PART III PRICE AND NON-PRICE STRATEGIES III.1 PRICE DISCRIMINATION

PART III PRICE AND NON-PRICE STRATEGIES

III.1 PRICE DISCRIMINATION

- So far, uniform pricing.

- Price discrimination:

o Different unit prices for different units of the same good

o Can be based on quantities, consumers’ characteristics, selling conditions

- In a competitive market:

o In theory, no discrimination. Otherwise, arbitrage.

- In practice, we observe price discrimination o Imperfect information on prices?

o High transaction costs?

o For services, arbitrage can be technically unfeasable (ex. Haircut) o Arbitrage is sometimes illegal (drugs in the US vs. Canada)

- Price discrimination versus production costs differences

o To check whether there is price discrimination, compare relative prices to relative marginal costs

o Difference between 1^st and 2^nd class, between soft-cover and hard-cover books

III. 1. 1 CLASSIFICATION

- 3^rd-degree price discrimination

o based on indicators, market segmentation

o examples

! country-specific prices

! member-specific prices

! student-specific prices / elderly-specific prices

- 2^nd-degree price discrimination

o based on self-selection.

o The producer knows that there are different groups of consumers but he is unable to tell them apart.

o Menus leading to self-selection:

! Price/quantity

! Price/selling conditions

o Examples

! Flights

! Sales

! Utilities

! 3 products for the price of 2

- 1^st-degree price discrimination

o Perfect price discrimination

o Each consumer pays his maximum WTP

o Producer extracts the consumers surplus completely

o Examples

! Piano lessons

! Lawyer

! Customer markets

III. 1. 2 THIRD-DEGREE PRICE DISCRIMINATION (INDICATORS)

- Market segmentation - Example

o Relative markup for cars in the EU: (P – c) / c

Belgium France Germany Italy UK

Fiat UNO 7.6 8.7 9.8 21.7 8.7

Peugeot 405 9.9 13.4 10.2 9.9 11.6

Mercedes 190 14.3 14.4 17.2 15.6 12.3

(Frank Verboven) - Interpretation

- The Model

o 1 monopoly, 2 markets (i = 1, 2)

o Π (p₁ + p₂) = p₁ D₁ (p₁) + p₂ D₂ (p₂) – c ( D₁ (p₁) + D₂ (p₂))

o FOC

o p₁ s.t. D₁ (p₁) + p₁ D’₁ (p₁) – c D’₁ (p₁) = 0 o p₂ s.t. D₂ (p₂) + p₂ D’₂ (p₂) – c D’₂ (p₂) = 0

o INVERSE ELASTICITY RULE

o

€

p₁ −c

p₁ = 1 ε₁

€

p

− c

p

= 1

ε

- With 3^rd-degree price discrimination:

o Prices are higher on markets with a lower price elasticity of demand.

- Examples

o Students-specific prices

o Drug prices as a function of insurance reimbursements

- Compared with a situation where prices are uniform

o Who win, who loose?

o Total welfare, total quantities

III. 1. 3 NON-LINEAR PRICING (SELF-SELECTION)

- Consumers decide whether to buy or not AND in what quantity.

- Examples

! Utilities

! Size of a drink

! Size of an icecream

- 2-part tarif (the simplest version)

! Expense = f + p q

! Unit price = p + f/q, non-linear

! Consumers are identical

! The profit-maximizing price scheme is p = c and f = CS (c) P  

Q   c  

- The general result

! With a 2-part tarif, a monopoly sets f > 0 and P < P^M.

! The total surplus is higher than under uniform pricing.

! At the consumers expense

- With several types of consumers

! Big consumers and other consumers

! Consumers can choose between different menus

! Examples: cell phones, internet, insurance

! Consumers differ in the utility they obtain from their consumption, reflected in their consumers surplus

! 2 types of consumers: 1 and 2, with CS₁ (P) < CS₂ (P)

- If the monopoly knows how is how,

! P₁ = c and f₁ = CS₁ (c) for type-1 consumers

! P₂ = c and f₂ = CS₂ (c) for type-2 consumers

- But, everyone would buy the scheme designed for type 1 because

! P₁ = P₂

! f₁ < f₂

- New price schemes, accounting for

! Incentive-compatibility constraint

! Participation constraint

! P₁ > c and f₁ = CS₁ (P₁)

! P₂ = c and f₁ < f₂ < CS₂ (P₂)

! Self-selection!

- Compared with the case with only one type of consumers

! P₁ > c " efficiency loss

! f₂ < CS₂ (P₂) " Monopoly profits are lower

III. 1. 4 OTHER DISCRIMINATING STRATEGIES

- Quality discrimination

! Examples: Flights with selling conditions, 1^st versus 2^nd class

! Different prices that are not motivated by different costs

! Only aim: discrimination

o Total welfare? Pareto-improvement?

! For the monopoly, ok

! For the consumers with a low valuation, ok (low quality better than ∅)

! For the consumers with a high valuation, ok (price is not too high because of self-selection)

- Bundling - Examples

! Movie distribution

! Xerox machines and maintenance

! Software - Illustration

Consumer type # WTP for text processor WTP for spread sheet editor

Writer 40 50 0

Book-keeper 40 0 50

Generalist 20 30 30

Assume production costs are zero.

3 scenari:

o Price of each software = 50

! Π = 2.000 + 2.000 = 4.000 o Price of each software = 30

! Π = 1.800 + 1.800 = 3.600 o Price of each software = 50

Price of the set of 2 softwares = 60

! Π = 2.000 + 2.000 + 1.200 = 5.200

- Here, discrimination Pareto-dominates uniform pricing.

- Durable goods

! The timing of purchases is important

! Ideally, high prices at the beginning to sell to high-valuation consumers, and low prices later on to attract lower-valuation consumers

! But, high-valuation consumers who are patient enough want to wait because rational anticipation of future lower prices

! Monopoly profits may be lower if it is possible to time-discriminate: the monopoly may prefer to sell to high-valuation consumers only at a high price than to sell to everyone at a low price

! One remedy: Commit to pay back any price difference in case of a future decrease in price (Chrysler)

- III. 1. 5 THE TOTAL SURPLUS

Monopoly uniform pricing versus perfect discrimination:

- Total surplus is higher with discrimination - CS is lower

- Different prices for different consumers

- Market coverage is higher under discrimination Trade-offs:

- Efficiency versus CS

- Fairness, equality versus accessibility

Moreover, in general

- Efficiency may actually decrease if discrimination is costly. In that case, the gains for the producer do not compensate the losses for the consumers.

- Discrimination may Pareto-dominate uniform pricing (see bundling and differentiated qualities)

- Total surplus increases only if total quantity increases