week 5

Chapter13-DirectPriceDiscrimination.pptx

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Direct Price Discrimination

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CHAPTER

If a seller can identify two groups of consumers with different demand elasticities, and it can prevent arbitrage between two groups, it can increase proﬁt by charging a higher price to group with the less-elastic demand.

Price discrimination is the practice of charging different people or groups of people different prices that are not cost-justiﬁed. Typically more people are served under price discrimination than under a uniform price.

Arbitrage can defeat a price discrimination scheme if enough of those who purchase at low prices re-sell to high-value consumers. This can force a seller to go back to a uniform price.

A direct price discrimination scheme is one in which we can identify members of the low-value (more price elastic) group, charge them a lower price, and prevent them from re-selling their lower- priced goods to the higher-value group.

It can be illegal for business to price discriminate when selling goods (not services) to other businesses unless

price discounts are cost-justiﬁed, or

discounts are offered to meet competitors’ prices.

Price discrimination schemes may annoy customers who know they’re paying more than others and can make them less willing to buy because they know someone else is getting a better price. If you can, keep them secret.

continued

Cell Phone Pricing

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.

The Philippine market was quickly approaching the crucial 10% penetration point.

At which this Rule of Thumb applies: the firm w/ 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

Cell Phone Pricing (cont’d)

Philippines in 1997

Introduction: Pricing schemes

This chapter looks at ways of (proﬁtably) designing and implementing price discrimination schemes.

So that sellers can charge different prices to different consumers based on differences in consumer demand.

This allows sellers to increase profit above the profit available from setting a single, uniform price.

Pricing tradeoff & discrimination

Frequently there is a pricing tradeoff based on simple demand curves:

Lower pricegsell more, but earn less on each unit sold

Higher pricegsell less, but earn more on each unit sold

Marginal analysis tells us how to optimize around this tradeoff: MR=MC 1 (P-MC)/P=1/|e|

Price discrimination allows sellers to avoid the tradeoff

Higher prices for some

Lower prices for others

Why (price) discriminate?

Example: a simple demand curve

Seven consumers willing to pay {$7,$6,$5,$4,$3,$2,$1}

Marginal Cost of the good= $1.50

Optimal price is $5

At a price of $5, low-value consumers, {$4, $3, $2, $1}, don’t purchase

Even though their values are above the MC

This leaves unconsummated wealth-creating transactions!

If a separate price is set for this group, i.e. price at $3 and sell 2 extra units, firm profit increases, and more customers are served.

Price discrimination

Motivation: price discrimination allows a firm to sell items to low-value customers who otherwise would not purchase because the price is too high (the firm consummates a wealth-creating transaction!)

Definition: Price discrimination is the practice of charging different prices that are not cost-justified to different people

P1/MC1  P2/MC2

Price discrimination allows two optimal prices to be set for two groups with different levels of price elasticity:

(P1-MC1)/P1=1/|elasticity1| (P2-MC2)/P2=1/|elasticity2|

Price discrimination (cont’d)

The bigger the difference between group elasticities, the more profit there is in designing a price discrimination scheme.

To price discriminate

ID different groups with different price elasticities or different values

Find a way to prevent arbitrage

Direct Price Discrimination occurs when you can:

ID members of the low-value group can be identified

Charge low-value costumers a lower price

Prevent resale (arbitrage) to higher-value consumers.

Price discrimination (cont’d)

Indirect Price Discrimination occurs when you:

Cannot ID members of groups; OR cannot prevent arbitrage

Instead, discriminate by offering two products, a higher-priced, higher-quality good and a lower-priced, lower-quality good.

Direct or indirect pricing schemes?

Tickets to a movie theaters (senior citizen discount, student discount, etc.)

Grocery stores (discount coupons, in-store or in weekly newspaper inserts)

Airlines (business vs. economy tickets)

Describe a price discrimination opportunity facing your company

The Robinson-Patman Act (US)

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

Pricing for laptops

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 pricing scheme allows Dell to sell identical computers at different prices based on the consumers’ price sensitivity.

Back to cell phone pricing

The cell phone manufacturer, IRK, reduced prices in Philippines to $90

PROBLEM: the Philippine phones used the same standard (GSM) as higher-priced European phones

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

IRK’s cell phone pricing (cont.)

In 1998, IRK sold 200,000 phones to Philippines – much better than the 50,000 units they would have sold without price discriminiation

IRK’s market share went from 10% to 25% in one year

1999, IRK returned to global uniform pricing

Competitors followed, and raised prices as well.

In 2000, the Phillipines cell phone penetration reached 12% and IRK market share rose to 34%

Warning: only schmucks pay retail

Consumers do not like knowing they are paying higher prices than others.

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.

Medical Test Strips

In Northern Europe (Ger., Holland and Scandinavia)

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

Medical Test Strips (cont’d)

North/South Europe price discrimination implementation

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).

Conference Pricing

The American Association for Clinical Chemistry (AACC) sponsors 3-day conferences

90% of the attendees from same city or surrounding region

Foreign participants

Greater travel costs

Longer travel times

Applying and interviewing for travel visas

The majority attend conferences in own countries

To increase attendance, the AACC proposed reducing price to foreign participants

QUESTION: HOW DID THEY PREVENT ARBITRAGE?

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Time in years from opening of first digital network

Mobile phone penetration .