Weekend 4: Pricing Strategies; Agency Issues

How does versioning enable segmented pricing?

(Perceived) quality differences can be created without changing product inputs - Marketing: Branded vs. generic - Timing of sale: End-of-season liquidation, advanced purchases - Cost of acquisition: Outlet stores, coupons

Price Discrimination

Charge different prices to different consumers for the same good, or different prices for different quantities purchased by a given consumer Price differences that are not due to cost differences The three basic forms of price discrimination are: - First-degree (or perfect) price discrimination - Second-degree price discrimination (nonlinear pricing) - Third-degree price discrimination

first degree price discrimination

Charging each individual consumer the maximum amount he will pay for each incremental unit Price = WTP for every unit sold to extra ALL of the consumer surplus (no deadweight loss) *transactions costs and information constraints make this difficult to achieve

demand heterogeneity

Differences in demand curves across consumers Implies that the optimal prices or quantity packages should vary across consumers

Key Takeaways from Price Discrimination

First-degree price discrimination, block pricing, and two-part pricing permit a firm to extract all consumer surplus (in theory, anyway) Commodity bundling, second-degree, and third-degree price discrimination permit a firm to extract some (but typically not all) consumer surplus Simple markup rules are the easiest to implement, but they leave consumers with the most surplus Different strategies require different information

What is a principal-agent problem?

Occurs when the principal cannot observe the effort of the agent Example: Shareholders (principal) cannot observe the effort of the manager (agent) Example: Manager (principal) cannot observe the effort of workers (agents) The Problem: Principal cannot determine whether a bad outcome was the result of the agent's low effort or due to bad luck (information disparity)

second degree price discrimination

practice of charging different prices per unit for different quantities of the same good or service Considerations: - Requires less information than 1st degree - Typically cannot extract all consumer surplus - Demand heterogeneity can create complications - Examples: Electric utilities, quantity discounts.

third degree price discrimination

practice of dividing consumers into two or more groups with separate demand curves and charging different prices to each group Groups must have characteristics that make them readily identifiable to sellers, and resale must be impractical (e.g., services). Examples include student discounts, senior citizen discounts, and regional and international pricing (e.g., "international" versions of U.S. textbooks sell for less abroad; although the internet has made it easier for U.S. students to circumvent this strategy by ordering online the cheaper versions for themselves).

If we cannot use observable groups, what is another way to segment pricing?

we use consumer self-selection to segment pricing

What are some examples of third degree price discrimination?

- Airfares: cheaper if stay over a Saturday night - Books: hardback vs. paperback editions. - "Director's Cut" of DVD that comes out later than the initial DVD - Coca-Cola vending machine: Developed in late 1990s with a computer chip and temperature sensor, it would automatically raise prices in hot weather. Never implemented, however, perhaps because of the bad press it got denounced by Pepsi. Men's vs. Women's haircuts? Note: It is not price discrimination if price differences are entirely attributable to differences in the cost of providing the good or service.

What are the two methods of segmentation (segmented pricing)?

1. Group Membership -- Same product is sold to groups with different WTP -- Group membership is observable and verifiable, consumers do not choose -- Must prevent re-sale from low- to high-price groups 2. Product Features -- Product variation creates tradeoff: price vs. feature -- Consumers self-select via choice of lower price or better product features -- No need to prevent re-sale

segmented pricing

A firm sells the "same" product or service at more than one price This is another name for price discrimination and related pricing strategies

What are cross-subsidies?

Prices charged for one product are subsidized by the sale of another product. May be profitable when there are significant demand complementarities between the products. Examples: Drinks and meals at restaurants, free popcorn and nuts at bars, free or cheap kids' meals.

Standard Pricing and Profits for Firms with Market Power: If the firm must charge the same price to all consumers, what is the profit-maximizing output level? Given: - Inverse Demand: P = 10-2Q - MR = 10 - 4Q - MC = 2

Profit maximizing when MR = MC 10 - 4Q = 2, so Q* = 2 P* = 10 - (2)(2) = 6 Profits = (6)(2) - (2)(2) = $8

Suppose the elasticity of demand for Starbucks coffee in Seattle is Es = -2, and the elasticity of demand in Dallas is Ed = -3. What is Starbuck's optimal third degree pricing strategy? Given: Marginal cost of a cup of coffee is $1

Ps = [Es/(1+ Es)] x MC = [-2/(1 - 2)] x $1 = $2.00 Pd = [Ed/(1+ Ed)] x MC = [-3/(1 - 3)] x $1 = $1.50 Starbucks' optimal third-degree pricing strategy is to charge a higher price in the Seattle (over Dallas), where demand is less elastic.

Is segmented pricing fair?

Segmentation using group membership means forcing some people to pay more than others for the same product/service, which can violate customers' perceptions of fairness Higher WTP may not always be seen as a "legitimate" reason to charge higher prices

How does the internet influence price discrimination?

Sellers have lots of information about buyers that could potentially be used to refine price discrimination: - Type of computer (Apple vs. PC) - Geographic neighborhood (rich vs. poor) - History of past searches and purchases - Demographic information from online profiles On the other hand, the internet makes it easier for buyers to compare prices and purchase from the cheapest seller

Remedies for the principal-agent problem

Shareholders must create plans to align the interest of the manager with those of the shareholders - Internal incentives -- Incentive contracts -- Stock options, year-end bonuses - External incentives --Personal reputation --Potential for takeover Managers must recognize the existence of the principal-agent problem and devise plans to align the interests of workers with those of the firm - Profit sharing - Revenue sharing - Piece rates - Time clocks and spot checks

How does a simple markup rule identify optimal price given the elasticity of demand for a firm?

The optimal price is a simple markup over relevant costs - More elastic the demand, lower the markup. - Less elastic the demand, higher the markup. E.g.: Suppose the elasticity of demand for the firm's product is Ef < 0 Recall that MR = P[1 + Ef]/ Ef. Setting MR = MC and simplifying yields this simple pricing formula: P = [Ef/(1+ Ef)] x MC E.g.: Elasticity of demand for iPad tablet is -3. P = [Ef/(1+ Ef)] x MC P = [-3/(1 - 3)] x MC P = 1.5 x MC (English > 50% markup)

How does block pricing enable segmented pricing?

The practice of packaging multiple units of an identical product together and selling them as one package Examples: Paper, Six-packs of soda. Tactical Example: Typical consumer's demand is: P = 10 - 2Q Costs: C(Q) = 2Q, so MC=2 Optimal number of units in a package? Optimal package price? Considerations: Optimal Price in attached image Profit is only 16 due to 8 in costs

What is peak-load pricing?

When demand during peak times is higher than the capacity of the firm, the firm should engage in peak-load pricing Charge a higher price (Ph) during peak times (Dh). Charge a lower price (Pl) during off-peak times (Dl).

How does two-part pricing enable segmented pricing?

When it isn't feasible to charge different prices for different units sold, but demand information is known, two-part pricing may allow sellers to extract all of the surplus from consumers - Two-part pricing consists of a fixed fee and a per unit charge (which can be zero) Eg. athletic club memberships. See picture for how it works:

You own a hotel with 12 rooms, and all your operating costs are fixed There are 4 groups of potential guests, each with its on demand curve for rooms You can charge each group a different price What prices should you charge to each group in order to maximize profit? (image available showing MR of each guest)

With limited capacity, opportunity costs are crucial to segmented pricing analysis MR of one group = cost of selling to another