MBA 201 a Versioning and Packaging Types of

MBA 201 a: Versioning and Packaging

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 1

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 2

Specific types of second-degree PD Versioning: design product lines that appeal to different consumers. – Examples: student and professional software. Damaged goods: a particular case when the differences between products are obtained by "damaging" basic product. – Examples: Intel’s 486 chip, U. S. Postal Service. Professor Wolfram MBA 201 a - Fall 2009 Page 3

Second-degree PD example (versioning 1. 0) Willingness to pay for ticket Type of Consumer # of cons (unrestricted) (Saturday-night stay) Tourist 10 $300 Businessperson 8 $800 $400 Strategy 1: Offer all tickets at price $300 Total revenue = $300 10 + $300 8 = $5, 400 Strategy 2: Offer only unrestricted tickets at price $800 Total revenue = $800 8 = $6, 400 Strategy 3: Offer Saturday-night-stay at price $300, unrestricted at price $800 Will the businessperson buy the unrestricted ticket? Professor Wolfram MBA 201 a - Fall 2009 Page 4

Second-degree PD example (versioning 2. 0) Willingness to pay for ticket Type of Consumer # of cons (unrestricted) (Saturday-night stay) Tourist 10 $300 Businessperson 8 $800 $400 Strategy 3: Offer restricted tickets at price $300, unrestricted at price $800 DOESN’T WORK. Businessperson wont buy the unrestricted ticket. Strategy 4: Offer restricted tickets at price $300, unrestricted at price $699 Total revenue = $300 10 + $699 8 = $8, 592 Professor Wolfram MBA 201 a - Fall 2009 Page 5

Second-degree price discrimination principles Induce customers to select into high and low price groups themselves. Key constraint: you can’t make the inexpensive version too attractive to those willing to pay more. If there aren’t many customers in the low-valuation group, you may want to ignore this group, since selling to it forces you to lower the price to the high valuation group. Professor Wolfram MBA 201 a - Fall 2009 Page 6

More types of second degree price discrimination Intertemporal price discrimination – Idea: high valuation users are also less patient. Quantity discounts (price per unit depends on the quantity bought). – Idea: high valuation consumers willing to pay more for more. Multiple two-part tariffs – Examples of two-part tariffs: cell phone plans with monthly and per minute fees. – Idea: separate between low volume users and high volume users. Professor Wolfram MBA 201 a - Fall 2009 Page 7

Takeaways – Firms would prefer to use perfect (aka first-degree) price discrimination, but this may be impossible. – Third-degree PD is one way to approximate perfect PD, but requires that firms can separately identify members of high and low value groups. – Second-degree PD induces customers to sort themselves into groups. – Recall the no arbitrage constraint—consumers can’t resell to others. – Price discrimination and other advanced pricing strategies are powerful tools; you now have the economic models to understand them. Professor Wolfram MBA 201 a - Fall 2009 Page 8