James Stodder and Houman Younessi

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Transparency and Credible Commitment Most-Favore
d-Customer Price Differentiation www.ewp.rpi.edu/
hartford/stodder/PriceDisc.ppt
James Stodder and Houman Younessi Lally School of
Management Technology Rensselaer Polytechnic
Institute at Hartford Hartford, Connecticut, USA
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Separable Markets 3rd Degree Price
Discrimination

• Domestic Examples
• Airline Tickets
• Starbucks Prices, Different Cities
• Student, Senior Discounts for Movies
• Dry Cleaning for Men and Women
• College Scholarships
• Pharmaceuticals
• See (1) www.merck.com/merckhelps/ ,
• (2) www.pfizerhelpfulanswers.com/pages/Find
  /findall.aspx

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International Price Discrimination

• Examples
• Starbucks Coffee
• Automobiles
• Software, Movies, Textbooks!
• Consumer Electronics
• Pharmaceuticals
• (1) www.merck.com/cr/enabling_access/developing_w
  orld/

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For Successful Price Discrimination, One Needs

• Price-Setting Power
• Differing Price Sensitivities
• Barriers to Resale, can be
• Practical (hard to re-sell your senior discount
  meal), or
• Legal (Big Pharma attempts to prohibit
  re-importation, a.k.a, parallel trade)

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A Well-Known Device to Combat Reselling

• Sell to the public at Single (High) Price, but
  then
• Give each customer a different Lump-Sum Rebate
  i.e., one that cannot be changed by the amount
  purchased (e.g., based on the customers past
  income).
• To be profitable, reselling must now be Above
  Original Price so it doesnt happen.

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However, in solving One Problem, the Lump-Sum
Rebate gives Rise to Another Problem

• Larger Customers will now try to Re-Negotiate
  Larger Rebates e.g., reference pricing.
• How can a Company defend against such pressures?

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Patricia Danzon (Wharton) idea on How to Prevent
Re-negotiation

• Keep Lump-sum Rebates Secret
• But how good are Governments at keeping other
  secrets?

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Consider a common device to defend a single
(monopolistic) price

• A Most-Favored-Customer (MFC) Clause
• Any Discount given to one customer must be given
  to All MFCs.
• A MFC Clause makes highly credible the sellers
  promise to not renegotiate prices since to do
  so would be very expensive.

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Most-Favored-Customer (MFC)
Price Differentiation (PD)
MFCPD

• Our idea is that the non-negotiable credibility
  of MFC can add transparency to PD to create
  MFCPD.
• Customers are most-favored in the sense that they
  see no one gets a better formula for their
  income-based rebate even though they have
  different incomes.
• Giving a better formula to anyone would mean
  giving that same formula to all with a big
  impact on profits.

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Derivation Linear Demand Function

• Demand for quantity Qi from segment i
• Qi Popia ßPi ?Yi
• where Popi is Population, Pi is Price,
• Yi is income to group i,
• and a, ß, ? are Market Parameters
• to be Estimated.

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Profit Maximizing Price for group i

• If Marginal Cost µ, then Comapany Profits from
  group i
• p i (Pi µ)Q i
• (Pi µ)Popia ?Yi ßPi
• First Order Condition for Profit Max
• Published Formula for Price After Rebate
• Pi (a ?Yi µß)/2ß

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Full Incentive Compatibility

• A MFCPD clause is fully incentive compatible
  i.e., will stop the Company from allowing a
  price-cut with group i (which costs it ?pi , even
  though it avoids threatened ? )
• when the resulting decrease in profits from all
  other groups ? j?i ?pj is so large that
• ?pi ? j?i ?pj gt ?
• from asked-for from lower price
  from threat of curtailed
• lower price by i impact on all j ? i
  purchases by i

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To overcome Incentive Compatibility for the
Company (reverse the inequality) Group i would
need a Very Large Threat Multiplier (ti)

• ?pi ? j?i ?pj lt ?
• then, dividing by ?pi, we have
• 0 lt 1 (? j?i ?pj) /?pi lt ? /?pi ti
  
• Effective Threat Multiplier

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Size of the Threat Multiplier

• Even for the largest economy (US), ti is still
  substantial.
• In our simulation of country-based price
  discrimination, US accounts for 38 of all
  Company profits.
• 1 (? j?i ?pj)/?pi lt /?pi ti
• 1 (62 / 38) 2.63 lt /?pi ti

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Finer Price Disc gt
Less Non-Linearity gt
More Stable Threat Multiplier
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Effective Threat to Companys Profits Implies a
Proportional Threat to Group is Own Surplus

• If group is demand is linear, we show that its
  hoped-for gain in consumer surplus, ??i, if
  backed up by threat multiplier ti
• poses a proportional threat to its own surplus
• gt ti ?pi gt gt ti ??i

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No-Negotiation is Sub-Game Perfect
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No-Negotiation is Sub-Game Perfect
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No-Negotiation is Sub-Game Perfect
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No-Negotiation is Sub-Game Perfect
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No-Negotiation is Sub-Game Perfect
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What about Imperfect Knowledge? Sub-Game Perf.
Eq. does not apply.
Call pi group is subjective probability of the
Company eventually acceding to its threat. Then
risk-neutral i should make threat if and only if
pi ??i (1- pi) ti (-??i) gt 0 gt pi gt (1-
pi) ti, and ti gt 2.66 gt pi /(1- pi) gt ti gt
2.66 gt pi gt 72.7
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Summary of Simulation Results
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World Monopoly Price Few Countries Can Purchase
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Pharma Futures Report (www.pharmafutures.org)

• Challenge 7 To Respond Appropriately to Demands
  for More Equitable and Extensive Access to
  Medicines
• As emerging markets become more commercially
  interesting they pose a two-pronged challenge to
  the industry, which requires a significantly
  different management skill set from those needed
  in industrialised markets.
• The first prong requires industry to develop a
  pricing policy that captures not only the premium
  markets but permits an extension of volume sales
  to a wider customer base. And this must be
  achieved while simultaneously preventing negative
  impacts such as reference pricing or
  inappropriate parallel trade in established
  markets.
• The second prong is to respond to demand for
  access to medicines in these markets (and in
  countries that are less commercially promising)
  in such a way as to defend the industrys
  commercial interests while at the same time
  persuading key decision makers that the response
  is sufficient to overcome mistrust, minimize
  criticism and extend licence to operate.