So far, Uniform /nonuniform. pricing. Cantaloupes. Price Quantity Expenditures. Exp $ $ $

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Derek Norman
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1 Nonlinear Pricing

2 So far, Uniform /nonuniform Cantaloupes pricing Price Quantity Expenditures Exp $ $ $ Q

3 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

4 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 Requires ability to prevent resale Creates vehicle for extracting consumer surplus that is otherwise unattainable

5 Single-type consumers P/Q Optimal linear price: p m p m B Optimal two-part tariff: = (A+B+C) + m*q A C MC = m q m q Q

6 But what if there are multiple-consumer types? $/Q p m MC = m MR low q m MR high D low D high Q

7 Multiple (optional) two-part tariffs P/Q If knew customer types and can prevent resale, then charge two tariffs, p m But suppose that all you know is that there are different customers, Not their identity? MC = m q m Q

8 Multiple (optional) two-part tariffs Exp. Consumers will tend To minimize expenditures (absent insurance considerations) F 2 F 1 Q

9 Optional Two-part Tariffs in Practice: Telephone Pricing in the United States Unlimited (Flat-rate) service $17.01/month Limited Per Call Service $ * Calls (for calls>65/month) Economy Call Service $ *Calls Source: Verizon, Montgomery County White pages, 2008

10 Telephone Expenditures with Nonlinear Pricing $17.01 What is the logical consumer response? What is the actual consumer distribution among the calling plans? $ $10.16 $ Calls

11 Discussion: Nonlinear pricing in practice Is the pricing of electricity in Basel linear or nonlinear? What are the economic and societal implications of such pricing? What is the structure of mobile telephone pricing? What competitive and economic dynamics have led to this pricing structure?

12 Caselet discussion: Paying by the Gig What is the current pricing model for Internet usage? In the United States? In Europe? India? What are the business drivers of the pricing scheme?

13 Minimum quantity pricing Consider a good or service with a highly fluctuating intertemporal demand (the demand for hotel rooms in Washington (Basel) during the Inauguration activities (Faschnacht) versus a normal demand Option one: Charge the linear price consistent with the extent of market power or impose minimum stay

14 Minimum Quantity Pricing $/Day Pm P* A B E C F D 1 2 mc Days Day 1: with monopoly pricing, consumers get A, firm gets profit Day 2 firm gets no profit and consumer Gets no surplus Alternatively, with two-day minimum And P*: day 1 - consumers get A+B+C Firm sacrifices B. Day 2 consumer gets Negative consumer surplus D. Decision to purchase depends on whether net CS is positive. Firm profits are E+F+D

15 Price Discrimination Price discrimination practice of charging consumers prices that differ by more than differences in the cost to produce the good (P i /mc i ) (P j /mc j ) [George Stigler] (cost-based differences are not considered price discrimination)

16 Profit Maximization with Market Power $ MC(Q) P* Is Q*, P* profit max? Why not sell these units? MR(Q) D=Q(P)=P(Q) Q* Q

17 Market Power and Price Discrimination $ Consumer Surplus MC(Q) P Unrealized Sales What would be ideal for the firm? MR(Q) D=Q(P)=P(Q) Q

18 Market Power and Price Discrimination $ Consumer Surplus MC(Q) P Unrealized Sales Is this a violation of our MR=MC rule? MR(Q) D=Q(P)=P(Q) Q

19 Effects of price discrimination Producer increases revenue and profits For consumers: who wins? Who loses? Low willingness-to to-pay consumers typically gain as they would be under-served otherwise High willingness-to to-pay consumers typically worse off

20 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

21 Price Discrimination $/Q First Degree Price Discrimination Allows firms to extract all consumer surplus p m mc mr D qm Q

22 First-Degree (Perfect) Price Discrimination Hard to achieve in reality, but some strategies come close Examples? Amazon.com dynamic pricing Used car dealers, mechanics, contractors, any negotiated price Haggling in the bazaar Credit card companies (e.g., Capital One) 1990s - Pricing long distance telephone

23 First-degree price discrimination Advantages: Extracts the most consumer surplus Disadvantages: Difficult (costly) to do - Valuation and pricing of M&Ms Risk consumer backlash (Amazon.com)

24 Profits & Price Discrimination (M&Ms) $/M&M 2.50 Uniform price: Π = ($ $1.00)*Q First Degree Price Discrimination: Π = Σ(V i MC)*Q 1.00 MC = ATC 365 bags M&Ms/yr

25 Second-Degree Price Discrimination Practice of charging consumers a volume- sensitive 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

26 Second Degree Price Discrimination Example: Electricity Pricing Electricity pricing $/kwh First 1000kwh P=.10 Next kwh P =.08 Kwh > 11,000, p= ,000 11,000 kwh

27 Second-degree degree price discrimination Advantages: Can target consumers with particular volume preferences Can encourage or discourage consumption by pricing for marginal customers Can discourage switching of suppliers (loyalty programs) Disadvantages: Disadvantages: Lower total revenue than 1 st degree Risk confusing consumers

28 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

29 Third Degree Price Discrimination π = P 1 Q 1 + P 2 Q 2 C(Q) mr 1 = p 1 (1 + 1/ε 1 ) and mr 2 = p 2 (1 + 1/ε 2 ) And profit maximization requires: mr 1 = mc and mr 2 = mc, so p 1 (1 + 1/ ε 1 ) = p 2 (1 + 1/ ε 2 ) = mc, or p 1 /p 2 = (1 + 1/ ε 2 ) / (1 + 1/ ε 1 ) So, say ε 1 =-6 and ε 2 = -4

30 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 3 rd degree p.d.: Senior/student discounts Drycleaners and haircuts AAA and AARP discounts Spatial groupings (Canadians)

31 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)

32 Third-degree degree price discrimination Advantages: Generally produces higher total revenue than a one price constraint Sorting mechanism is observable/verifiable Disadvantages: Lower total revenue than 1 st degree Risk consumer backlash

33 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 s of like grade and quality, where the effect of such discrimination may be substantially to lessen competition or tend to create a monopoly oly in any line of commerce, or to injure, destroy, or prevent competition ion 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

34 Supplier Discriminations and Retail Competition P= aaargh! P = $1.75/can Conway Drugs Walmart P= $2.00/can P = $1.00/can Penn tennis balls

35 Peak Load Pricing Suppose that demand is predictably volatile Variation may be daily, seasonal Pricing response?

36 Intertemporal Price Discrimination: Peak Load Pricing P mc p2 D2 p1 D1 mr2 q1 mr1 q2

37 Pizza for $2.99???

38 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?

39 Necessary conditions for Price discrimination 1. Monopoly power (but( but, Borenstein (1985) 2. Ability to identify different customers 3. Ability to prevent arbitrage

40 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?

41 The Economics of Price Discrimination /Q Finland /Q Portugal /Q Combined Market P F P D Q F mr QQ P P d Q P mr Q d Q MR mc Q With linear demand and costs, price discrimination fails to benefit consumers

42 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 to-pay customers Make additional profitable sales to low willingness-to to-pay consumers Be aware of legal restrictions

43 Discussion question: Price Discrimination What factors affect the effectiveness of price discrimination? Market power» How do we see market power in our framework? Ability to sort consumers on relevant dimensions or mechanism to allow consumers to sort themselves» Information on consumers attributes and purchase behavior Ability of consumers to arbitrage price differences» Restrict resale and limit purchase volume Legal restrictions (Robinson Patman Act)

44 Two Sided markets

Chapter 11 Pricing Strategies for Firms with Market Power

Managerial Economics & Business Strategy Chapter 11 Pricing Strategies for Firms with Market Power McGraw-Hill/Irwin Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved. Overview I. Basic