Chapter 13:Direct Price

Discrimination

Managerial Economics: A Problem Solving Approach (2nd Edition)Luke M. Froeb, luke.froeb@owen.vanderbilt.edu

Brian T. McCann, brian.mccann@owen.vanderbilt.edu

Website, managerialecon.com

COPYRIGHT © 2008Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Slides prepared by Lily Alberts for Professor Froeb

Summary of main points• If a seller can identify two groups of consumers

with different demand elasticities, and it can prevent arbitrage between two groups, it can increase profit by charging a higher price to group with the less-elastic demand.

• Price discrimination is the practice of charging different people or groups of people different prices that are not cost-justified. Typically more people are served under price discrimination than under a uniform price.

• Arbitrage can defeat a price discrimination scheme if enough of those who purchase at low prices re-sell to high-value consumers. This can force a seller to go back to a uniform price.

Summary of main points (cont.)

• A direct price discrimination scheme is one in which we can identify members of the low-value (more price elastic) group, charge them a lower price, and prevent them from re-selling their lower- priced goods to the higher-value group.

• It can be illegal for business to price discriminate when selling goods (not services) to other businesses unless • price discounts are cost-justified, or

• discounts are offered to meet competitors’ prices.

• Price discrimination schemes may annoy customers who know they’re paying more than others and can make them less willing to buy because they know someone else is getting a better price. If you can, keep them secret.

Introductory anecdote: cell phone pricing• 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.

• The Philippine market was quickly approaching the crucial 10% penetration point.

• At which this Rule of Thumb applies: the firm w/ 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

Cell phone pricing (cont.)• The company was worried, however, about the consumer response, and potential fallout, due to discriminatory pricing

Introduction: Pricing schemes

• This chapter looks at ways of (profitably) designing and implementing price discrimination schemes.

• So that sellers can charge different prices to different consumers based on differences in consumer demand.

• This allows sellers to increase profit above the profit available from setting a single, uniform price.

Pricing tradeoff & discrimination

• Frequently there is a pricing tradeoff based on simple demand curves:

• Lower price sell more, but earn less on each unit sold

• Higher price sell less, but earn more on each unit sold

• Marginal analysis tells us how to optimize around this tradeoff: MR=MC (P-MC)/P=1/|e|

• Price discrimination allows sellers to avoid the tradeoff

• Higher prices for some

• Lower prices for others

Why (price) discriminate?• Example: a simple demand curve

• Seven consumers willing to pay {$7,$6,$5,$4,$3,$2,$1}

• Marginal Cost of the good= $1.50• Optimal price is $5

• At a price of $5, low-value consumers, {$4, $3, $2, $1}, don’t purchase• Even though their values are above the MC• This leaves unconsummated wealth-creating

transactions!

• If a separate price is set for this group, i.e. price at $3 and sell 2 extra units, firm profit increases, and more customers are served.

Price discrimination• Motivation: price discrimination allows a firm to sell

items to low-value customers who otherwise would not purchase because the price is too high (the firm consummates a wealth-creating transaction!)

• Definition: Price discrimination is the practice of charging different prices that are not cost-justified to different people

• P1/MC1 P2/MC2.

• Price discrimination allows two optimal prices to be set for two groups with different levels of price elasticity:• (P1-MC1)/P1=1/|elasticity1|

• (P2-MC2)/P2=1/|elasticity2|

Price discrimination

• The bigger the difference between group elasticities, the more profit there is in designing a price discrimination scheme.

• To price discriminate • ID different groups with different price elasticities

or different values

• Find a way to prevent arbitrage

• Direct Price Discrimination occurs when you can:• ID members of the low-value group can be

identified

• Charge low-value costumers a lower price

• Prevent resale (arbitrage) to higher-value consumers.

• Indirect Price Discrimination occurs when you:• Cannot ID members of groups; OR cannot prevent

arbitrage• Instead, discriminate by offering two products, a

higher-priced, higher-quality good and a lower-priced, lower-quality good.

Direct or indirect pricing schemes?• Tickets to a movie theaters (senior citizen discount,

student discount, etc.) • Grocery stores (discount coupons, in-store or in

weekly newspaper inserts)• Airlines (business vs. economy tickets)• Describe a price discrimination opportunity facing

your company

Price discrimination (cont.)

The Robinson-Patman Act (US) • 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

Pricing for laptops• 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 pricing scheme allows Dell to sell identical computers at different prices based on the consumers’ price sensitivity.

Back to cell phone pricing• The cell phone manufacturer, IRK, reduced prices

in Philippines to $90

• PROBLEM: the Philippine phones used the same standard (GSM) as higher-priced European phones • 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

IRK’s cell phone pricing (cont.)

• In 1998, IRK sold 200,000 phones to Philippines – much better than the 50,000 units they would have sold without price discriminiation

• IRK’s market share went from 10% to 25% in one year

• 1999, IRK returned to global uniform pricing • Competitors followed, and raised prices as well.

• In 2000, the Phillipines cell phone penetration reached 12% and IRK market share rose to 34%

Warning: only schmucks pay retail

• Consumers do not like knowing they are paying higher prices than others.

• 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.

Alternate intro anecdote: medical test strips• In Northern Europe (Ger., Holland and

Scandinavia)• 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

North/South Europe price discrimination implementation

• 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).

Anecdote: conference pricing• The American Association for Clinical Chemistry (AACC)

sponsors 3-day conferences

• 90% of the attendees from same city or surrounding region

• Foreign participants• Greater travel costs

• Longer travel times

• Applying and interviewing for travel visas

• The majority attend conferences in own countries

• To increase attendance, the AACC proposed reducing price to foreign participants

• QUESTION: HOW DID THEY PREVENT ARBITRAGE?

201. Introduction: What this book is about2. The one lesson of business3. Benefits, costs and decisions4. Extent (how much) decisions5. Investment decisions: Look ahead and reason back6. Simple pricing7. Economies of scale and scope8. Understanding markets and industry changes9. Relationships between industries: The forces moving us towards long-run equilibrium10. Strategy, the quest to slow profit erosion11. Using supply and demand: Trade, bubbles, market making 12. More realistic and complex pricing13. Direct price discrimination14. Indirect price discrimination15. Strategic games16. Bargaining 17. Making decisions with uncertainty 18. Auctions19. The problem of adverse selection20. The problem of moral hazard21. Getting employees to work in the best interests of the firm22. Getting divisions to work in the best interests of the firm23. Managing vertical relationships24. You be the consultantEPILOG: Can those who teach, do?

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