1 msu weekend mba program– may 5, 2012 price discrimination- ch. 11, pgs 395-400, pgs 402-415

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MSU Weekend MBA Program– May 5, 2012

Price Discrimination- Ch. 11, pgs 395-400, pgs 402-415

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Profit Maximization when setting a Single Price Profits are maximized

at Q=4 and P=6.Profits=TR-TC=6*4-4.5*4= 24-18=6OrProfits=P*Q-ATC*Q

=(P-ATC)*Q=(6-4.5)*4=6

• Consumer Surplus -the value consumers get from a good but do not have to pay for.

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AVC

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ATC

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PROFITS

CONSUMER SURPLUS

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Definition of Price Discrimination The practice of charging different

prices to consumers for the same good or service (and the price differences do not reflect cost differences)

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Web May Reduce Price DiscriminationThe New York Times, December 6, 2001

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Web May Reduce Price DiscriminationThe New York Times, December 6, 2001

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Three Conditions Required for Price Discrimination to Occur

1. Seller must exercise some “price control” (i.e. face a downward sloping demand)

2. Seller must be able to distinguish among customers who are willing to pay different prices.

3. It must be impossible or too costly for one buyer to resell the good to other buyers (i.e., buyers cannot arbitrage).

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Strategic Behavior By FirmsWhat actions do firms take to prevent resale

or make resale more “costly”?

1. Warranty becomes invalid if item is resold.

2. Software firms do not provide support services if software is resold.

Any others you can think of?

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Types of Price Discrimination1. First-Degree (Perfect) Price Discrimination -

Occurs when the seller charges the highest price each consumer would be willing to pay for the product (consumer's reservation values) rather than go without it.

Universities, Car Dealers, Contractors, Flea Market (at least they all try)

2. Third-Degree Price Discrimination - Occurs when the seller charges different prices in different markets, or charges a different price to different segments of the buying population.

Movies, Soda, Computers, prescription drugs, textbooks, safety gates, airlines, dry cleaning, haircuts, …

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Types of Price Discrimination3. Second-Degree Price Discrimination - Occurs

when the seller charges a uniform price per unit for one specific quantity, a lower price for an additional quantity, and so on. QUANTITY DISCOUNTS (2-part Pricing is a type of quantity discount)

Electric Utilities, Country Clubs, Michigan Athletic Club, Disneyland (in old days), Grocery Stores, Espresso Royale, …

4. Peak Load Pricing – the practice of charging higher prices during “peak hours” (i.e. high demand times) than during off-peak hours.

Hotels, Ski Resorts, Airlines, Stadiums, Restaurants, Toll roads, Bridges, …

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Types of Price Discrimination5. Bundling – the practice of bundling several

different products together and selling them at a single “bundle price”.

Happy Meals, Restaurants, Stereos, Cars with Options, Celebrity Endorsements, Movies (years ago),…

6. Screening- the practice of requiring consumers to “jump over a hurdle” to obtain a lower price.

Coupons, Warranties, Rebates, Outlet malls, Saturday Night Stayovers for airlines,….

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No Price Discrimination

Profits are maximized at Q=20 and P=30.

Profits=TR-TC

=P*Q-ATC*Q

=30*20-14*20=320

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First-Degree (Perfect) Price Discrimination

Definition:

Occurs when the seller charges the highest price each consumer would be willing to pay for the product (consumer's reservation values) rather than go without it.

Universities, Car Dealers, Contractors, Flea Market (at least they all try)

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1st-Degree Price Discrimination

Charge Every Consumer the maximum he/she is willing to pay. The demand curve is based on what consumers are willing to pay.

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Market Demand is Obtained from Adding Individual Demand Curves

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Suppose Market Demand is Obtained from Individual Demands Below

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1st-Degree Price Discrimination What output would the

firm produce to maximize profits if it could 1st-degree price discriminate?

Q=30 What would be the firm’s total

revenue?TR=.5*(50-20)*30+20*30

=1050 What would be the firm’s TC at

an output of 30?TC=ATC*Q=15*30=450 Profits=1050-450=600

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Marginal Revenue is the Demand Curve

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Certain Degrees Now Cost More at UniversitiesThe New York Times, July 29, 2007

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Expensive Lesson: Colleges Manipulate Financial Aid Offers

The Wall Street Journal, April 4, 1996

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Expensive Lesson: Colleges Manipulate Financial Aid Offers

The Wall Street Journal, April 4, 1996

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Expensive Lesson: Colleges Manipulate Financial Aid Offers

The Wall Street Journal, April 4, 1996

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Expensive Lesson: Colleges Manipulate Financial Aid Offers

The Wall Street Journal, April 4, 1996

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Expensive Lesson: Colleges Manipulate Financial Aid Offers

The Wall Street Journal, April 4, 1996

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Expensive Lesson: Colleges Manipulate Financial Aid Offers

The Wall Street Journal, April 4, 1996

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Reckonings; What Price Fairness?The New York Times, October 4, 2000

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Third-Degree Price Discrimination

Definition:

Occurs when the seller charges different prices in different markets, or charges a different price to different segments of the buying population.

Movies, Soda, Computers, prescription drugs, textbooks, safety gates, airlines, …

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0255075100125150175200225250275300325350375400

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Qt

0255075100125150175200225250275300325350375400

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Qb

Tourist Traveler Business Traveler

D: Pt = 200-5Qt

MR =

D: Pb = 400-5Qb

MR =

DtDb

200-10Q

MRt MRb

400-10Q

MRt=MRb=MC=50

30 3515

Suppose MC for airline is constant at $50 up to the capacity limit of 75. Also assume that Fixed Cost of airlines is $1000.

MCMCProfits=125*15+225*35- 50*(15+35)-1000 =6250

Note: When MC constant, MC=AVC.

Note: Not at capacity limit.

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Summarize

Firm sells 50 tickets 35 to business travelers @ $225/ticket 15 to tourists @ $125/ticket

Which type of traveler is relatively more elastic?

Q

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slope

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3.135

225

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b 7.1

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125

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Lower Rates for Women Are Ruled UnfairNew York Times, August 13, 2008

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Insurance ‘eggheads” Make Women PayLos Angeles Times, June 22, 2008

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Second-Degree Price Discrimination Definition:

Second-Degree Price Discrimination - Occurs when the seller charges a uniform price per unit for one specific quantity, a lower price for an additional quantity, and so on. QUANTITY DISCOUNTS (2-part Pricing is a type of quantity discount).

Electric Utilities, Country Clubs, Michigan Athletic Club, Disneyland (in old days), Espresso Royale, …

http://steelers.strmarketplace.com/

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2-Part Pricing

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Suppose the graph to the right depicts the demand and cost curves for a country club where quantity (Q) represents the number of rounds of golf.

Q

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Suppose the country club sets the price per round of golf at $20. What membership fee

(fixed fee) should the country club set?

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•If the price per round is $20 and the membership fee isn’t too high, how many rounds of golf will Individual A play?

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•What is the maximum membership fee Individual A will pay given the price per round is $20?

.5*(50-20)*3=45

Individual A

Maximum membership fee Individual A is willing to pay.

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Suppose the country club sets the price per round of golf at $20. What membership fee

(fixed fee) should the country club set? •If the price per round is $20

and the membership fee isn’t too high, how many rounds of golf will Individual B play?

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•What is the maximum membership fee Individual B will pay given the price per round is $20?

.5*(50-20)*6=900

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Maximum membership fee Individual B is willing to pay.

Individual B

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Suppose the country club sets the price per round of golf at $20. What membership fee (fixed fee) should the country club set? Given the cost of each round is $20, the country club should charge

a membership fee of either $45 or $90.

Profits if membership fee is $45Both types of individuals join with Type A golfing 3

rounds each and Type B golfing 6 rounds.45*9+20*(8*3+1*6)-15*30= 555

Profits if membership fee is $90Only Type B joins and Type B golfs 6 rounds.

90*1+20*(1*6)-35*6= 0SET MEMBERSHIP FEE AT $45

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2-Part Pricing

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•If membership fee is $45, total number of rounds golfed is 8*3+1*6=30. At Q=30, ATC=15 so TC=ATC*Q=15*30=450.

•If membership fee is $90, total number of rounds golfed is 1*6=60. At Q=6, ATC=35 so TC=ATC*Q=35*6=210. Q

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Peak Load Pricing

Definition

The practice of charging higher prices during “peak hours” (i.e. high demand times) than during off-peak hours. Hotels, Ski Resorts, Airlines, Stadiums,

Restaurants, …

http://panynj.info/bridges-tunnels/tolls.html

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Demands at a Restaurant for Lunch and Dinner

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Suppose Restaurant’s Capacity is 45 seats, Fixed Costs are $1800 per day and Marginal

Cost of a meal is constant at $20 What prices will the

Restaurant charge for lunch and dinner?

PL=$35 and PD=$60

What are the Restaurant’s daily profits?

TR-TC=TR-TVC-TFC= 35*15+60*40-

20*(15+40)-1800= 25-10-505101520253035404550556065707580859095100

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Suppose Restaurant’s Capacity is 30 seats, Fixed Costs are $1200 per day and Marginal

Cost of a meal is constant at $20 What prices will the

Restaurant charge for lunch and dinner?

PL=$35 and PD=$70

What are the Restaurant’s daily profits?

TR-TC=TR-TVC-TFC= 35*15+70*30-

20*(15+30)-1200= 525-10-505101520253035404550556065707580859095100

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Bundling Definition The practice of bundling several different

products together and selling them at a single “bundle price”. Happy Meals, Restaurants, Stereos, Cars with

Options, Celebrity Endorsements, Movies (years ago),…

What are possible explanations as to why firms do this?

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Quote from Lebron James (article in November 28, 2007 Fortune)

So in 2006, James founded LRMR Marketing, so named for the initials of the four buddies: Lebron, Randy Mims, Maverick Carter, and Richard Paul.

While James is LRMR's core business, the goal is to diversify by representing other athletes. Right now they have only one other client. In August the company signed a contract with Ted Ginn Jr., the Ohio State star and a rookie wide receiver on the Miami Dolphins. …

"He should be looking at multiyear deals with a vested interest," says Doug Shabelman, the president of Burns Entertainment & Sports Marketing. "He'll probably be in a position to take some ownership stakes." Shabelman added that if LRMR develops a stable of athletes, it could package them in deals for marketers. In other words, if you want LeBron, you gotta take the others.

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Bundling – Example 1

Assume there are 10 Type I individuals and 10 Type II individuals and that each individual only demands one appetizer and one entrée. For simplicity, assume costs are zero.

Willingness to Pay

Type I Type II

Appetizer 10 8

Entrée 12 15

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Bundling – Example 1

Assume there are 10 Type I individuals and 10 Type II individuals and that each individual only demands one appetizer and one entrée. For simplicity, assume costs are zero.

No Bundling

PA=8, PE=12Profits= 8*20+12*20=400

Bundling

PAE=22Profits = 22*20 = 440

Willingness to Pay

Type I Type II

Appetizer 10 8

Entrée 12 15

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Bundling – Example 1

Assume there are 10 Type I individuals and 10 Type II individuals and that each individual only demands one appetizer and one entrée. For simplicity, assume costs are zero.

No Bundling

PA=8, PE=12Profits= 8*20+12*20=400

Bundling

PAE=22Profits = 22*20 = 440

Willingness to Pay

Type I Type II

Appetizer 10 8

Entrée 12 15

For Both 22 23

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Bundling – Example 2

Assume there are 10 Type I individuals and 10 Type II individuals and that each individual only demands one appetizer and one entrée. For simplicity, assume costs are zero.

No Bundling

PA=8, PE=12Profits= 8*20+12*20=400

Bundling

PAE=20Profits = 20*20 = 400

Willingness to Pay

Type I Type II

Appetizer 8 10

Entrée 12 15

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Bundling – Example 2

Assume there are 10 Type I individuals and 10 Type II individuals and that each individual only demands one appetizer and one entrée. For simplicity, assume costs are zero.

No Bundling

PA=8, PE=12Profits= 8*20+12*20=400

Bundling

PAE=20Profits = 20*20 = 400

Willingness to Pay

Type I Type II

Appetizer 8 10

Entrée 12 15

For Both 20 25

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Bundling – Example 3

Assume there are 10 Type I individuals and 10 Type II individuals and that each individual only demands one appetizer and one entrée. For simplicity, assume costs are zero.

No Bundling

PA=10, PE=12Profits= 10*10+12*20=340

Bundling

PAE=17Profits = 17*20 = 340

Willingness to Pay

Type I Type II

Appetizer 10 2

Entrée 12 15

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Bundling – Example 3 Assume there are 10 Type I

individuals and 10 Type II individuals and that each individual only demands one appetizer and one entrée. For simplicity, assume costs are zero.

No BundlingPA=10, PE=12

Profits= 10*10+12*20=340 Bundling

PAE=17Profits = 17*20 = 340

Mixed BundlingPE=15, PAE=22

Profits= 15*10+22*10=370

Willingness to Pay

Type I Type II

Appetizer 10 2

Entrée 12 15

For Both 22 17

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Bundling – Example 4

Assume there are 10 Type I individuals and 10 Type II individuals and that each individual only demands one appetizer and one entrée. For simplicity, assume costs are zero.

No Bundling

PA=10, PE=12Profits= 10*10+12*20=340

Bundling

PAE=14Profits = 14*20 = 280

Willingness to Pay

Type I Type II

Appetizer 2 10

Entrée 12 15

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Bundling – Example 4 Assume there are 10 Type I

individuals and 10 Type II individuals and that each individual only demands one appetizer and one entrée. For simplicity, assume costs are zero.

No BundlingPA=10, PE=12

Profits= 10*10+12*20=340 Bundling

PAE=14Profits = 14*20 = 280

Mixed BundlingPE=12, PAE=25 ?

WRONG BECAUSE TYPE II WILL BUY ONLY ENTRÉE

Willingness to Pay

Type I Type II

Appetizer 2 10

Entrée 12 15

For Both 14 25

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Bundling – Example 4 Assume there are 10 Type I

individuals and 10 Type II individuals and that each individual only demands one appetizer and one entrée. For simplicity, assume costs are zero.

No BundlingPA=10, PE=12

Profits= 10*10+12*20=340 Bundling

PAE=14Profits = 14*20 = 280

Mixed BundlingPE=12, PAE=22

Profits= 12*10+22*10=340

Willingness to Pay

Type I Type II

Appetizer 2 10

Entrée 12 15

For Both 14 25

Assume that Type II buys bundle even though indifferent between buying bundle and just entrée. If you don’t like this assumption, just set PAE=21.99.

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Bundling – Example 5

Assume there are 10 Type I individuals and 10 Type II individuals and that each individual only demands one appetizer and one entrée. Assume marginal cost of an appetizer is $5 and marginal cost of an entrée is $10 .

Willingness to Pay

Type I Type II

Appetizer 10 8

Entrée 12 15

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Bundling – Example 5

Assume there are 10 Type I individuals and 10 Type II individuals and that each individual only demands one appetizer and one entrée. Assume marginal cost of an appetizer is $5 and marginal cost of an entrée is $10 .

No Bundling

PA=8, PE=15

Profits= (8-5)*20+(15-10)*10=110 Bundling

PAE=22

Profits = (22-15)*20 = 140

Willingness to Pay

Type I Type II

Appetizer 10 8

Entrée 12 15

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Bundling – Example 5

Assume there are 10 Type I individuals and 10 Type II individuals and that each individual only demands one appetizer and one entrée. Assume marginal cost of an appetizer is $5 and marginal cost of an entrée is $10 .

No Bundling

PA=8, PE=15

Profits= (8-5)*20+(15-10)*10=110 Bundling

PAE=22

Profits = (22-15)*20 = 140

Willingness to Pay

Type I Type II

Appetizer 10 8

Entrée 12 15

For Both 22 23

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Bundling – Example 5 Assume there are 10 Type I

individuals and 10 Type II individuals and that each individual only demands one appetizer and one entrée. Assume marginal cost of an appetizer is $5 and marginal cost of an entrée is $10 .

No BundlingPA=8, PE=15 Profits= 110

BundlingPAE=22 Profits = 140

Mixed BundlingPA=10, PAE=23

Profits= (10-5)10+(23-15)10=130 OR

PE=14, PAE=22Profits= (14-10)10+(22-15)10=110

Willingness to Pay

Type I Type II

Appetizer 10 8

Entrée 12 15

For Both 22 23

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Screening

The practice of requiring consumers to “jump over a hurdle” to obtain a lower price.

Coupons, Warranties, Rebates, Outlet malls, Saturday Night Stayovers for airlines,….

http://maps.google.com/maps?ie=UTF-8&oe=UTF-8&q=car+wash&near=Okemos,+MI&fb=1&cid=42682926,-84430200,9316045653265795993&li=lmd&z=14&t=m

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Coupon for Box of Cereal – Assume MC of a box is constant at $.50 and TFC=15

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Suppose Don’t Issue a CouponSet Price at $2 or $3 to maximize

profits.

If Set Price=$2Profits = 30*2-30*.5-15= 30

If Set Price=$3Profits = 10*3-10*.5-15= 10

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Suppose the opportunity cost of cutting a coupon is $0 for Type A individuals and

$1.50 for Type B individuals. What Price and Coupon Value Maximizes

Profits?

Price=$3 and Coupon Value=$1Type A cuts coupon and Type B does not.

TR=3*10+(3-1)*20 = 70TC=.5*30+15=30Profits= 70-30=40

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Suppose the opportunity cost of cutting a coupon is $0.25 for Type A individuals and

$1.50 for Type B individuals. What Price and Coupon Value Maximizes

Profits?

Price=$3 and Coupon Value=$1.25

Type A cuts coupon and Type B does not.

TR=3*10+(3-1.25)*20 = 65

TC=.5*30+15=30

Profits= 65-30=35

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Suppose the opportunity cost of cutting a coupon is $0.75 for Type A individuals and

$1.50 for Type B individuals. What Price and Coupon Value Maximizes Profits?

Price=$2.75 and Coupon Value=$1.50Type A cuts coupon and Type B does not.

TR=2.75*10+(2.75-1.50)*20 = 52.50TC=.5*30+15=30Profits= 52.50 -30=22.50Better off just charging a price of $2 and not using

coupon.

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Suppose the opportunity cost of cutting a coupon is $0.75 for Type A individuals and

$1.50 for Type B individuals. What Price and Coupon Value Maximizes

Profits?

Price=$2.75 and Coupon Value=$1.50

TR=2.75*10+(2.75-1.50)*20 = 52.50TC=.5*30+15=30Profits= 52.50 -30=22.50You could make Price=$2.74 and Coupon

Value=$1.49 if you want to make Type B strictly prefer to not cut the coupon.

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iPhone Buyer SuesThe Times (London), October 3, 2007

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Reckonings; What Price Fairness?The New York Times, October 4, 2000