical? Yes, widely used practice -- This is a very standard practice in entertainment goods (such as food, movies and sporting events).
By separating low-value buyers from the high-value buyers, and charging different prices, the firm makes sales it would otherwise forego.
Remember - Successful third degree price discrimination requires two things
1. High and low value groups must be separable cost effectively
2. There must be a way to prevent one group from reselling to the other. (If this is not prohibited, then arbitrage will eliminate sales in the high-value market).
Graphs:
Assume MC is equal in both markets.
Review: A firm will attempt to choose an output level where MR = MC. Why?
Second Degree Price Discrimination:
Each customer pays her own price, depending on characteristics of purchase (how much bought, bundling, as examples).
(imperfect form of first degree) –
The difference with 3rd-degree price discrimination: the firm cannot classify consumers into groups, ie.,it knows there are two (or more) groups of consumers, but doesn't know who belongs in what group and has no way of knowing this until the sale is made.
So - set up a pricing scheme so that each type of consumer buys the amount they want: rely on consumer self-selection.
Groups, or types, of consumers are distinguished by their willingness-to-pay for the firm’s product.
Characteristic of purchase is a signal of a consumer's type.
Graph (for the case of amount purchased – (similar to the two-part tariff but there is no entry fee):
For each buyer, the first Q1 units purchased at P1, the next Q1 - Q2 units are priced at P2, and all additional units purchased are priced at P3.
Why profitable? Notice that more consumer surplus is going to the seller again.
Is it Practical? A lot more so than first degree
Different characteristics could include:
a. Amount purchased (nonlinear pricing).
Examples: sizes of grocery products or how much bought.
b. Bundle of products purchased (bundling, tie-ins).
Familiar example: fast-food combos vs. just the burger
c. Characteristics of the service or item purchased – in some sense the “versions” idea.
Example One: Let’s look at airline pricing first. Assume the firm cannot distinguish between business travelers and tourists or more casual fliers, but knows that the former are willing to pay much more for 1st-class seats.
Formally: the firm wants to price according to type - business or tourist (3rd degree) but cannot; therefore it does next best thing: set prices for 1st-class and coach seats so that consumers self-select.
Airline chooses prices of first-class vs. coach fares such that business travelers choose first-class seats and tourists choose coach seats.
EC
Example Two: Suppose Best Buy sells a first CD for $15, and then additional CD’s for $10.
Suppose that the MC of selling the CD’s was $5 each. Suppose that your demand is such that consumers would pay up to $15 for a first CD and $10 for a second CD.
If they charged $10 each they would earn $10 ($10 x 2 = $20 - $10 cost = $10), and if they charged $15 each they would earn $10 ($15 - $5 cost = $10). By using second degree price discrimination they earn $15 ($15 + $10 = $25 - $10 cost = $15).
Example Three: Electricity
Block Tariff or Block-book pricing is a form of second degree price discrimination:
Here is an example from economist George Stigler: Block booking
Movie theatre orders two movies: Gone with the Wind (GWW) and Getting Gertie's Garter (GGG).
There are movie theaters with high and low willingness to pay (WTP) for each movie.
Theater WTP for GWW and WTP for GGG:
A: $8,000 and $2,500
B: $7,000 and $3,000
Specific assumption about preferences:
Theater A has high demand for GWW, and low demand for GGG.
Theater B has low demand for GWW and high demand for GGG!
A firm would like to charge each theater a different price for GWW (same with GGG), but they are afraid that is against the law.
Without bundling, charges $7,000 = min ($8000; $7000) for GWW and $2500 = min ($2500; $3000) for GGG.
Total revenues: 2 x ($7000 + $2500) = $19,500.
With bundling, the firm charges $10,000 = min ($8000 + $2500; $7000 + $3000) for the bundle:
Total revenues: 2 x $10000 (higher)
What about price discrimination? How is it happening?
Akin to charging theater B $7000 and $3000 for GWW and GGG, and theater A $8000 and $2000.
This will not work if preferences are NOT as assumed.
With or without bundling, preferences of theater B (low type) dictate market prices.
More generally, (this view of) bundling illustrates other methods of indirect price discrimination.
Must make sure that block book pricing is price discrimination -- it could be due to different costs (start up costs, etc.)
Block-book pricing sometimes is associated with tie-in sales (basically a form of bundling).
Ways to Prevent Resale
Of course for some goods, it is difficult, if not impossible, to resell (services, utilities). But other goods can be resold. So:
1. legal restrictions (computer software contracts, etc.)
2. change the product (student versions for example)
3. mark the product (“Not for resale”)
4. and there are outside barriers imposed by tariffs, taxes, transport costs (international price differences, for example)
Other Classifications of Price Discrimination:
1. Personal discrimination.
Examples include:
a. Size up the customer's income - customers are charged what the market will bear, depending on how wealthy the customer is - medical and legal services (at least used to be that way).
b. Haggle every time - each exchange is a separately negotiated transaction. Examples - bazaars in the Middle East and markets in Latin America or at flea markets in the United States. And many private deals -- purchases of used items through the classifieds.
c. Measure the use - those buyers who use the good or service more intensively are charged more -- Xerox machine rentals based on number of copies made, IBM's rental of machines and sale of computer cards.
2. Group discrimination
Examples include:
a. Dump the surplus (dumping) - sales priced lower in foreign markets than in domestic markets in order not to depress the domestic price (drugs, TV's, steel)
b. Absorb the freight - freight is either absorbed or overcharged to customers who are located at varying distances from the production site.
c. Promote new customers - new customers are offered lower prices than old customers. Promote brand loyalty. (magazine subscriptions, rent)
d. Divide them by elasticity - when a group is classified by occupation, age, or sex. (children's vs. adult's haircuts or meals, student vs. non-student rates, senior citizen discounts, etc.)
e. Protect the intermediary - large retail buyers are charged the same price as small retail buyers who buy from wholesalers even though large retail firms do their own warehousing and distribution. This protects wholesalers from competition with retailers that might otherwise turn to vertical integration.
f. Favor the big ones - large buyers are given price reductions that exceed cost savings normally associated with quantity sales.
3. Product Discrimination
Examples include:
a. Pay for the label - manufacturers distribute homogenous produces under various brands. Better known brands have higher prices. (clothing, food, paint).
b. Appeal to the classes - price differences are greater than differences in marginal cost when quality is upgraded. (hardback vs. paperback books, first class vs. coach air fares)