PowerPoint Slides © Michael R. Ward, UTA 2014

Bagel Shop• You run a small bagel shop. You have engaged in a market

study to categorize your customers’ willingness to pay for a meal (coffee & bagel) into 8 equal sized groups: ($5.00, $4.50, $4.00, $3.50, $3.00, $2.50, $2.00, $1.50). All of your costs are fixed except labor and materials, which cost $2.25 per meal sold.

• What price should you charge for a meal?

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Bagel Shop• Sort them from highest WTP to lowest• If you charge them their WTP or lower, they purchase• So this generates a demand curve

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Price Quantity Total Rev MR MC Profit$5.00 1$4.50 2$4.00 3$3.50 4$3.00 5$2.50 6$2.00 7$1.50 8

Bagel Shop• Multiply price times quantity to get total revenue

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Price Quantity Total Rev MR MC Profit$5.00 1 $5.00 $4.50 2 $9.00 $4.00 3 $12.00 $3.50 4 $14.00 $3.00 5 $15.00 $2.50 6 $15.00 $2.00 7 $14.00 $1.50 8 $12.00

Bagel Shop• Multiply price times quantity to get total revenue• Calculate the MR from the change in total revenue

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Price Quantity Total Rev MR MC Profit$5.00 1 $5.00 $5.00 $4.50 2 $9.00 $4.00 $4.00 3 $12.00 $3.00 $3.50 4 $14.00 $2.00 $3.00 5 $15.00 $1.00 $2.50 6 $15.00 0$2.00 7 $14.00 ($1.00)$1.50 8 $12.00 ($2.00)

Bagel Shop• Multiply price times quantity to get total revenue• Calculate the MR from the change in total revenue• Compare this with the MC

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Price Quantity Total Rev MR MC Profit$5.00 1 $5.00 $5.00 $2.25 $4.50 2 $9.00 $4.00 $2.25 $4.00 3 $12.00 $3.00 $2.25 $3.50 4 $14.00 $2.00 $2.25 $3.00 5 $15.00 $1.00 $2.25 $2.50 6 $15.00 0 $2.25 $2.00 7 $14.00 ($1.00) $2.25 $1.50 8 $12.00 ($2.00) $2.25

Bagel Shop• Verify by calculating the profits at each price

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Price Quantity Total Rev MR MC Profit$5.00 1 $5.00 $5.00 $2.25 $2.75 $4.50 2 $9.00 $4.00 $2.25 $4.50 $4.00 3 $12.00 $3.00 $2.25 $5.25 $3.50 4 $14.00 $2.00 $2.25 $5.00 $3.00 5 $15.00 $1.00 $2.25 $3.75 $2.50 6 $15.00 0 $2.25 $1.50 $2.00 7 $14.00 ($1.00) $2.25 ($1.75)$1.50 8 $12.00 ($2.00) $2.25 ($6.00)

Bagel Shop• Does your profit maximizing price depend on the total

number of consumers?• Not if the groups are equally sized

• Suppose your market research tells you that the four lowest value groups are all students. Should you offer a student discount? • If so, how much?

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Student Discounts• Separate the last four students from the rest• Prices charged to them do not affect the revenues from

non-students• Like a whole new demand curve• Maximize profits here yield a different “student” price• Implement with a $1.00 student discount

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Price Quantity Total Rev MR MC Profit$3.00 1 $3.00 $3.00 $2.25 $1.00 $2.50 2 $5.00 $2.00 $2.25 $0.50 $2.00 3 $6.00 $1.00 $2.25 ($0.75)$1.50 4 $6.00 ($0.00) $2.25 ($3.00)

Student Discounts• You earn $5.25 in profit from the $4.00 price• You earn an additional $1 from the students at a $3.00

price• You have increased profits through “price discrimination”

• That is, P1/MC1 P2/MC2

• What did we need for this to work?1. Need to be able to identify the groups which are less demand

elastic from the groups which are more demand elastic (high WTP versus low WTP)

2. Need to prevent arbitrage

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Price Discrimination• Identifying demand segments is more common than you

might imagine• Could be due to differences in demand

• Ex Student or senior citizen discounts• Ex Household services (e.g., maid, yard, plumber) in Park Cities

versus South Dallas • Ex Early bird special or matinee pricing• Ex Air travel with a Saturday stay-over • Ex Air travel booked a month in advance versus ‘week of’• Ex McDonalds on Cooper versus Champs d'Elise• Ex Patented pharmaceutical product in US versus Canada versus

Mexico versus Haiti

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Differences in Demand• Could be due to differences in rivalry

• Ex Cowboy boots in Texas versus Boston• Ex Pharmaceutical product in US pre-patent expiration versus in

Brazil with price regulation• Ex Mobile phone service in US with many carriers or in the

Philippines with few carriers

• Always indicates difference in demand elasticity across groups

• Direct = observe group membership• Indirect = infer group membership

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Limiting Arbitrage• Limiting Arbitrage can be tricky• What if group 3 could pass for students?

• They get the lower price and your whole scheme falls apart

• What if business travelers can book months in advance?• What if Florida retirees can travel to Canada for their

medicines?

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Limiting Arbitrage• Need a cost to arbitrageurs that you do not face to

prevent reselling product• High transportation costs

• Shipping boots from Texas to Boston

• High transactions costs• Prosecuted for re-importing possibly counterfeit drugs

• Services versus products• Hard to resell a haircut or dry cleaning

• No price discrimination scheme will work perfectly• You usually just need that there is not ‘too much’ arbitrage

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Limiting Arbitrage• 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.

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Limiting Arbitrage• Once sales hit 10%, diffusion from luxury to mass market

happens very quickly

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Limiting Arbitrage• The Philippine market was quickly approaching the crucial

10% penetration point• At which this Rule of Thumb applies: the firm with 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

• IRK reduced prices in Philippines to $90• Problem: the Philippine phones used the same standard

(GSM) as higher-priced European phones

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Limiting Arbitrage• 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

• Have to change the algorithm every few years in a never-ending “arms race”

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Capturing Value• Our typical profit maximizing situation from simple pricing

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Capturing Value• What do the Blue regions represent?

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Capturing Value• These are part of the value that the product generates in

excess of your cost going to the consumer

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Un-captured Consumer Value

Capturing Value• Price discrimination is a way to try to capture this

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Un-captured Consumer Value

Capturing Value• With perfect price discrimination, you would charge all N

customers a different price and capture it all• Not possible but is the limiting case we aim for

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Un-captured Consumer Value

Modified Simple Pricing• Simple rule for different groups• Set contribution margins to the inverse of their respective

elasticities• (P1-MC1)/P1=1/|e1|

• (P2-MC2)/P2=1/|e2|

• So if you know demand for cowboy boots is less elastic in Boston (luxury good, few competitors), set prices higher

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Price Discrimination Online• 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 scheme allows Dell to sell identical computers at different prices based on the consumers’ price sensitivity

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When is it Illegal?• 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

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Blood Tests• In Northern Europe (Ger., Holland and Scandinavia)

• Medical blood test 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

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Blood Tests• 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)

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Distribution• Your family business produces a secret recipe salsa and

distributes it through both smaller specialty stores and chain supermarkets. The chains have been demanding sizable discounts but you do not want to drop your prices to the specialty stores. How can you legally accommodate the chains without losing profits from the specialty stores?

• Must alter it somehow to justify differences in prices• High volume implies full pallets which are cheaper to distribute

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Customer Perceptions• Consumers do not like knowing they are paying higher

prices than others• “Only Schmucks pay Retail”

• 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

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From the Blog• Chapter 13• Cable Car in Barcelona• Weekend airline purchases• Women’s Haircuts?• Price Discrimination at the FTC!

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Main Points• Price Discrimination is charging different markups to

different groups of customers• Must be able to identify differences in WTP (elasticity)• Must be able to limit arbitrage• Engage in “simple pricing” for each group• Typically additional customers are served than would be

under simple pricing

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