MBA 201 a Price Discrimination Note for pricing

MBA 201 a: Price Discrimination* * Note for pricing projects: This is the beginning of the “advanced pricing” material.

Basic price discrimination Definition: A firm is price discriminating if it is selling goods at prices that differ by more than the firm’s marginal costs of producing the goods. – One important example is selling the same good for different prices. – Cost-based price differences are not considered price discrimination (e. g. price differences based on transportation costs). Professor Wolfram MBA 201 a - Fall 2009 Page 1

When can a firm price discriminate? A firm’s ability to price discriminate is hampered if: – Consumers can arbitrage price differences, for instance by reselling the good to other consumers. – It faces competition from other firms providing perfect or near -perfect substitutes. – It faces legal restrictions (more on this later). Professor Wolfram MBA 201 a - Fall 2009 Page 2

One type of price discrimination P MC D Q - Each consumer is charged his or her willingness to pay. - Often done through negotiation. - Called “perfect” or “first-degree” price discrimination. Professor Wolfram MBA 201 a - Fall 2009 Page 3

The effects of perfect price discrimination P MC D MR Professor Wolfram MBA 201 a - Fall 2009 Q Page 4

The effects of perfect price discrimination P Profits at monopoly price* MC D MR Q *Assuming no fixed costs Professor Wolfram MBA 201 a - Fall 2009 Page 5

The effects of perfect price discrimination P Profits from perfect price discrimination MC D MR Professor Wolfram MBA 201 a - Fall 2009 Q Page 6

Effects of price discrimination in general – The seller gains: revenue and profits go up. – The low-price buyer often gains, since under monopoly pricing he would have been priced out of the market. – The high-price buyer often loses, since he is charged a higher price. – On net, it is not clear whether this is good or bad for society as a whole. It depends! Professor Wolfram MBA 201 a - Fall 2009 Page 7

Types of price discrimination 1. First-degree PD: charge every consumer his or her willingness to pay. 2. Third-degree PD: sort customers into several groups based on observable, exogenous characteristics. 3. Second-degree PD: present all customers with a menu of prices and allow the customers to self-select. Professor Wolfram MBA 201 a - Fall 2009 Page 8

Discrimination among groups: 3 rd degree PD – Firm must be able to identify the different segments (e. g. require student id for student discount, driver’s license for senior-citizen discount). – Rule: different elasticities different prices • Recall the “elasticity rule” from our discussion of monopoly prices. • Here it means that the firm should set higher prices in less elastic market segments. Professor Wolfram MBA 201 a - Fall 2009 Page 9

Markups on European cars Model Belgium France Germany Italy UK Fiat Uno 7. 6 8. 7 9. 8 21. 7 8. 7 Fiat Tipo 8. 4 9. 2 9. 0 20. 8 9. 1 Ford Escort 8. 5 9. 5 8. 9 11. 5 13. 0 9. 2 9. 5 9. 0 Renault 19 8. 9 Professor Wolfram MBA 201 a - Fall 2009 Page 10

Second-degree price discrimination Basic idea: Present consumers with a menu of (price, quality) pairs and let them sort themselves into groups. – A consumer’s willingness to pay for quality should be correlated with his or her willingness to pay a high price for the underlying good. – Examples: • Retail: Old Navy, Gap and Banana Republic jeans. • Airlines: first class and coach seats. Professor Wolfram MBA 201 a - Fall 2009 Page 11