Price Discrimination MBAngalore With Examples

Managerial Tools from the
Economist Toolkit: some advanced

microeconomics
Miguel URDANOZ
10/10/2015
www.tbs-education.fr
Pricing Strategies - BRICK7

2
Uniform pricing
Price Discrimination:
First Degree
Second Degree
Third Degree
Bundling
Dynamic Price Discrimination
Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)
2015
Uniform pricing with market power

3
What is going to determine your price?

Facing a downward sloping demand curve, a firm
has a trade-off between
high-margin/small volume
low-margin/large volume
The price-sensitivity of consumers demand

determines which of the two strategies is the
optimal one
2015
Price-sensitivity of consumers (2)

4
Price p
p0
p1
D1
q0
q1
Quantity q
2015
Price-sensitivity of consumers
5
Elasticity
Demand price elasticity is the ratio of a relative quantity
variation to a relative price variation, in absolute value (i.e. an
elasticity is always positive even if demand decreases with price)
= |(Q/Q) / (P/P)|
If the price relative variation is 1% (P/P = 1), the relative
quantity variation is Q/Q %
If 0 < < 1, demand is inelastic: a price increase of 1% reduces
the volume by less than 1%
If 1 < , demand is elastic and an increase in price by 1%
reduces the volume sold by more than 1%
2015

6
Elasticity
Demand price elasticity is the ratio of a relative quantity
variation to a relative price variation, in absolute value (i.e. an
elasticity is always positive even if demand decreases with price)
= |(Q/Q) / (P/P)|
If the price relative variation is 1% (P/P = 1), the relative
quantity variation is Q/Q %
If 0 < < 1, demand is inelastic: a price increase of 1% reduces
the volume by less than 1%
If 1 < , demand is elastic and an increase in price by 1%
reduces the volume sold by more than 1%
2015

7
Price p
p0
p 1
p1
q 1
q0
D1
q1
Quantity q
2015

8
With an inelastic demand, the strategy should be a

high price (margin)
With an elastic demand, the strategy should be
volume (and a low margin)
Elasticity is not constant: changes in time and over
demand
Other elasticities can be computed:
Cross-price: substitutes (+) or complements (-)
Income: normal and inferior goods
2015
Example: Railroads
9
Author
Year of
Publication
Behrens and
Pels
2009
Wardman
Market
LondonParis
Price Elasticity
Short run
Long run
-0.41 -0.56
2006
UK
Ivaldi and
Vibes
2005
CologneBerlin
-0.99
-1.21 -1.29
Asteriou et al.
2005
UK
-0.18 -0.2
Van Vuuren et
Rietveld
2002
Netherland
Wardman et al.
1996
UK
-0.7 -1.01
-1.37
-0.59
Goodwin et al.
1992
UK
-0.65 -0.79
De Rus
1990
Spain
-0.18 -0.41
Ben-Akiva &
Morikawa
1990
Netherland
-0.15 -1.50
Owen and
Phillips
1987
UK
-0.69
-1.08
-1.08
2015
How to measure elasticity of demand

10
Surveys and/or interviews

Statistical analysis: Study previous changes in prices
and their effect on demand
Pricing experiments:
can only be conducted in certain markets
characterized by relatively low demand with excess
capacity
2015
Optimal uniform price of a firm with

market power
11
Average and marginal revenues

When increasing the price it charges, a firm with
market power must integrate the reduction in volume
and vice-versa
The marginal revenue of a price increase decomposes
as a gain in price when increasing slightly the quantity,
and a loss in volume
2015

market power
12
When lowering the price from P0 to P1, a monopoly

looses (P0 - P1) x Q, and gains P1 x (Q1- Q0)
Price P
The revenue variation is equal to

R = P1 x Q - P x Q0
P0
Relatively to the increase in quantity, the variation is
Decrease in
revenue
R / Q = P1 (P / Q ) x Q0 < P1
What is the variation of the cost of production,
relatively to a production increase? Price to fix?
Demand
P
P1
Increase in
revenue
Q0
Q1
Quantity Q
Q
2015

market power
13
Price ()
Marginal Revenue: Twice as steep rule applies

only for linear demand functions
Demand
100
Marginal revenue
When Marginal Revenue = 0, total revenue is at

its maximum level
>1
What about costs and profits?
=1
50
<1
0
0
5000
10000
Quantity
(units)
2015
MR vs MC
14
Marginal Revenue (MR):

Change in Total revenue given a one-unit (or marginal)
change in quantity
Marginal Cost (MC):

Change in Total cost given a one-unit (or marginal)
change in quantity
Is Marginal cost the same as average cost?
2015

market power
15
As long as the additional revenue from selling an

extra unit exceed the extra cost of production of
this unit, the monopoly may earn a positive
additional profit on this unit
Price ()
100
The production (and market price) of a monopoly

must be such that the marginal revenue of its
production is equal to its marginal cost
Demand
Marginal revenue
55
Monopoly Marginal cost
10
0
4500
10000
Quantity
(units)
P M MC M 1
=
PM
P M = MC M
Monopoly Equilibrium
1
2015
Competitive pricing
16
If at Q0 price is over marginal cost, firms increase

their production or new firms enter the market
Price ()
100
Competitive Demand
Consider a very small change in production, say

Q = 1 unit. To exhaust all gains from trade, /
Q = C / Q for Q = 1
P0
P1
Competitive Supply
Competitive Equilibrium
10
0
Q0
Q1
9000 10,000
Quantity
(units)
2015
Welfare
17
Inverse demand measures willingness to pay

Consumer surplus: difference between willingness to
pay and actual price paid
Welfare: profit of the firm + consumer surplus
Monopoly: Dead-weight loss
Monopoly: Cost distortions
Rent seeking behaviour
2015
Market power
18
Degree of market power of a firm can be

measured by its ability to increase price without
loosing a too large part of its customers
Perfect Competition
Monopoly
Measures of market power
Concentration Index C = s
Herfindahl Hirshman Index: HHI HHI = s
k
i =1
2
i
i =1
SSNIP test: Small but Significant and Non-transitory

Increase in Price
2015
19
Pricing strategies, Price and Non-price

Discrimination
How to price when the firm enjoys a large
degree of market power?
2015
Introduction
20
Price Discrimination: Two units of the same physical

good are sold at different prices, either to the same
consumer or to different consumers.
Stigler (2004): Discrimination exists when similar
products are sold at prices that are in different
ratios to their marginal costs.
Why?
Consumers are different: willingness to pay varies
(price sensitivity)
Some consumers receive a surplus with uniform pricing
2015
10
Requirements:
21
Is it legal?
Market Power
Firm needs information on demand: required
information varies with type of price discrimination
Instruments: different types of price discrimination
Limits: No resale/arbitrage possibilities
Goods: taxes, transportation costs, law
Services: train/air tickets
2015
Introduction
22
If individuals are (almost) identified, tailored offers

(1st degree)
Else group tariffs are possible (2nd degree)
If individuals are not identified but types are known,
another (3rd degree)
Bundling is another tool to discriminate consumers
(non price)
Example: Yield Management and the Airline industry
2015
11
Price Discrimination and Yield

Management
23
Tourists vs. business travelers

Offer discounts to early purchasers of tickets
The danger of segmented pricing
Lower fare passengers may largely take the available
inventory
So, yield management system is used to adjust seat

inventory (seat allocation among different price
levels based on expected demand)
2015
First degree (or perfect) price

discrimination
24
DEFINITION: Perfect price discrimination refers to a situation in which a seller

observes perfectly the characteristics of its customers and is able to taylor the tariff
specifically for each of them
DIRECT CONSEQUENCE: if buyers do not have any market power, it is possible to
extract the entire profit created by the purchase of the product from each of them
REAL LIFE EXAMPLES: Past/Present: Doctors in rural areas.
Future:Advertising in Google is context sensitive, databases on
our purchases may allow us to get personal mail/email offers or
pay different prices.
HBR, October 2012 Getting Control of Big Data
2015
12
Two possible cases

25
Unitary demand per customer

Example: different hostel rates
Multiple unit demand per customer:

Take it or leave it package
Two part tariff (non linear pricing)
2015
A simple example to fix ideas

26
Producer P faces two customers, C1 and C2 and knows their

demand
Customers behave competitively, and cannot resell the
product to each other
Each customer has a demand that varies with price
V1(Q1) = 100 Q1 and V2(Q2) = 50 Q2
Unit cost of production of P is 10

IDEAL PRICES OF PRODUCER P ?
2015
13
First Degree Price Discrimination

27
Price ()
Price ()
PARTICIPATION CONSTRAINTS:
Fee paid by C1 lower than A1,
100
Max.
Fee A2
Max.
Fee A1
50
Fee paid by C2 lower than A2

Unit production cost of U
10
0
40
0
10
50
Quantity
(units)
0
0
90
100
Quantity
(units)
2015
Third degree (or group) price

discrimination
28
Some characteristics are identifiable, and possibly

verifiable (i.e. it is possible to verify whether an
individual claiming to have the characteristic is
lying or not)
Different groups pay different prices:
More price sensitive consumers pay a lower price
Less price sensitive consumers pay a higher price
Examples of characteristics
age,
employment status (including student),
club membership,
2015
14
Third degree price discrimination

29
Maximize profit for each group

Examples:
Cinema
Zara
2015
Ipad prices and taxes

30
2015
15
Iphone 5
31
2015
2015
32
16
33
2015
2015
34
17
35
2015
2015
36
18
Example: Coca Cola

37
Coca-Cola announces that it is developing a "smart"

vending machine. Such machines are able to change
prices according to the outside temperature.
Suppose for the purposes of this problem that the
temperature can be either "high" or "low". On days of
"high" temperature, demand is given by Q = 280 - 2p,
where Q is the number of cans of Coke sold during the
day and p is the price per can measured in cents. On
days of "low" temperature, demand is only Q = 160 2p. The marginal cost of a can of coke is 20 cents.
2015
Example: Coca Cola

38
Suppose that Coca-Cola installs a "smart" vending

machine and thus is able to charge different prices for
Coke on "hot" and "cold" days. What price should
Coca-Cola charge on a "hot" day? What price should
Coca-Cola charge on a "cold" day?
Alternatively, suppose that Coca-Cola continues to use
its normal vending machines which must be
programmed with a fixed price, independent of the
weather. What is the optimal price for a can of Coke?
Assume there are an equal number of days with "high"
and "low" temperature.
2015
19
Example: Coca Cola

39
What would Coca-Cola's profits be under constant

and weather-variable prices? How much would
Coca-Cola be willing to pay to enable its vending
machine to vary prices with the weather, that is, to
have a "smart" vending machine?
Applied by Coca Cola in 1999
"A cynical ploy to exploit the thirst of faithful
customers" (San Francisco Chronicle)
"Lunk-headed idea", (Honolulu Star-Bulletin)
"Soda jerks" (Miami Herald)
2015
Welfare
40
Firm is better off (in the worst case the firm is as

well off)
Consumers in inelastic markets are worse off
Consumers in highly elastic markets are better off
In some cases no one is worse and some improve:
cases of non-served markets
Intermediary goods markets: Robinson Patman Act
Protect small business from unfair advantages
possessed by large buyers
2015
20
2nd Degree price discrimination

41
Demand with heterogenous consumers

Proposed personalized packages or bundles:
perfect discrimination
What if monopolist can not identify each consumers
demand function
Do we offer only one bundle?
Offer a menu of bundles
2015

42
A simple example to fix the ideas

Producer P faces to customers, C1 and C2, knows it but cannot tell
whether any customer coming to the shop is high sensitive to prices
or not
Customers behave competitively
Each customer has a demand that varies with price
V1(Q1) = 100 Q1 and V2(Q2) = 50 Q2
Unit cost of production of P is 10

IDEAL PRICES OF PRODUCER P ?
2015
21
2nd Degree price discrimination :

example
43
Price ()
Price ()
100
Max.
Fee A2
Max.
Fee A1
50
Unit production cost of P
10
Quantity
(units)
0
40
0
10
50
Unit production cost of P
0
90
100
Quantity
(units)
2015
2nd Degree price discrimination :

example
44
Price ()
100
Price ()
Max.
Fee A2
Min.
payoff
of C1
Under the tariffs offered in PP, Ti(q)= Ai +

10 x q for any i=1,2. All customers would
choose tariff T2(q). Anything better for the
producer?
Max. Fee
paid by C1
50
10
0
40
0
10
50
Quantity
(units)
0
0
90
100
Quantity
(units)
2015
22

45
The generic expression of the tariff is

Ti(q) = Fi + vi x q
If the producer wants customer i to use the tariff
tailored for himself, customer i must earn a larger
payoff than if he chooses the tariff of customer j
Known as the INCENTIVE COMPTABILITY CONSTRAINT
If customers incentives are not compatible with a firms
objectives, then the firm will miss its goal
2015
An example of possible tariff

46
Increase the unit price for the tariff taylored

for C2 (i.e. w2 > 10), leave him indifferent
between participating or not (i.e. A2 maximal),
set w1=10 but leave him a positive payoff
2015
23
An example of possible tariff

47
Price ()
Max. Fee paid

by C1 under T2
Max. Fee
A2
100
Min. payoff
of C1 under
T2
Price ()
The loss accepted by P due to the increase

in w2 is compensated by the extra money
raised on C1. Net gain = 150 for P.
50
Variable profit on C2
20
10
Quantity
(units)
0
30
0
20 = w2
10 = w1
0
0
80 90 100
50
Gain for C1 if he buys
at w1=10 instead of w2
= 20. How large A1?
Quantity
(units)
Loss on C2 =
(40 10) x
(20 10)/2
as this
amount was
obtained in
fee A2 in the
previous
tariff with
unit price w
= c for2015
i=1,2
Example: phone companies

48
Consider the good offered by the monopoly is a mobile

phone, and that two contracts can be offered :
a contract with a small fee A2 and a high per unit cost of
communication w2 (extreme form is Pay-As-You-Go with A2 = 0
and w2 large)
and a regular contract with a fixed fee A1 (larger than 0 if the
other contract is PAYG) and a smaller per unit cost of the
communication minute w1 closer to the unitary cost
The groups of consumers are talkative (group 1) and nontalkative (group 2) so that talkative is more valuable for the firm
than non-talkative
You cannot force consumer to buy one contract or the

other, you have to let them self-select (i.e. choose the one
they prefer)
2015
24
Optimal tariffs
49
Optimum:
Customer C2 (low demand consumer) is charged his
maximum willingness to pay
Customer C1 (high demand consumer) is charged the
highest price that makes him choose tariff 1 rather than
tariff 2
Or sell only to high demand consumers: corner

solution
You need to design at most as many tariffs as
groups of consumers
2015
Bundling
50
A multi-product monopoly can use consumers

preferences to sell bundles and extract more surplus
Homogeneous goods
Heterogeneous goods
Pure Bundling: selling products only as a bundle, not

individually
Mixed Bundling: selling products as a bundle and
individually
2015
25
Bundling
51
Assume 2 products, A and B, that can be separately

sold at pA and pB, or together at pAB < pA + pB, with
pAB > pA and pAB > pB
Consumers willingness to pay are vA, vB, or vA+vB
Then depending on correlations between willingness to
pay bundling will increase profits or not
2015
Bundling
52
vA
vA
Consumers
buying A
only
Consumers
buying A
and B
Consumers
buying A
only
Consumers
buying A
and B
pA
pA
Consumers
buying B
only
Consumers
not buying
pB
Consumers
not buying
vB
Consumers buying
B only
pB
vB
2015
26
Bundling
53
The firm looses some profit on consumers who were

buying A and B when sold separately
The firm gains some profit on consumers who are
buying the bundle instead of A or B or nothing
Whether the gains exceed the looses depends on
the distribution of valuations
If the masses of consumers are mostly on high vA and
low vB (or the opposite), bundling is profitable
Roughly valuations must be negatively correlated
2015
An example: 2 consumers (Mr Pink and Mr Green) and 2

goods (A and B), valuations in the table
54
Sum of
valuations
Mr Pink
11
Mr Green
Without bundles, the firm is better off fixing pA = 7 (and

sell to Mr Green) and pB = 8 (and sell to Mr Pink), raising
15 of profit
A bundle priced at 9 can be sold twice, raises 18
In that case willingness to pay are negatively correlated
2015
27
55
2015
2015
56
28
Price discrimination: next step

57
First 6 months subscription: 50% discount

Which kind of price discrimination?
Renewal of subscription: 35% discount
Why
decides to change the discount?
Which kind of price discrimination?
Dynamic price discrimination

2015
Static versus dynamic analysis

58
Static: You know your demand and costs,

and current prices (or quantities) do not
affect:
Future costs
Future equilibrium strategy
Future level of demand
2015
29
Future costs and strategies

59
Future Costs: price today affects quantity today

and this affects costs tomorrow
Learning by doing
Strategies
Your price today gives information to the action of your
competitor tomorrow
INFORMATION!
2015
Dynamic demand
60
Price today affects demand today, and demand

today structures demand tomorrow:
Durable goods
Temporarily storable goods
Experience goods
Goods with network externalities: penetration pricing
Prices today affects demand today and this gives

information about your present and future demand
Behavior-based price discrimination
2015
30
Durable goods
61
Book: Industrial Organization Rules!
2015
Durable goods
62
Book: Industrial Organization Rules!

P
P1
MR(Q)
c
Q1
2015
31
Durable goods
63
Time 2
P
Q1
Q
Residual Demand
2015
Durable goods
64
Time 2
P
P2
c
Q1
Q2
2015
32
Intertemporal Price Discrimination

65
Time 3, 4, 5N
P
P1
P2
P3
PP4
5
Q1
Q2 QQ
3Q
45
2015

66
Year 3, 4, 5N
P
P1
P2
PN=c
Q1
Q2
QN=Qc
2015
33

67
If you could start again from year 1, would you fix

the same price?
Cream skimming or skimming pricing
Ex. Movies: Cinema - DVD - Renting - TV
Do you think you can play that kind of strategy?

Coase conjecture:
a durable goods monopolist has no monopoly power if
the time between price adjustments is vanishingly
small
2015
Coase conjecture
68
Disney announces DVD

12 weeks after
release on cinema
instead of traditional
17 weeks. Why?
Boycott from 40%
cinemas in UK and
Ireland
2015
34
How to recover market power:

69
Quality degradation: books, software, airlines

Planned obsolescence
Limit capacity
Production takes time
Reputation: Disney limited-time available classics
boost sales in excess of 400%
Contractual commitments: best price clause
Leasing: problems
New customers
2015
Bundling and the law of large numbers

Case of firm with 2, 3, 4, products
A firm selling many products can extract consumer
surplus if valuations for the different products are
independent across products and consumers by:
Selling products at unit price close to the marginal costs
Charging a fixed fee based on the average valuation
across products
Do you know examples of such behavior?
2015
70
35
Law of large Numbers

Law of Large Numbers: if ( v , v ..., v ) are the valuations of
consumer t for n products drawn independently from a
distribution
with known mean , then if n sufficiently
n
t
large vi , is approximately equal to n
t
1
t
2
t
n
i =1
The same applies to any customer as long as valuations

are independently drawn from the same distribution
Key idea: it is easier to predict consumers total surplus
than the consumers surplus derived from each product
Efficient outcome is approximately achieved and the
firm extract all the gains
2015
71
How does it works

Tariff system: two-parts tariffs
pi* = ci
F * = n * i =1 ci
Warning: there exists a marginal cost for each

good higher than zero c>0 that makes bundling
result in lower profits and higher deadweight loss
than selling the goods separately
Case of correlated valuations: menu of tariffs
Analysis applies also to situations in which
consumers buy several units of each product
2015
72
36

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Managerial Tools from the

Economist Toolkit: some advanced

Pricing Strategies - BRICK7

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

Uniform pricing with market power

What is going to determine your price?

The price-sensitivity of consumers demand

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

Price-sensitivity of consumers (2)

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

Price-sensitivity of consumers (1)

Price-sensitivity of consumers (2)

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

Price-sensitivity of consumers (3)

With an inelastic demand, the strategy should be a

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

How to measure elasticity of demand

Surveys and/or interviews

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

Optimal uniform price of a firm with

Average and marginal revenues

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

Optimal uniform price of a firm with

When lowering the price from P0 to P1, a monopoly

The revenue variation is equal to

Relatively to the increase in quantity, the variation is

Optimal uniform price of a firm with

Marginal Revenue: Twice as steep rule applies

When Marginal Revenue = 0, total revenue is at

What about costs and profits?

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

Marginal Revenue (MR):

Marginal Cost (MC):

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

Optimal uniform price of a firm with

As long as the additional revenue from selling an

The production (and market price) of a monopoly

If at Q0 price is over marginal cost, firms increase

Consider a very small change in production, say

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

Inverse demand measures willingness to pay

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

Degree of market power of a firm can be

SSNIP test: Small but Significant and Non-transitory

Pricing strategies, Price and Non-price

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

Price Discrimination: Two units of the same physical

If individuals are (almost) identified, tailored offers

Price Discrimination and Yield

Tourists vs. business travelers

So, yield management system is used to adjust seat

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

First degree (or perfect) price

DEFINITION: Perfect price discrimination refers to a situation in which a seller

HBR, October 2012 Getting Control of Big Data

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

Two possible cases

Unitary demand per customer

Multiple unit demand per customer:

Managerial Economics - MBA (c) M. Urdanoz (Toulouse Business School)

A simple example to fix ideas

Producer P faces two customers, C1 and C2 and knows their

Unit cost of production of P is 10

First Degree Price Discrimination