Outline Nine - Pricing Strategies - Price Discrimination

Pricing strategy is perhaps one of the toughest business issues to deal with -- and one of the most important.
The challenge for management is to price strategically while still satisfying customers. This requires truly understanding:

1. the customer (subjective value)

This involves two key things:

 First, how much value does your product represent in the customer’s eyes?

The second issue is how to encourage profitable behavior. Vendors can “bond” with customers via pricing. For example, in financial services like insurance and banking customer tenure can correlate with profitability.
Therefore, pricing strategies which promote longevity are desired. Tactics may be as simple as term discounts or frequent user programs, or
they may be less direct like requiring large upfront investments.

2. and the dynamics of the marketplace.

Most companies know the market prices in their industry, but do they truly have a feel for what really drives prices in markets?
It is crucial to know where you stand versus your competition.

Predict actions and reactions.

There are no hard and fast rules for developing a pricing strategy. However one thing is clear: market leaders are leaders because they understand how pricing relates to the economics of their business, their customers and their competitors.

Particular Pricing Strategies

Let's start with Price Discrimination:

What is it?  Charging different prices to two or more consumers or markets when the prices do not reflect variations in the cost of supplying the product.

So you can have price discrimination even though the same price is being charged for the good ............ salad bar example.

But usually, the costs are the same, but the price differs.

Why do it?  Because you can increase your profits (of course).  But it also helps out consumers in the process.

Necessary Conditions for Price Discrimination:

1. Can separate markets in terms of price elasticity of demand in a cost effective way.  Which market gets the higher price?

2. Prevent resale.

We can classify price discrimination in two different ways:  By degree or other?

Types of Price Discrimination:

First Degree Price Discrimination:  Charging the maximum price possible (reservation price) for each unit of output.  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?  First degree price discrimination is not common because 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.

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.

Second Degree Price Discrimination:  (imperfect form of first degree) - Pricing based on the quantities of output purchased by individual consumers. 

In most cases this involves goods and services whose consumption is metered.

Graph:

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.

Example:  Quantity discounts.  "Buy two get the third free."

Another Example:  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:  Electricity

    Block-book pricing is a form of second degree price discrimination:

    First 100 kilowatt hours - $.10 per kwh

    Second 300 kilowatt hours - $.08 kwh

    All additional kilowatt hours - $.06 per kwh

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 - movie theatres are an example (we will do an in class exercise on this).

But let's look at this example:

Tie-In Sales or Bundling  The practice of bundling several different products together and selling them at a single “bundle price.”  The potential profitability of bundling can be seen in the following example. 

            Suppose a firm sells computers and monitors, but that different consumers value the different products differently.

Suppose, for simplicity that MC equals zero.  If demand consisted of only these two consumers, then the best the firm could do with a single product, nondiscriminatory price is $1500 for the computers, and $200 for the monitors - if priced at the higher price would lose the second consumer.

            However, if the firm charged $1,800 for the computer/monitor combination, it could earn 100 more per sale.  The $1,800 is the lowest combined value of the two consumers. 

             Notice that effective first-degree price discrimination would be more profitable.  However, when it is impossible to distinguish consumers before the fact, this is a profit-improving option relative to single-product pricing. 

Other examples:  gas, water, computer usage (not as popular), movie theatres, fast food establishments:

    Soft drink = $1.00

    Refill = $.50

Multipart pricing -- careful, costs could be different too -- but does the cost of the cup justify the entire 50 cent difference?

Reflects diminishing marginal utility.

Third Degree Price Discrimination:  Involves separating consumers or markets in terms of their price elasticity of demand.

Can separate: 

1. geographically

2. nature of use

3. personal characteristics of consumers.

Examples of each:

1. Books outside the U.S. - must have greater elasticity of demand.

2. Telephone customers - residential or business.  Business more inelastic.

3. Movie theatres and air fares.

Why profitable? -- see below.

Is it Practical?  Yes, widely used practice -- This is a very standard practice in entertainment goods (such as food, movies and sporting events):  “Senior citizen’s discounts,” “Student discounts”, etc. appear to be a way for the firm to help out particular groups of people.  In fact, it is also a way to increase profits.  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. (This is often pretty easy. Senior citizens can be required to show a driver’s license, etc.)

            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 = in both markets.

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)