1 economics 3200m lecture 8 march 9, 2011. 2 price discrimination sale of identical good/service at...

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ECONOMICS 3200MLecture 8

March 9, 2011

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Price Discrimination

• Sale of identical good/service at different prices to different buyers or at different prices to same buyer

• Alternative form of price discrimination– Different bundles of features/characteristics and

different prices

– Hotels: suites, singles, doubles, floor level, other amenities (access to lounge, health clubs; breakfast included; priority check-in)

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• Conditions for price discrimination– Firm must have some degree of market power

– Firm must be able to infer each consumer’s willingness to pay– Firm must be able to prevent arbitrage

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• First degree price discrimination – perfect price discrimination– Each unit sold at a different price – extract all consumer surplus

– Difference between maximum price consumer willing to pay for product and actual price paid; at each price for a particular product, each person that purchases the product gains a different value of consumer surplus – different willingness to pay for a product

– Potential for market segmentation and price discrimination companies can exploit differences among consumers to increase their revenues and profits

– Auctions – eBay

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• Second degree– Nonlinear pricing– Two-part tariffs – fixed price (entry/membership fee) + usage fee– T(Q) = A + PQ, where A = CS/N [CS is aggregate consumer

surplus, N is the total number of consumers with each one buying only one unit]

• Preceding graph: fixed price = consumer surplus, and usage fee = P100

– With large numbers of consumers – trade-off between entry fee and usage fees

• Large entry fee locks in consumers, reduces potential market; but corresponding low usage fee makes entry less attractive consider what has happened to pricing for cell phones

• Multiple entry/usage fee combinations self selection by consumers

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Second degree• Examples:

– Membership in golf clubs

– Taxis

– Utilities: electricity, water/sewer rates

– Cell phone plans

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• Third degree price discrimination • Aggregate demand can be divided into N distinct segments

on basis of exogenous information (signals reflecting consumer preferences, market research) – different preferences reflected in different elasticities of demand

• Different prices to different groups of buyers (independent demands, interdependent cost model for monopolist)

• Prices differ on basis of signals related to perceived consumers’ preferences (age, location, occupation, income, ethnicity, etc.)

• Consumers on different demand curves as compared to first degree where consumers are at different positions on the same demand curve

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Third degree price discrimination• [Pi – MC]/Pi = 1/i higher prices in markets with lower

elasticities of demand

• Rule of thumb pricing: P1/P2 = (1 + 1/ 2)/(1 + 1/ 1)

• Price discrimination may enable monopolist to survive – example (MR1 = MR2 = … MRN = MC

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Third degree price discrimination• Movie theaters – special rates for seniors, children

• Frequent user programs

• Wealth management

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Third degree price discrimination• Same delivered price for customers

– Freight absorption by producer

– Customers located farther from production/distribution (warehouse) facility may have alternative suppliers thus more elastic demand

• Other examples– Monthly vs. hourly parking rates

– Metro Pass vs. single fare

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Second degree plus• Different bundles

– Inter-temporal pricing – peak/off-peak pricing– Product and time comprise bundle– MC may differ between peak and off-peak periods thus not the

same as 3rd degree price discrimination which assumes same MC for product

– Inter-temporal pricing – fashion/technology– Price decreases over time – consumers who are impatient or

fashion/status conscious willing to pay higher price than consumers who are patient or less fashion/status conscious

• If learning curve for producer: MC declines over time so dissimilar from 3rd price discrimination

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Second degree plus• Mixed bundling

• Examples:– Tour packages vs. buying travel, accommodation, ground travel,

food, entertainment separately

– Subscriptions vs. single purchase – theaters, magazines

– CATV – tiering of services

– Dell, Air Canada

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• Mixed bundling strategy: 4 consumers, 2 goods– Reservation prices

• Consumer A: $90 for good 1, $10 for good 2• Consumer B: $50 for good 1, $50 for good 2• Consumer C: $40 for good 1, $60 for good 2• Consumer D: $10 for good 1, $90 for good 2

– MC1 = $20, MC2 = $30– Pricing strategies:

• Bundling: Price for 1 unit of both good 1 and 2 = $100• Profit: All 4 consumers buy bundle; profit = $200 = 4(100-20-

30)• Mixed bundling: P1 = P2 = $89.95 or price for 1 unit of both =

$100• Profit: A buys good 1, D buys good 2, C & D buy bundle;

profit = $229.50 = (89.95-20) + (89.95-30) + 2(100-20-30)

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• Price discrimination in intermediate products when large customer has bargaining advantage– Large customer may be able to integrate upstream (internalize) –

implications for competition in downstream market

– Price discrimination (i.e. price concessions) depends upon credibility of backward integration

– Bank loans: large firms charged lower interest rates because they have direct access to commercial paper and bond markets

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Arbitrage• If transactions costs between consumers small relative to price of product,

consumers who are able to pay low price buy extra quantities and re-sell to consumers who are willing to pay and are charged higher prices

• Scalping – opportunity cost of time

• International price discrimination (dumping) and possibility for arbitrage – transactions costs include transportation costs, tariffs, reputation

• Limit arbitrage– Services cannot be resold – entertainment services, telecom services exceptions

– Warranties valid only for original buyers

– Different bundles/prices

– Signals

– Vertical integration

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• Vertical integration example to prevent arbitrage

• Monopolist produces good used as input by two separate industries

• Elasticities of demand for input in 2 industries: 1 > 2

– P1 < P2

• To prevent arbitrage– Monopolist buys firm in industry 1 and sells only to this firm in this

industry and sells to all firms in industry 2 at P2

– Other firms in industry 1 will be driven out of business

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• Tying – generalized form of bundling

• Consumer buys one product only if another product also purchased

• Products bought/sold in combination– Apple: hardware,peripherals and operating systems

– Mercedes Benz: warranty and services at MB dealers

– Funeral homes: caskets and burial services

– Reasons:• Economies of scope

• 2 separate, but consecutive monopolies in value chain

• Assure quality

• Interrelated demands (independent costs) – complements/substitutes

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Another example of bundling

• Quality discrimination – segment market on basis of preferences for quality/brand names– Offer different combinations of prices/qualities (different brand names)

– Broader product line

– Automobile companies

– Beer companies

– Clothing labels

– Disney studios

– Airlines – United/Ted; Qantas/Jetstar; Cathay Pacific/Dragonair

– Economies of scope – production, marketing, distribution

– Spatial pre-emption – block entry

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Market Segmentation

Market segmentation – price discrimination (telephone companies, airlines, hotels); multiple branding – auto companies; Rogers; Disney movie studios; retail (Banana Republic, GAP, Old Navy, Piperlime); hotels (Hilton – Waldorf-Astoria Collection, Conrad Hotels & Resorts, Hilton, Hilton Garden Inn, Doubletree, Embassy Suites, Hampton Inn, Homewood Suites); beer companies

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Networks

• Bandwagon effects– Aggregate demand: effects of price changes and bandwagon

effects [see diagram]

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P

Q

P0

P1

10 20

D10

30

D20

AD

QN

Price effect Bandwagon effect

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Networks

• Networks – externalities– PCs and software, smartphones and apps, game stations and games,

tablets and apps; wireless networks

– Economies of scope and scale

• Demand per period depends on price and cumulative sales (total number of customers/users)

• Expectations regarding future size of network influences demand today for longer-lived products

• Direct network effects– Benefit to network user depends on how may other users are connected

via the network

• Indirect effects– Benefit to users because size of network affects price and availability of

complementary products

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Networks

• Direct network effects– Size of network depends on economies of scale, externalities of

additional connections

• Indirect effects– Economies of scale in production of complementary products– Similar in non-network industries – demand for complementary

products depends on total number of consumers

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Networks• Strategic use of tie-in sales and product design• Product compatibility reduces price competition• Tipping point for networks – if one network overtakes another in

terms of size, the other may become insignificant– VHS and Beta formats for video recording– Apple and DOS operating systems– Plasma vs. LCD for flat screen TVs– Sony (Play Station), Microsoft (X-box), Nintendo– Bluray and HD DVD

• Use standard setting process to gain advantage for one technology/network

• Announcements of future product availabilities (software) compatible with a technology

• Switching costs – incentive to develop new products/services which appeal to new customers because existing customers locked in– Upgrades – software

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Networks

• Hub and spoke networks – telecommunications, airlines– Cost efficiencies

– Demand side effects

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Pricing

• Market power – short-term, longer-term

• Product characteristics – commodity vs. differentiated; network– Basis for competition

– Cooperative behavior

• Market segments – ability to price discriminate

• Uncertainty re. demand curve (position, shape); competitors’ responses; costs

• Complementary goods – vertical integration

• Consumer information re. quality, reliability (lemons’ model)

• Economies of scale, scope; experience curves

• Signaling effects of price

• Competition law

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Vertical Controls

• Vertical controls – vertical integration and vertical restrictions– Relationships between upstream and downstream firms

• Vertical integration – firm participates in more than one successive stage of value chain (production/distribution chain)

• Advantages of vertical integration– Internalization

• Lower transactions costs – avoid opportunistic behavior

• Quality control

• Coordination – feeder networks in transportation, JIT delivery

• Uncertainty re. prices, availability

– Assure steady supply of key input

– Avoid government restrictions, regulations, taxes• Regulated utilities and unregulated service companies

• Transfer pricing and allocation of profits

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Vertical Controls

Vertical integration

• Eliminate externalities– Quantity demanded depends upon P and other services provided

– Distribution: free riding among distributors – sub-optimal provision of services (information, sales staff and waiting times, promotional activities, after sales service (credit, free delivery), shelf space

– Maintain reputation for quality by controlling distribution

• Downstream retailer provides services– Q = D(P, S)

– S: level of services

– Costs to retailer: (S) per unit of output

– Total service costs: Q(S)

– Vertically integrated solution: Max = [P – C - (S)] D(P, S)

– Optimal price and service level

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Vertical Controls


• Double monopoly– M has unit costs of C and sells product to R at P* = PM (C) > C

– R incurs no other costs and sells at PM (P*) > PM (C)

– Q[PM (P*)] < Q[PM (C)], so aggregate profits of R and M lower than if single monopoly

– If R operates in competitive environment, no negative externality for M since PC = PM (C)

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P

Q

C

DMR

Q1

P*

Q2

PM (P*)

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Vertical Controls


• Increase market power – foreclose entry, price discrimination– Increase profits when selling product which is combined with another

input (supplied by competitive industry) to produce a final product (also sold by competitive industry) – variable proportions production function; problem does not arise with fixed proportions P.F

• Without vertical integration, competitive industry substitutes other input for input supplied by monopolist

• Higher costs for downstream firm because input sold by monopolist at P > MC

– Close distribution channels, lock up key suppliers

– Interbrand competition – set up own distribution network to increase costs of entry

• Ford’s attempt to buy back dealers in order to offset bargaining advantages of large, independent dealers

1 economics 3200m lecture 8 march 9, 2011. 2 price discrimination sale of identical good/service at...

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