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Lecture 5: Price Discrimination. AEM 4160: Strategic Pricing Prof. Jura Liaukonyte. Lecture Plan. HW1, HW2 Second degree price discrimination Designing pricing plans for consumers to self-select themselves Examples Third degree price discrimination Market segmenting Examples.

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lecture 5 price discrimination

Lecture 5: Price Discrimination

AEM 4160: Strategic Pricing

Prof. Jura Liaukonyte

lecture plan
Lecture Plan
  • HW1, HW2
  • Second degree price discrimination
    • Designing pricing plans for consumers to self-select themselves
    • Examples
  • Third degree price discrimination
    • Market segmenting
    • Examples
second degree price discrimination principles
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.

price discrimination based on self selection
Price Discrimination Based on Self-Selection
  • Often firms cannot distinguish between groups of consumers based on observable characteristics
  • Price discrimination may still be possible
  • Offer a menu of alternatives
    • If properly designed, customers with different willingness to pay will choose different alternatives
  • A common practice
    • Examples: supermarket discounts for shoppers who clip coupons, wireless phone companies with multiple calling plans



Coupons distributed in the first half of 2009 increased 12% while the number of coupons redeemed increased 19%

Internet coupons, not favored but on the rise (83% increase since 2005)

75% of coupon users say the coupons had at least some influence on their decision to purchase a new product



  • A form of second-degree price discrimination
  • Used to reduce heterogeneity in consumer search costs
  • Enables retailers to attract informed customers by discounting

Beyond the Many Faces of Price: An Integration of Pricing Strategies

coupons and income
Coupons and Income
  • Trends relating to newspaper readership provide some explanation for this imbalance. 
  • According to Scarborough Research, better educated and higher income households buy and read the newspaper more than others and newspapers remain a key vehicle for delivering coupons.
  • Additionally, promotions are generally targeted in areas with more affluent consumers.
  • In essence, the better educated and more affluent consumers are much better at looking for deals as they recognize the value of money.
more types of second degree price discrimination
More types of second degree price discrimination
  • 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.
two part tariffs14
Two-Part Tariffs
  • A two-part tariff is a lump-sum fee, p1, plus a price p2 for each unit of product purchased.
  • Thus the cost of buying x units of product is p1 + p2x.
two part tariffs15
Two-Part Tariffs
  • p1 + p2x
  • Q: What is the largest that p1 can be?
two part tariffs16
Two-Part Tariffs
  • p1 + p2x
  • Q: What is the largest that p1 can be?
  • A: p1 is the “entrance fee” so the largest it can be is the surplus the buyer gains from entering the market.
  • Set p1 = CS and now ask what should be p2?
two part tariffs17
Two-Part Tariffs
  • The monopolist maximizes its profit when using a two-part tariff by setting its per unit price p2 at marginal cost and setting its lump-sum fee p1 equal to Consumers’ Surplus.
profit with a two part tariff
Profit with a Two-Part Tariff
  • Per-unit charge equals marginal cost
  • Fixed fee is the consumer’s surplus at that per-unit price
  • Maximizes aggregate surplus
  • Leaves the consumer no surplus


two part pricing
Two-part pricing
  • Jazz club serves two types of customer
    • Old: demand for entry plus Qo drinks is P = Vo – Qo
    • Young: demand for entry plus Qy drinks is P = Vy – Qy
    • Equal numbers of each type
    • Assume that Vo > Vy: Old are willing to pay more than Young
    • Cost of operating the jazz club C(Q) = F + cQ
two part pricing20
Two-Part Pricing



The entry charge

converts consumer

surplus into profit

Set the unit price equal

to marginal cost

This gives consumer

surplus of (Vi - c)2/2




Set the entry charge

to (Vi - c)2/2


Vi - c


Profit from each pair of Old and Young is now d = [(Vo – c)2 + (Vy – c)2]/2

clearvoice wireless example
Clearvoice Wireless Example
  • Clearvoice is a wireless telephone monopolist in a rural area
  • Two types of consumers, high-demand and low-demand
    • Distinct monthly demand curves for wireless minutes for each group
  • Clearvoice’s marginal cost is 10 cents
clearvoice wireless example23
Clearvoice Wireless Example
  • If could observe consumer characteristics, would offer two-part tariff with 10-cent per-minute price
    • Fixed fee for low-demand customers: $8 =(40*.4)/2
    • Fixed fee for high-demand customers: $40.50 = (90*.9)/2
profit maximizing two part tariff
Profit-Maximizing Two-Part Tariff
  • Suppose Clearvoice wants to offer a single two-part tariff
  • Per-minute price of 10 cents and monthly fee of $40.50
    • High-demand customers accept
    • Low-demand customers reject
  • Per-minute price of 10 cents and monthly fee of $8
    • All consumers accept
  • Which plan is better?
    • If there are a large number of low-demand customers, $8 monthly fee is better
profit maximizing two part tariff25
Profit-Maximizing Two-Part Tariff
  • If the monopolist plans on selling to both types of consumers it is always profitable to raise the per-unit price at least a little above marginal cost
    • Regardless of the types’ relative proportions
  • INTUITION: Would like to extract some of high-demand consumers’ surplus without changing surplus of low-demand consumer (already zero)
    • Raise per-unit price to get more surplus from high-demand consumers
    • Adjust fixed fee so low-demand consumers’ surplus is unchanged
  • The smaller the faction of low-demand consumer, the more worthwhile it is to raise the per-unit price
using menus to increase profit
Using Menus to Increase Profit
  • Can do even better by offering a menu of two-part tariffs, each designed to attract a specific type of consumer
    • Extract more surplus from high-demand consumers by making the low-demand plan less attractive to high-demand customers
high demand consumers
High-Demand Consumers
  • Suppose Clearvoice offers a pair of two-part tariffs
  • One designed for low-demand consumers:
    • Per-minute price of 20 cents, fixed fee of $4.50
  • Second option intended to attract high-demand customers:
    • Per-minute price of 10 cents, equal to Clearvoice’s marginal cost
    • Fixed fee should be set as high as possible without causing high-demand consumer to choose the other plan
  • With menu of plans:
    • Firm profits are higher from high-demand consumers
    • Profits from low-demand consumers are the same
making the low demand plan less attractive
Making the Low-Demand Plan Less Attractive
  • Can increase profit even more by making the low-demand plan less attractive to high-demand consumers
    • That plan determines the fixed fee the firm can charge a high-demand consumer
    • It is the level that makes the high-demand consumer indifferent between the two plans
  • Limit the number of minutes a consumer can purchase in the 20-cent-per-minute plan
    • Set the limit equal to the number low-demand consumers want
    • Will have no effect on value a low-demand consumer derives
    • Make the plan less attractive to high-demand customers
    • Will increase the fixed fee Clearvoice can charge high-demand consumers for the 10-cent-per-minute plan
menu of two part tariffs32
Menu of Two-Part Tariffs
  • A firm can often profit by offering a menu of choices
    • Designed for different types of consumers
  • To maximize its profits, firm should try to make each plan attractive to one group only
    • And unattractive to other consumer groups
  • Firm benefits from setting the per-unit price in the plan intended for consumers with the highest willingness to pay equal to the marginal cost