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AEM 4160: STRATEGIC PRICING PROF.: JURA LIAUKONYTE LECTURE 6 THIRD DEGREE PRICE DISCRIMINATION BUNDLING AND TYING. Third Degree PRICE DISCRIMINATION. Third-degree price discrimination. Consumers differ by some observable characteristic(s)

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AEM 4160: STRATEGIC PRICINGPROF.: JURA LIAUKONYTELECTURE 6THIRD DEGREE PRICE DISCRIMINATIONBUNDLING AND TYING



Third degree price discrimination1
Third-degree price discrimination

  • Consumers differ by some observable characteristic(s)

  • A uniform price is charged to all consumers in a particular group – linear price

  • Different uniform prices are charged to different groups

    • subscriptions to professional journals [library/student]

    • airlines

      • the number of different economy fares charged can be very large indeed!

    • early-bird specials; first-runs of movies


Third degree price discrimination2
Third-degree price discrimination

  • The pricing rule is very simple:

    • consumers with low elasticity of demand should be charged a high price

    • consumers with high elasticity of demand should be charged a low price


Third degree price discrimination example
Third degree price discrimination: example

  • Harry Potter volume sold in the United States and Europe

  • Demand:

    • United States: PU = 36 – 4QU

    • Europe: PE = 24 – 4QE

  • Marginal cost constant in each market

    • MC = $4


The example no price discrimination
The example: no price discrimination

  • Suppose that the same price is charged in both markets

  • Use the following procedure:

    • calculate aggregate demand in the two markets

    • identify marginal revenue for that aggregate demand

    • equate marginal revenue with marginal cost to identify the profit maximizing quantity

    • identify the market clearing price from the aggregate demand

    • calculate demands in the individual markets from the individual market demand curves and the equilibrium price


The example
The example

United States: PU = 36 – 4QU

Invert this:

QU = 9 – P/4 for P< $36

At these prices only the US market is active

Europe: PU = 24 – 4QE

Invert

QE = 6 – P/4 for P< $24

Aggregate these demands

Q = QU + QE = 9 – P/4 for $24 <P< $36

Now both markets are active

Q = QU + QE = 15 – P/2 for P < $24


The example1
The example

Invert the direct demands

$/unit

P = 36 – 4Q for Q <3

36

P = 30 – 2Q for Q > 3

Marginal revenue is

MR = 36 – 8Q for Q< 3

17

MR = 30 – 4Q for Q> 3

Demand

MR

Set MR = MC

MC

Q = 6.5

6.5

15

Quantity

Price from the demand curve

P = $17


The example2
The example

Substitute price into the individual market demand curves:

QU = 9 – P/4 = 9 – 17/4 = 4.75 million

QE = 6 – P/4 = 6 – 17/4 = 1.75 million

Aggregate profit = (17 – 4)x6.5 = $84.5 million


The example price discrimination
The example: price discrimination

  • The firm can improve on this outcome

  • Check that MR is not equal to MC in both markets

    • MR > MC in Europe

    • MR < MC in the US

    • the firms should transfer some books from the US to Europe

  • This requires that different prices be charged in the two markets

  • Procedure:

    • take each market separately

    • identify equilibrium quantity in each market by equating MR and MC

    • identify the price in each market from market demand


The example3
The example

$/unit

Demand in the US:

36

PU = 36 – 4QU

Marginal revenue:

20

MR = 36 – 8QU

Demand

MR

MC = 4

4

MC

Equate MR and MC

4

9

Quantity

QU = 4

Price from the demand curve

PU= $20


The example4
The example:

$/unit

Demand in the Europe:

24

PE = 24 – 4QE

Marginal revenue:

14

MR = 24 – 8QE

Demand

MR

MC = 4

4

MC

Equate MR and MC

2.5

6

Quantity

QE = 2.5

Price from the demand curve

PE= $14


The example5
The example

  • Aggregate sales are 6.5 million books

    • the same as without price discrimination

  • Aggregate profit is (20 – 4)x4 + (14 – 4)x2.5 = $89 million

    • $4.5 million greater than without price discrimination


Some additional comments
Some additional comments

  • Suppose that demands are linear

    • price discrimination results in the same aggregate output as no price discrimination

    • price discrimination increases profit

  • For any demand specifications two rules apply

    • marginal revenue must be equalized in each market

    • marginal revenue must equal aggregate marginal cost


Price discrimination and elasticity
Price discrimination and elasticity

  • Suppose that there are two markets with the same MC

  • MR in market i is given by MRi = Pi(1 – 1/hi)

    • where hi is (absolute value of) elasticity of demand

  • From rule 1 (above)

    • MR1 = MR2

    • so P1(1 – 1/h1) = P2(1 – 1/h2) which gives

Price is lower in the market with the higher demand elasticity


Takeaways
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 different 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.



Introduction
Introduction

  • Firms often bundle the goods that they offer

    • Microsoft bundles Windows and Explorer

    • Office bundles Word, Excel, PowerPoint, Access

  • Bundled package is usually offered at a discount

  • Bundling may increase market power

    • GE merger with Honeywell

  • Tie-in sales ties the sale of one product to the purchase of another

  • Tying may be contractual or technological

    • IBM computer card machines and computer cards

    • Kodak tie service to sales of large-scale photocopiers

    • Tie computer printers and printer cartridges

  • Why? To make money!


More examples of bundling
More Examples of Bundling

  • Telecommunications

    • firms bundle local, long-distance, and mobile telephone services,

  • Banks

    • bundle checking, credit, and investment services

  • Hospitals bundle an array of medical services.


Incentives to bundle
Incentives to Bundle

  • Bundling may arise in many contexts to sort consumers in a manner similar to second-degree price discrimination

  • When consumers have heterogeneous tastes for several products, a firm may bundle to reduce that heterogeneity, earning greater profit than would be possible with component (unbundled) prices

  • Bundling—like price discrimination—allows firms to design product lines to extract maximum consumer surplus.


Bundling advantages
Bundling advantages

  • Simplifies consumer choice (as in telecommunications and financial services)

  • Reduces costs from consolidated production of complementary products

  • Reduces consumer search costs and product or marketing costs.

  • Bundling to extend market power and/or deter entry

    • as witnessed by antitrust challenges to Microsoft’s bundling of software applications (e.g. its Internet browser, media player) with its dominant Windows operating system


Cable tv
Cable TV

  • Crawford’s (2001) empirical study of bundling decisions of cable providers

  • bundle several networks into a basic bundle service, cable provider increases its profit on average above unbundled sales by 14%

  • 13% less CS than from unbundled sales

  • bundling together similar networks is less profitable than bundling dissimilar ones


Computer software suites
Computer software suites

  • Microsoft and others bundle dissimilar programs—word processors and spreadsheets—into a suite

  • Gandal (2003):

    • survey of home PC users: 43% use both programs;50% used only one; 7% used neither

    • survey business PC users: 63% used both, 37% used only one

    • A lot of users use only one (but not both) pieces of software

    • consumers with a high value for spreadsheets had a low value for word processors and vice versa: negative correlation in demand


Tie in sales
Tie-In sales.

  • Generally considered to be an ‘extension of monopoly’ by courts. In other words, courts believed it was an attempt to use one monopoly to create a second.

  • Frequently, tying good is sold very cheaply, while tied good is very expensive. Famous cases: IBM and computer cards, Xerox and toner, Canning machines and tin plate.


Printers and ink cartridges
Printers and Ink Cartridges

  • High-intensity usage consumers => high willingness-to-pay

  • Low-intensity usage consumers => print small volumes => a low willingness-to-pay.

  • Strategy: lower the price of the initial, one-time purchase printer and raise the price of the aftermarket, repeat purchase ink cartridge.

  • Ink cartridge becomes the mechanism by which consumers' intensity of usage is metered:

    • inducing high-intensity users to pay a higher overall price

    • low-intensity users a lower overall price.


Examples cont d
Examples cont’d

  • This basic idea holds for a variety of other aftermarket situations:

    • razors and razor blades

    • video game consoles and video games

    • etc.


Anti trust and bundling
Anti-trust and bundling

  • The Microsoft case is central

    • accusation that used power in operating system (OS) to gain control of browser market by bundling browser into the OS

    • need\ to show

      • monopoly power in OS

      • OS and browser are separate products that do not need to be bundled

      • abuse of power to maintain or extend monopoly position

    • Microsoft argued that technology required integration

    • further argued that it was not “acting badly”

      • consumers would benefit from lower price because of the complementarity between OS and browser


And now
And now…

  • This view gained more force and support in Europe

    • bundling of Media Player into Windows

    • Competition Directorate found against Microsoft

      • no on appeal


Antitrust and tying arrangements
Antitrust and tying arrangements

  • Tying arrangements have been the subject of extensive litigation

  • Current policy

    • tie-in violates antitrust laws if

      • there exists distinct products: tying product and tied one

      • firm tying the products has sufficient monopoly power in the tying market to force purchase of the tied good

      • tying arrangement forecloses or has the potential to foreclose a substantial volume of trade


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