Price Discrimination

1
Price Discrimination

• We thus far have studied a monopolist that
  charges
• A. Same price for all units.
• B. Same price to all customers.
• Changing one or both of these is called Price
  Discrimination. Can one profit from this?
• 1st degree is different prices for both consumers
  and units (both A and B are changed)
• 2nd degree is different prices for different
  units (A changed).
• 3rd degree is different prices to different
  consumers (B changed).

2
1st-Degree Price Discrimination

• Different prices for both consumers and units.
• To do this properly, a monopolist must have
  strong information on
• Consumers preferences.
• Who is who.
• 1st degree captures the whole consumer surplus.
• 1st degree is efficient.

3
Effort to Discriminate

• In 1990, IBM introduced the LaserPrinter E.
• The difference is that it printed 5 ppm rather
  than 10 ppm.
• They did so by ADDING 5 chips in the E model. The
  purpose of the chips was to make the printer
  WAIT.
• The price of the new laserprinter E was 60 of
  the old one.
• Why did IBM pay for a reduction in the speed?

4
Effort to Discriminate Model

• Jim values the faster printer at 1000 and the
  slower printer at 700.
• Sean values the faster printer at 700 and the
  slower printer at 600.
• It costs 450 to make the faster printer and 500
  to make the slower printer.
• What should IBM charge for either printer?
• If IBM only sells the fast printer, what should
  it charge?
• If IBM wants to sell the fast printer to Jim and
  the slow printer to Sean, what is the max/min
  price difference.
• What happens if the fast printer costs 1000 and
  the slow printer 600?

5
Other Examples of Effort to Discriminate

• Intel with its SX processors had the math
  coprocessor disabled.
• Fast delivery service may hold back packages that
  are 2nd day rather than overnight.
• Photo shops wont give you films in 1 hour even
  though they may be ready if you have ordered the
  longer service.
• Sony Minidisc 60 minute vs. 74 minute versions
  minidiscs are the same except for a code on the
  60 minute version written to stop it from writing
  the longer time.
• Hard disks in MP3 players. Sometimes is cheaper
  to buy the MP3 player and take out the hard disk.
  People did this so they had to take precautions.

6
2nd degree Price Discrimination

• Ari values 1 umbrella at 10 pounds and has no
  need for another umbrella.
• Jodi values 1 umbrella at 11 pounds and also
  values 2 umbrellas at 15 (together).
• They each want to maximize the difference between
  their value and the price they pay.
• What is the maximum a monopolist with zero
  marginal cost could make charging the same price
  per umbrella?
• What is the max it could make charging a price
  for 1 and a special for two together?
• Hint what would happen if they charge 10 for one
  and 15 for two?

7
Movie Release Dates

• Studios want to maximize revenue.
• Groups want the delay from the Theater release to
  be short and the release to the next outlet to be
  long.
• Consumers must decide when (if) to watch the
  film.
• What incentive does the studios have once the
  consumers have made their decision?

8
Movie Release A simple model.

• There are only two formats Theater and Home.
• The home release can be early or late. The
  studio gets 5 for each Theater sale and 2 for
  each home viewer.
• Four Consumers.
• A only wants to see the movie in the theater.
• B only wants to see the movie at home.
• C will see the movie in the theater if the
  release is late. Otherwise, C will see it at
  home.
• D will see the movie at home only if only if the
  release is early.
• What is studio profit for early? Late? What
  should the studio do?

9
Movie Releasefurther analysis

• After the studio announces release date and the
  movie is released, what should it do?
• What stops this from happening each time?
  Consumers judge the release date not by what the
  studio says, but by either previous record or
  what the studio has incentive to do.
• Do you remember which studio produced the
  Titanic?
• If consumers judge the industry as a whole rather
  than individual studios, then what happens?

10
International Pricing of Pharmaceutical Companies

• Prices of antipsychotic drug in various
  countries.
• Why such a difference?

11
3rd-degree price discrimination

• There are two groups of people that make up total
  demand D(p)D1(p)D2(p).
• Example MC0, D1(p)100-p and D2(p)60-p.
• qD1(p)D2(p)160-2p.
• We find p80-q/2. Marginal revenue is 80-q.
• MRMC implies q80 and p40.
• Profit with one price is 3200.
• MR in market 1 is 100-2q1 and in market 2 is
  60-2q2.
• Find q1, q2, p1 and p2.
• Show that combined profits are 25009003400.
• At home Try the same for D1(p)100-p and
  D2(p)100-p.
• Need to ensure one group cant sell to another
  (leakage).
• Companies try to prevent leakage and take
  advantage when it is limited DVDs and camcorders
  (PAL vs. NTSC).

12
Examples of Price Discrimination.

• Book publisher having a cheap international
  edition of a book.
• How about paperbacks.
• Publisher charging libraries a higher rate to
  libraries than to individuals.
• Frequent Flyer Programs.
• First Class Train tickets.
• Saturday stayover for airfares.

13
Two-Part Tariffs

• The sports center charges a fee to join and then
  a per usage fee.
• Why dont they just charge one or the other to
  make it simple?
• What form of price discrimination (if any) is
  this?
• Sometimes this may have a high transaction cost
  Disneyland dilemma.

14
Other two-part pricing

• This is also the case with video games such as
  the Xbox.
• We also saw this with IBM and its punchcards
  (overpriced).
• There are two types of consumers.
• A is a heavy user and will make calculations all
  day long needs 100 punch cards.
• B is a light user and will need to make
  calculations only at the end of the day needs 50
  punch cards.
• C is a hobbiest and would only fool around with
  the machine needs 5 punch cards.
• The value of each calculation is 100 (over the
  year). C values owning the machine at 1000. The
  machine costs 3000 to produce and punch cards
  0.

15
Two-part tariff punch cards

• What is the monopolys profits if it charges 0
  for each punch card?
• What happens if the monopoly charges 0 for the
  machine and only for the punch cards?
• What happens if the monopoly charges 1500 for
  the machine and 70 each punchcard?

16
Bundling

• Two types of people
• A values 120 for Word, 100 for Excel.
• B values 100 for a Word, 120 for Excel.
• If Microsoft charges separately for each program,
  it can make 200 for each software product for a
  total of 400.
• They could package both together (and stop
  selling it individually) and sell it for 220
  making a total profit of 440.

17
Anti-Competitive Bundling

• A library has 10,000 to spend on journals.
• There are 10 good journals out there.
• They want to buy as many journals as they can for
  the budget as long as each journal is less than
  2000.
• Six journals are owned by one publisher -E.
• The 4 independent journals cost 1000 each.
• What is the maximum the E can make if it charges
  a separate price for each (assume marginal cost
  is zero)?
• How about if E bundles all 6 together?
• If E bundles all together, what can the
  independent journals do?

18
Hotellings (1929) linear city

• Why do all vendors locate in the same spot?
• For instance, on Cowick street they just opened a
  new Pharmacy right next to another one.
• Why do political parties (at least in the US)
  seem to have the same agenda?
• This can be explained by firms trying to get the
  most customers.
• This isnt efficient!
• If firms first choose location and then prices,
  what do you think would happen?

19
Hotelling
Voters vote for the closest party.
R
L
Party B
Party A
If Party A shifts to the right then it gains
voters.
R
L
Party B
Party A
Each has incentive to locate in the middle.
20
Hotelling Model
R
L
Party B
Party A
Average distance for voter is ¼ total.
R
L
Party B
Party A
Most efficient has average distance of 1/8 total.
21
Hotelling Model

• Firms choose location and then prices.
• Consumers care about both distance and price.
• If firms choose close together, they will
  eliminate profits as in Bertrand competition.
• If firms choose further apart, they will be able
  to make some profit.
• Thus, they choose further apart.

22
Future Profits?

• Do you want to spend more today (have higher
  costs) in order to save tomorrow (have lower
  costs)?
• This can be either an investment decision
  (patent/learning curve) or an inventory decision
  (save the best for last).

23
Save the best for last?(salesman)

• A salesman is working on commission. He has two
  houses for sale. They are both similar except for
  one the seller is willing to sell for 150k and
  the other the seller is willing to sell for 170k.
  
• The salesman meets a buyer who is willing to pay
  180k. (Assume the salesman gets the buyer to pay
  180.)
• Which should he try to sell first?
• Does this strategy generate the highest surplus
  for the sellers?

24
Save the best for last solution.

• If the next buyer is willing to pay 175 (or
  anything above 170), it doesnt matter.
• Both houses would be sold and seller surplus
  would be 35.
• If the next buyer is willing to pay 165, then
• If he sells the 170 first and the 150 second,
  then the salesman gets commissions on 180165
  while the surplus is 25.
• If he sells the 150, then he cant sell the 170
  and gets commissions on 180 while the surplus is
  30.
• If the next buyer is willing to pay only 145,
  then
• In either case, only the first house will be
  sold. If it is the 170, surplus would be 10. If
  it is the 150, surplus would be 30.

25
Summary
Sales
Seller Surplus
Sales is maximized by selling the most expensive
first. Surplus is maximized by selling the least
expensive first.
26
Learning curve.

• Learning economies depend on cumulative output
  rather than the rate of output and are not
  reversible. Applies to surgeons learning new
  procedures, lecturers, airframe makers etc.
• Learning leads to lower costs, higher quality and
  more effective pricing and marketing.
• Learning reduces unit cost through experience

27
Learning curve strategy

• Expand output rapidly to benefit from the
  learning curve and achieve a cost advantage?
• May lead to losses in the short term but ensure
  long term profitability.

28
Investment in Cost Reduction

• Similar to learning curve, a firm can invest
  today in a cost reducing technology.
• When does this make sense?
• Is it a straight-forward cost-benefit analysis?
• Is salessavings per unitinvestment plus
  interest?
• Or even taking into account extra sales (from
  lower price charged)

29
Strategic gains.

• Firm A and Firm B are competing in quantity
  competition. They each can choose a small amount
  S of goods to sell or a large amount L of goods
  to sell.
• Firm A can invest in a cost reducing technology
  this will reduce his costs per unit. This makes a
  larger difference for L than for S.
• Saves 15 for L.
• Saves 5 for S

30
Cost Reduction in Competition
Firm A
High Cost
Low Cost
S
L
S
L
60
65
55
70
S
40
55
40
55
Firm B
45
60
50
55
L
50
45
50
45
31
Shift in equilibrium

• The equilibrium of the game changes from Firm A
  choosing S and Firm B choosing L to Firm A
  choosing L and Firm B choosing S.
• Profit for Firm A shifts from 50 to 70. An
  investment of 17 would not look good on paper
  since the maximum savings on cost would be 15.
• This calculation would not take into account the
  strategy affect of the reduced cost. (Resulting
  in higher prices for goods sold.)
• Conclusion Firms may over-invest in cost
  reducing measures or learning curve reasons for
  strategic reasons rather than simply Cost-Benefit.

32
Planned Obsolescence

• Why does microsoft products have many bugs and
  are they always introducing updates?
• Why are certain durable goods not so durable?
• It is in the best interest for the manufacturer
  to keep us coming back for more.

33
Planned Obsolescence

• There is 1 monopoly good (marg cost 0), 2 time
  periods and 2 types of consumers.
• A is willing to pay 15 per time period.
• B is willing to pay 5 per time period.
• If the monopolist sells a good that lasts for two
  periods, what should he do?
• If he charges a price of 30, he sells only to A.
• If he charges a price of 10, he sells to both A
  and B.

34
Commitment problems

• If he chooses a price of 30 and A buys his good,
  what will he do at time 2.
• What should A do in this case?
• If he chooses a price of 20 at time 1 and 5 at
  time 2, what will A do and what will B do?
• What will the monopolists profits be?
• What will the monopolists profits be if he was
  able to limit the lifetime of the product to only
  one year?
• Limiting lifetime to one year is the same as
  renting. IBM recognized this early! Perhaps, once
  microsoft develops there software rental market,
  they will have incentive to get the bugs out.