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Mass Market Pricing. How to price to markets with large numbers of consumers. Looking forward . Concept of mass market demand Relationship between revenue and demand Profit maximising price levels Concept of elasticity Innovative pricing. Playing games with consumers.

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mass market pricing

Mass Market Pricing

How to price to markets with large numbers of consumers

looking forward
Looking forward ...
  • Concept of mass market demand
  • Relationship between revenue and demand
  • Profit maximising price levels
  • Concept of elasticity
  • Innovative pricing
playing games with consumers
Playing games with consumers

(High Margin, Low Consumer Surplus)

Buy

Consumer

Not

($0, $0)

Firm

Choose

Price (same for all)

(Low Margin, High Consumer Surplus)

Buy

Consumer

Not

($0, $0)

roll back
Roll back

Few sales with high margins

Firm

Choose

Price (same for all)

Lots of sales with low margins

posted prices versus negotiation
Posted prices versus negotiation
  • In mass markets, only price-posting may be feasible

 It’s like making a take-it-or-leave-it offer!

  • Consumers whose WTP > p purchase from you
    • If all consumers’ WTPs equal, can extract all the surplus
    • But, if WTPs are different, same p can’t extract all the surplus
when is price posting reasonable
When is price-posting reasonable?
  • Price haggling too costly relative to value of product
    • Large numbers of customers  bargaining is inefficient
  • Information requirements too demanding
    • Do you know buyer’s WTP, in a big anonymous market?
  • Markets are perfectly competitive
    • Bargaining not an issue anyway
  • Price-posting should be efficient
    • Usually, firms post (set) prices
puzzle luxury boxes
Puzzle: Luxury Boxes
  • Among the many decisions made by sports stadium designers is the number of luxury boxes to build
  • Suppose that, for a particular stadium under construction, luxury boxes will be sold outright to local businesses and can be constructed at a cost of $300,000 apiece. The stadium designer plans to build 25 boxes and expects, at this number, to sell each for $1 million, for a net profit of $700,000 x 25 = $17.5m.
  • An associate asserts that this is crazy. Since the box can be built for $300,000 and sold for around $1m apiece, building only 25 leaves money on the table, even if a small price reduction is needed if more are built.
  • Is the associate correct? What if the price to sell 26 is $950,000?
demand curves
Demand curves
  • In mass markets, relevant consumer information summarised by a demand curve
  • A demand curve identifies how many units of product sell at any posted price
  • The market demand curve is derived from the WTPs of all potential consumers
numerical example
Numerical Example
  • 1,000 potential buyers (only interested in a single unit each). Have different WTP ranging from $0 to $999
  • Monopoly seller with constant per-unit cost of $200,
  • Sufficient capacity to supply everyone
  • Question: what quantity maximises monopolist profit?
pooled pricing o ne price fits all
Pooled pricing: “one price fits all”
  • Assume same price charged to everyone
    • This is called “pooled” pricing
    • Reasonable in markets with resale and arbitrage
      • Customers cannot pay different prices
      • Otherwise, ones with low price can re-sell (at profit) to others
    • Later, we relax this assumption
  • The monopolist faces a tradeoff
    • Prices can be increased,
    • But only at the expense of lower sales volume (and, visa versa)
what quantity do you choose
What quantity do you choose?
  • You have a monopoly in this market
    • But, can you do whatever you want?
    • For example, can you sell 800 units at a price of $700?
    • NO
      • You can sell 800 units at $200 per unit
      • Or you can price at $700, and sell 300 units
  • You can choose price OR quantity, but not both!
    • Quantity choices imply prices
    • Price choices imply quantities
    • Pick one or the other(we’ll assume you choose quantity)
changes in total revenue tr
Changes in total revenue (TR)
  • Consider TR as you increase quantity 1 unit at a time
    • To sell 1 unit, price = $999, TR = $999
    • To sell 2 units, price = $998, TR = $998*2 = $1,996
  • Notice that, going from 1 unit to 2 units
    • You have to drop price, which reduces what you get on unit 1
      • You were getting $999
      • Now you get $998
    • But, you get to sell an additional unit at $998
    • Dropping price, you lose $1 TR on unit 1 but gain $998 on unit 2
    • The net effect is an increase in TR of $1,996 – $999 = +$997
  • As quantity increases 1 unit at a time
    • You lose more and more TR from lower prices on previous units
    • You gain less and less on the additional unit sold
    • At some point, the losses exceed the gains!
graphically tr from 4 to 5 units
Graphically: TR from 4 to 5 units

The change in TR going from 4 to 5 units is $991 = 995 – 4

To sell 4 units, price = $996

To sell 5 units, price = $995

P = $996

P = $995

Lose $1 per unit on 4 units

TR = area of rectangle

= 996*4 = 3984

Gain$995on5th

unit

marginal revenue
Marginal revenue
  • The marginal revenue (MR) of the nth unit is the change in total revenue induced by going from the (n – 1)th unit
  • In our example

Here, WTP is low ($600) and the lost revenue on previous units required to get the sale is large ($399) – net effect $201

graphically

MR = $1

MR = – $1

MR = – $3

MR = $3

Graphically

MR = change in TR

  • The marginal revenue of the 500th unit is $1
  • The marginal revenue of the 502th unit is – $3
total cost tc versus marginal cost mc
Total cost (TC) versus marginal cost (MC)
  • Costs can be analysed in exactly the same way
  • The MC of the nth unit is the change in TC induced by moving production from (n – 1) units to n units
    • If you supply 100 units, MC = additional cost of supplying 100 instead of 99
    • In this example, each additional unit costs $200 MC = $200 for any level of production
decision rule mr mc
Decision rule: MR = MC
  • Monopolist should produce as long as doing so is profitable
  • The monopolist wants to continue to expand sales up to the point where the last unit sold adds just enough TR to offset its effect on TC
    • Obviously, if the overall effect on TR does not offset the overall effect on TC, don’t produce it!
    • Profit is maximised by producing 1 unit less than the first unit at which MR – MC < 0
maximising profit
Maximising Profit
  • Marginal Profit

= (Revenue from another unit) - (cost of another unit)

= Marginal Revenue - Marginal Cost

  • When should monopolist supply one more unit?
    • Whenever the marginal profit is positive
    • That is, until marginal profit just-above or equal to 0

Produce so long as MR  MC!

stopping rule for our example
Stopping rule for our example?
  • Each additional unit yields less incremental revenue
  • But each additional unit costs $200
    • Each additional unit increases your total costs by $200
    • Monopolist has constant marginal cost of $200
  • If you earn more than $200 in revenue from increasing output by one more unit, do it!
  • If you earn less than $200, don’t!

 Stop when Marginal Revenue is $200

a snapshot
A Snapshot

MR – MC goes negative here

Stop here

–1

+1

this can also be solved graphically
This can also be solved graphically

Profit maximising price

Point where MR = MC

restricting supply
Restricting supply
  • Motive for restricting supply, under bargaining:

= reducing the bargaining power of buyers

  • Motive for restricting supply, under posted pricing

= capturing more value from buyers with high WTP

marginal thinking
Marginal Thinking

Very powerful: right way to approach any decision in which

  • You can make choices in small increments
  • Each increment brings less benefit

Look at the last increment: is it worth it?

  • Should I study 8 or 9 hours, today?
  • Should I eat another spoonful of ice cream?

Marginal thinking, for the firm:

Should I produce one more unit?

calculus shortcut
Calculus “shortcut”
  • Working through these calculations using the brute-force approach (i.e., unit-by-unit) is tedious, time-consuming and prone to error
  • We can get very good approximations using calculus
    • Cost: learn appropriate calculus rules
    • Benefit: huge reduction in time spent working unit-by-unit cases
  • For those who remember their calculus, cost = 0
  • To proceed, we need to make some simplifying assumptions
a necessary assumption
A necessary assumption
  • To use calculus, must assume price-quantity relationship is “smooth”
  • That is, must assume the relationship
  • P = 1000 – Q
  • holds for all quantities – even non-integer amounts
  • The equation above, called the inversedemand curve, describes price as a function of quantity
  • Demand is actually “lumpy”
  • At P = $999.00, sell 1 units
  • At P = $998.50, sell 1 unit!

P = 1000 – Q

  • In large markets, it is simpler (and close enough)to assume smooth demand
    • At P = $999.00, sell 1 units
    • At P = $998.50, sell 1.5 units
demand inverse demand curves
Demand & inverse demand curves
  • The equation describing price as a function of quantityis called the inversedemand curve
  • The sister equation, describing quantity as a function of price, is called the demand curve
  • If we wish to treat quantity as the choice variable (we do), use inverse demand curve
  • Key difference between lumpy and smooth demand:
    • Tiny change in quantity tiny change in price
    • Indeed, changes can be infinitesimal
    • When quantities are in the millions, increasing demand one unit is close to an infinitesimal change
    • It may help to imagine the product is something divisible into arbitrary quantities, like petrol

P = 1000 – Q

smooth tr curve

$250,000

Total Revenue(smooth version)

Smooth TR curve

Once we assume price is a smooth function of quantity, TR is also a smooth function of quantity

  • TR = Price x Quantity = PQ
  • So, substitute (1000 – Q) in for price (from inverse demand equation) to get TR as a function of quantity only
  • TR = (1000 – Q)Q = 1000Q – Q2

1000Q – Q2

marginal revenue of 500 th unit

$250,000

$1

$249,999

1 unit

Marginal revenue of 500th unit

MR of 500th unit = change in TR, 499 to 500 units = $1

NOTE: 1 = slope of the line through these points on the TR curve (slope = “rise over run”)

But, with smooth TR, quantity increments can be much smaller than 1 unit …

… and, this is useful!

TotalRevenue

maxima of smooth functions
Maxima of smooth functions

The slope of a curve at a point is its instantaneous rate of change at that point(e.g., the change in TR for a minuscule change in quantity)

$250,000

Notice anything special about this line?

$249,999

FACT: The maximum of a function occurs at the point where its slope = 0

FACT: The instantaneous rate of change in TR at a given quantity is the slope of the line tangent to the TR curve at that quantity

TotalRevenue

calculus the management summary
Calculus: the management summary
  • The derivative of a curve at a particular point is the slope of the curve at that point
  • To use calculus, you need to know the rule for finding the derivative
  • Calculus knowledge for Man Ec
    • If y is a function of x, the “derivative of y with respect to x,” denoted y/ x, is the slope of the function – the rate at which y changes with x
    • The only calculus rule you ever need (in this class) is that curves of the form

where a, b and c are constants (may be positive, zero, or negative)

    • Have derivatives of the form
  • So, plug a number in for x to determine the slope of y(x) at that value of x
why calculus is useful
Why calculus is useful

TR = PQ = 1000Q - Q 2

  • To find the slope at any Q, write down the derivative using the “only rule you will ever need”
  • This tells you the slope of the TR curve for any value of Q
  • Total revenue hits its max when the slope = 0
mr and mc with smooth functions
MR and MC with smooth functions
  • MR at a specific Q is equal to the value of the derivative at the quantity
    • From before,
    • E.g., MR at Q = 300 is 1000 – 2*300 = 400
  • The same idea applies to costs
    • TC = 200Q, so, using the “only rule you will ever need”
    • MC at Q = 300 is 200
    • In this case, marginal costs are constant (the same at any level of production)
firm objective maximise profit
Firm objective: maximise profit
  • Now, let’s apply the procedure to find maximum profit (what the monopolist really cares about!)
  • Monopolist wishes to choose optimum Q
    • Profit = TR – TC = (1000Q – Q2) – 200Q = 800Q – Q2
  • Apply the calculus rule to get
  • Calculate where the slope equals 0

Notice: same as the answerobtained using brute-force

graphically1
Graphically

Same principle as before

Profit = 1000Q – Q2

Q*

this can be stated as a marginal rule
This can be stated as a “marginal rule”
  • Marginal profit = 800 – 2Q = (1000 – 2Q) – 200
    • In other words, marginal profit = MR – MC
    • MR = 1000 – 2Q
    • MC = 200
  • To maximise profit, set MR = MC
  • At the ideal output, Q*:

1000 - 2Q* = 200

or

Q* = 400

  • To find ideal price, substitute Q* into the inverse demand function:

P* = 1000 – Q* = $600.

exercise marginal cost
Exercise: marginal cost
  • Same demand curve as before, but now the cost of production is increasing:

Total Cost = 200Q + Q2.

  • What is the cost of producing 30 units? 31 units? What is the marginal cost of the 31st unit?
  • Calculate Marginal Cost, using derivatives. Is your answer for the marginal cost of the 31st unit approximately correct?
  • How much does the monopolist choose to produce?
  • Now suppose that you can sell as much as you want to on the US market, for $900 apiece, but demand in the Australian market is (1000 – P). What do you do?
why split profits into mr and mc
Why split profits into MR and MC?
  • Marginal analysis is a powerful tool, beyond the case of one factory producing for one market
  • If selling in two markets:
    • Equalise the MRs
    • Why? Imagine you sell a fixed quantity (say 180)
      • If MR higher in AU, do better by moving one unit from US to AU
      • This gradually pushes MR down in Australia.
    • Now choose total quantity: set MR = MC
    • Double-check that you want to sell in both markets!
similar plant production levels
Similar: plant production levels
  • Assume 2 factories, 1 in Melbourne and 1 in Geelong:

Total Cost in Factory M = 200QM

Total Cost in Factory G = 150QG + QG2

  • Same demand curve as before (can only sell in AU)
  • How much do you produce in each factory?
  • How about if the total cost in Factory G = 300QG + QG2?
solution same idea as before
Solution: same idea as before

The marginal revenue and marginal cost equations (for each plant) are:

Set MC = MR in both plants, solve for optimal quantities (2 eqs, 2 unknowns):

When the marginal cost in factory G is 300 + 2QG

elasticity

Elasticity

A convenient measure of sensitivity for use in pricing

your demand curve in the real world
Your demand curve in ...the REAL world!
  • Algebraic analysis is useful for building general intuition
  • But not for setting prices in the real world
    • Usually, you don’t know the whole of your demand curve
    • You do know at least one point on your demand curve = demand at the current price
    • You can experiment with slightly higher prices and slightly lower prices, to see how demand changes
    • If you also know your marginal cost, that’s enough to figure out if you should move your price up or down
e lasticity
Elasticity
  • In determining Q & P, it is important to know how sensitive demand is to price changes.
    • If it is relatively insensitive, then by raising price the monopolist does not exclude many buyers
    • If it is relatively sensitive, raising price can exclude many buyers
  • The measure of how sensitive a demand function is to a change in price = “elasticity”
  • Prices are higher in markets with less sensitive demand (“less elastic”)
  • In our example: AU market more inelastic than US
  • Price higher in Australia
perfectly elastic demand
Perfectly Elastic Demand

Price

Demand

Quantity

perfectly inelastic demand
Perfectly Inelastic Demand

Price

Demand

Quantity

calculating elasticity
Calculating Elasticity
  • Price elasticity of demand is the percentage change in quantity demanded divided by a given percentage change in price
  • More often we use the point elasticity of demand

= elasticity for a “minuscule” percentage change in price

(derivative of quantity with respect to price, times price divided by quantity)

some properties of elasticity
Some Properties of Elasticity
  • e is a negative number:

e.g., if 10% increase in price of oil decreases quantity by 20%, e = – 2

  • “More elastic” means “Bigger in absolute value”

e.g., if eUS= – 2 and eAU= – 10, AU demand is more elastic

  • Unit-Free Measure
    • you can compare elasticities among different goods
    • Is oil more price sensitive than butter, at their current prices?
  • Elasticity vs. Slope
    • These are not the same thing
    • Slope is P/Q
estimated price elasticities
Estimated Price Elasticities

Elasticities calculated at current market prices

accounting for differences
Accounting for Differences
  • Degree of Substitutability
  • Temporary vs. Permanent Price Changes
  • Long-run vs. Short-run elasticity
price as a function of e
Price as a function of e
  • This is useful for testing markups
    • Get independent estimates of your marginal cost and e
    • Check your price: it should be

From before,

To maximise profit, set MR = MC

  • Alternatively
    • Estimate e implied by current prices and marginal costs
    • How does this track relative to your intuition regarding demand sensitivity?
    • Compare against other industries
    • Adjust price if necessary
the elasticity sanity check
The elasticity ‘Sanity Check’
  • Suppose that you sell goods for $50 a unit. Your marginal costs are $20 a unit.
  • An independent market research firm has estimated your elasticity of demand as -2.0.
  • Should you consider increasing or decreasing your price by a little bit?
linear str aight demand
Linear (straight) demand
  • Confusing!

If the demand curve is actually straight, the elasticity is differentat different points on the line.

There is only one point at which the line has unit elasticity

  • MR = 0 at the unit elastic point
    • If MC=0, profits maximized when MR=0
    • Therefore, if MC=0, produce at the unit elastic point
      • CDs
      • Software
      • Amazon orders
  • If MC > 0, always price in the elastic portion of demand curve (e < 1)
    • Marginal revenue is positive only on this part of the curve
    • So, profit can only be maximised (MR = MC) here
    • Note: this implies optimal prices (previous slide) are never negative
innovative pricing

Innovative Pricing

How to use price discrimination to increase value and profits

linear pricing
Linear Pricing

$

“Triangles of Opportunity”

P*

Q*

Quantity

linear prices and lost opportunities
Linear prices and lost opportunities

From social point of view, value is lost

 Customers with WTP > MC not served = reduced surplus

From firm’s point of view, more opportunity lost

 Many pay less than their WTP= reduced appropriation

Both “triangles of opportunity” attractive to firm

 Do both & create more surplus = beneficial to society

railroads and transport one price
Railroads and Transport: one price?
  • Railroad tariffs specify charges based on the weight, volume, and distance of eachshipment.

For instance, discounts on the charge per mile per hundredweight areoffered for full-car shipments and for long-distance shipments

  • In other transportindustries such as trucking, airlines, and parcel delivery the rates depend also onthe speed of delivery or the time of the day, week, or season
electricity one price
Electricity: one price?
  • Electricity tariffs specify energy charges based on
    • Total kilowatt hours used inthe billing period, as well as
    • Demand charges based on peak power load duringyear
  • Lower rates apply to successive blocks of KWh (sometimes demand charges also divided into blocks)
  • Energy rates for most industrialcustomers further differentiated by the time of use, as between peak and off-peakperiods during the day
price discrimination when customers have different wtp
Price discrimination When customers have different WTP
  • By charging different prices to customers with different WTP, a monopolist can create more surplus
  • To achieve this, the monopolist must find ways to charge different prices to different buyers

= segment the market.

how do you charge different prices
How do you charge different prices?

Cappuccino for the lavish $3.50

Cappuccino for the thrifty $1.00

Will anyone say they are ‘lavish’?

What if you offer different coffees? One based on fair price to growers. The other not.

fair trade coffee
Fair Trade Coffee

Cappuccino for the concerned $3.50

Cappuccino for the unconcerned $1.00

The difference is much less than the additional premium paid to growers for fair trade coffee.

But, caused a stir …

revised plan
Revised Plan

Cappuccino for the concerned $2.80

Cappuccino for the unconcerned $2.50

So there are constraints on the ability to price discriminate.

origin energy green power
Origin Energy Green Power
  • Pay for normal electricity
  • Pay 25% more for electricity coming from ‘green’ sources
brunetti s
Brunetti’s

Hot chocolate $2.20

Cappuccino $2.55

Caffe Mocha $2.75

White Chocolate Mocha $3.20

20 oz Cappuccino $3.40

translation
Translation …

Hot chocolate – no frills $2.20

Cappuccino – no frills $2.55

Mix them together – I feel special $2.75

Use different powder – I feel

very special $3.20

Make it huge – I feel greedy $3.40

All of these have approximately the same cost to the cafe

types of price discrimination
Types of price discrimination

Personalised pricing

Achieved by discriminating on individual observables : charge different prices to different people.

Group pricingAchieved by discriminating on group observables: charge different prices to different groups whose WTPs are correlated with identifiable characteristics

VersioningAchieved by discriminating on features: charge more for products with special features of interest to high WTP customers

personalised pricing
Personalised pricing
  • Identify ‘unique’ targets
    • Car dealerships
    • Discount cards and coupons
    • Amazon tracking – now defunct
group pricing
Group pricing
  • Why are there often discounts for seniors & students?
    • Students have lower WTP, on average,
    • And, their demand is more elastic
    • May want to charge lower price to them
  • Membership in the group must be observable to the monopolist, to avoid arbitrage
  • Arbitrage = actions taken to exploit price differences

Ex: claiming you’re a student

geographic pricing
Geographic pricing
  • Selling at different prices in different geographical markets is price discrimination!
  • Pricing to different geographic markets
    • Textbooks
      • US edition textbook: $70
      • Indian edition textbook: $5
      • Arbitrage?
    • US to AU air tickets vs. AU to US
    • By neighborhood: car insurance versus other goods
    • Pharmaceuticals (effect of CA–US drug “re-importing”?)
example railroads
Example: Railroads
  • Railroads set different prices for coal and grain
  • Coal 2 or 3 times higher elasticity than grain Should have a lower price
  • How are markets segmented?
versioning
Versioning
  • Find a feature that high WTP buyers care about
    • Convenience,
    • Release date, etc.

**High-WTP buyers must care more about this extra feature than low-WTP buyers **

  • Sell 2versions of the product
    • One with the feature
    • One without
  • Customers self-select: they all look identical to the monopolist, but they decide which version to buy
  • Versioning essentially no-cost product differentiation
example airline tickets
Example: Airline Tickets
  • Why is there a discount for a Saturday night stay?
    • Business travellers less likely to do so
    • Price elasticity (discount passenger): –1.83
    • Price elasticity (full economy passenger): –1.3
  • What is the “feature” that high-WTP buyers pay for?

= ability to return on weekday

  • Of course, ability to extract higher price limited by buyer’s next-best option
quantity discounts
Quantity discounts
  • “Block” Electricity Pricing:
    • Suppose there are large and small customers
    • Charge a certain price up to x MWh
    • Then, allow a discount
    • Small buyer demand unchanged
    • Larger buyers purchase more
  • What is the “feature” offered? = the right to buy small quantities
making self selection work
Making Self-Selection Work
  • Adjust prices so that:
    • Low-WTP buyers want version without the feature: price of the basic version is just below their WTP
    • High-WTP buyers prefer version with the feature: price at indifference point to next-best alternative
  • Double-check that you earn more than with just one version!
  • If both groups have same WTP for feature, both should have it!

 For price discrimination, feature should be one that high-WTP buyers value much more

example car with or without gps
Example: Car with or without GPS
  • High-WTP buyers:

WTP for car: $40,000

WTP for car with GPS: $48,000

 WTP for the feature = $8,000

  • Low-WTP buyers:

WTP for car: $30,000

WTP for car with GPS: $31,000

Questions:

  • How do you price, so that low-WTP buy the basic car and high-WTP buy the car with GPS?
  • If the cost of producing the car is $17,000 and the cost of producing & installing GPS is $3,000, and 50% of buyers are low WTP, what will the monopolist do?
price discrimination based on features
Price discrimination based on features

Q: How much extra is the high-WTP buyer going to pay for the version “with feature”?

= her WTP for the feature

= extra utility she gets from having the feature

Example of GPS:

High-WTP buyer gets $8000 more utility from GPS

  • The car with GPS will cost $8000 more than basic
  • Basic will be priced at low-WTP
  • That’s why you need a feature high-WTP people value a lot
example harry potter delay
Example: Harry Potter delay
  • Book sale can be immediate or one month later
  • Buyer dislikes waiting
    • Everyone else wants to talk about Harry Potter this month and
    • Utility next month = 50% of utility today
  • Seller has no delay costs
  • The seller can commit to a price schedule:
    • Price for this month (hardback)
    • Price for next month (softback)

 “feature” offered = no delay!

(From a marketing point of view, it’s better if they view this month’s product as “better,” e.g. hardback)

harry potter price schedule
Harry Potter price schedule
  • Half the buyers have WTP of $60, and half have WTP of $40
  • Production cost is $10 per book
  • What price schedule does the seller choose w/o versioning? (in this case, it’s $40)
  • With screening, choose prices so that
    • High-WTP buyers purchase now
    • Low-WTP buyers purchase later
  • Second month price is $40
  • What should today’s price p be?
    • Make high-WTP buyer indifferent

$60 – p > 0.5 ($60 - $40) = $10

    • So long as p is less than $50, will get self-selection
profits from screening
Profits from Screening

The seller is using screening, that is, structuring prices to reveal information

  • Get $40 from low-WTP buyers, and
  • $50 from high-WTP buyers
  • On average, price is $45
  • Before screening, average price was $40
  • Is this worth it?
    • Gains could be small
    • Yet it cost low value buyers a month of waiting…

 might incur ill-will, maybe not worth it

related examples inter temporal effects
Related examples: inter-temporal effects
  • Product life cycle discrimination
  • Early buyers often have much more inelastic demand
    • First-run movies
    • Computer software
    • Computer hardware
    • CDs
    • New sports equipment
damaged goods
Damaged goods
  • Product crimping: costly adjustments to create low-quality products in order to price discriminate

Example: Student versions of software, printer models

  • What is the “feature” offered?

= better version of the product (i.e., not crimped)

product differentiation
Product differentiation
  • Firms offer different products for reasons other than P-discrimination
    • “Horizontal” differentiation
      • Products of equal quality
      • But different people prefer different features
    • E.g., sweet cereals, crunchy cereals,…
  • Often, real reason to charge different prices for different goods
    • “Vertical” differentiation
      • Some products have superior quality
      • Everyone agrees on what’s the best good,
      • Not everyone can afford extra cost to produce it
    • E.g., supercomputers, Ferraris,…
    • Even if we earned $0 profits per sale, we’d charge different prices for products
  • Note: “crimping a product” is clearly for pricing purposes only!(Even so, it’s not necessarily bad for customers)
making self selection work continued
Making self-selection work (continued)
  • May need increase quality at high end (add more features)
  • May need to cut quality at low end (reduce features)
    • It may cost more to produce the low-quality version, if features have to be subtracted
    • In design, make sure you can turn features off!
  • You may want more than 2 versions of the product, if there is a range of different WTPs
non linear pricing two part tariffs

Non-linear pricing: “Two-part tariffs”

Moulding individual purchases

customers who demand multiple units
Customers who demand multiple units
  • Up to now, we have thought of a demand curve as being composed of many individuals, each with a different WTP (999,998,997,…) and each wanting 1 unit of the good only.
  • But in many markets, most customers want more than 1 unit: mobile phone minutes, for example
  • A demand curve is still the right representation of the market!
  • Example from our demand curve: There could be 100 identical consumers, who each demand 10 – (P/100) units: so if the price is $400, each customer wants 6 units, but if the price goes up to $500, each customer wants only 5 units.
  • The quantity each customer buys will depend on the price.

(In general, a demand function is composed of people with different willingness to pay for 1 unit, different willingness to pay for a second unit,… ex: Designer clothing store.)

a revision to the on going example
A revision to the on-going example
  • Before: 1000 consumers, each wants 1 unit, WTPs range from 0 to 999
  • Now: 100 identical consumers,
    • Personal demand given by P = 1000 – 100Q units: so
    • To sell each buyer 6 units (600 total) post P = $400
    • At P = $500, each customer wants only 5 units
  • Individual demand curve

Maximum possible surplus per customer

1000

$

Individual Demand

MC

200

8

10

Quantity

customers who demand multiple units1
Customers who demand multiple units
  • Two-part prices allows a monopolist to extract more surplus from customers, in a variable-quantity market
  • The following scheme works in this case
    • Charge an up-front fee of $3200 per customer
    • Post price of $200 per unit = MC
      • Each customer buys 8 units = the surplus-maximising quantity
      • This creates $3200 surplus, which monopolist extracts up-front
applications of two part pricing
Applications of two-part pricing
  • Water bill
  • Telephone bill
  • Internet: unlimited-access accounts
  • Mobile phone plans.
two part pricing
Two-part pricing

Notice that there are two different reasons to offer two-part pricing:

  • Reason we’re looking at now

= the quantity a customer wants depends on the price

  • they will demand more and get more surplus if the marginal price is lower
  • and that extra surplus can be extracted through up-front fee
  • Discrimination based on features:

= customers buying more are more price-sensitive, more likely to walk away at a high price

  • a two-part price gives a bulk discount to large users
reality checks
Reality checks
  • Does your firm really have scarcity power?
    • If charge high price to some consumers, they may go to another firm
  • Can your firm plug leaks?
    • Consumers may re-sell goods from one group to another
    • Basic products made even more basic!