Strategic Pricing:

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Strategic Pricing Theory, Practice and Policy
Professor John W. Mayo mayoj_at_georgetown.edu
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Nonlinear Pricing
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So far, Uniform /nonuniform pricing
Cantaloupes
Exp.
Price Quantity Expenditures
.90 1 .90
.90 2 1.80
.90 3 2.70
.90 4 3.60
Q
Q
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Linear and Nonlinear Pricing

• Linear Pricing expenditures increase
  proportionately with consumption
• E.g., Beer P 5 per beer
• Nonlinear Pricing expenditures rise
  disproportionately with consumption
• E.g. Redskins tickets
• Exp Personal Seat License X per game

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Two-part Tariffs

• Two-part Tariff involves a fixed fee plus a per
  unit price
• Examples
• Restaurants (á la carte v buffet)
• Nightclubs cover plus drinks
• Country clubs monthly charge plus greens fees
• Important Features of nonlinear pricing
• Requires ability to prevent resale
• Creates vehicle for extracting consumer surplus
  that is otherwise unattainable

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Single-type consumers
P/Q
Optimal linear price pm
Optimal two-part tariff
B
(ABC) mq
pm
A
C
MC m
Q
qm
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Multiple-type consumers
P/Q
pm
MC m
Q
qm
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Multiple (optional) two-part tariffs
P/Q
If knew customer types and can prevent resale,
then charge two tariffs,
But suppose that all you know is that there are
different customers, Not their identity?
pm
MC m
Q
qm
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Multiple (optional) two-part tariffs
Exp.
Consumers will tend To minimize
expenditures (absent insurance considerations)
F2
Receipts will tend to be Defined by the lower
Envelope of the curves
F1
Q
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Optional Two-part Tariffs in PracticeTelephone
Pricing in the United States

• Unlimited (Flat-rate) service 17.01/month
• Limited Per Call Service
• 10.16 .10 Calls (for calls gt 65/month)
• Economy Call Service
• 5.92 .10Calls

Source Verizon, Montgomery County White pages
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Telephone Expenditures with Nonlinear Pricing
What is the logical consumer response?
What is the actual consumer distribution among
the calling plans ?

17.01
10.16
5.92
Calls
110
134
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Nonlinear pricing in practice

• Is the pricing of electricity in Basel
  (Washington) (elsewhere) linear or nonlinear?
  What are the economic and societal implications
  of such pricing?
• Why would such a firm ever set a price to
  encourage conservation?
• What is the structure of mobile telephone
  pricing? What competitive and economic dynamics
  have led to this pricing structure?

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DiscussionPaying by the Gig

• What is the current pricing model for Internet
  usage?
• What is being trialed by Time Warner Cable?
• What are the business drivers of the pricing
  scheme?

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Minimum quantity pricing

• Consider a good or service with a highly
  fluctuating intertemporal demand
• The demand for hotel rooms in Washington during
  the Inauguration activities versus a normal
  demand
• The demand for hotel rooms in Basel during
  Fachnacht
• Option one Charge the linear price consistent
  with the extent of market power or impose minimum
  stay

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Minimum Quantity Pricing
/Day
Profit Consumer Surplus
Monopoly Pricing BE A
Minimum Stay EFD A B C - D
Net FDgtB? BCgtD?
A
C
Pm
B
Pstay
D
E
F
mc
1
2
Days
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Price Discrimination

• Price discrimination practice of charging
  consumers prices that differ by more than
  differences in the cost to produce the good
• (Pi/mci) ? (Pj/mcj ) George Stigler
• (cost-based differences are not considered price
  discrimination)

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Profit Maximization with Market Power

MC(Q)
Is Q, P profit max?
P
Why not sell these units?
DQ(P)P(Q)
MR(Q)
Q
Q
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Market Power and Price Discrimination
Consumer Surplus

MC(Q)
P
Unrealized Sales
What would be ideal for the firm?
DQ(P)P(Q)
MR(Q)
Q
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Market Power and Price Discrimination
Consumer Surplus

MC(Q)
P
Unrealized Sales
Is this a violation of our MRMC rule?
DQ(P)P(Q)
MR(Q)
Q
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Effects of price discrimination

• Producer increases revenue and profits
• Low willingness-to-pay consumers typically gain
  as they would be under-served otherwise
• High willingness-to-pay consumers typically worse
  off

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Forms of Price Discrimination

• First Degree practice of charging each consumer
  her individual reservation price
• Second Degree Practice of charging consumers a
  volume-sensitive price that is noncommensurate
  with cost charges
• Third Degree practice of sorting consumers into
  different groups based on observable
  characteristics and charging different prices

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Price Discrimination
/Q
First Degree Price Discrimination Allows firms to
extract all consumer surplus
pm
mc
D
mr
Q
qm
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First-Degree (Perfect) Price Discrimination

• Hard to achieve in reality, but some strategies
  come close
• Examples ?
• Amazon.com dynamic pricing (more later)
• Used car dealers, mechanics, contractors, any
  negotiated price
• Haggling in the bazaar
• Capital One
• 1990s - Pricing long-distance telephone
  calls

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First-degree price discrimination

• Advantages
• Extracts the most consumer surplus
• Disadvantages
• Difficult (costly) to do - Determining
  willingness
• to pay is exceedingly hard
• Risk consumer backlash (Amazon.com)

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Second-Degree Price Discrimination

• Practice of charging consumers a volume-sensitive
  price that is noncommensurate with cost charges

MMs 1.74 oz. P .89 or 8.18/lb MMs 14 oz
P2.50 or 2.85/lb
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Second Degree Price Discrimination Example
Electricity Pricing
Electricity pricing First 1000kwh P .10 Next
10000 kwh P .08 Kwh gt 11,000, p .07
/kwh
.10
.08
.07
kwh
1,000
11,000
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Second-degree price discrimination

• Advantages
• Can target consumers with particular volume
  preferences
• Can encourage or discourage consumption by
  pricing for marginal customers
• Disadvantages
• Lower total revenue than 1st degree
• Risk confusing consumers

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Third Degree Price Discrimination

• Occurs when firm charges different consumers
  different prices for the same good
• Consider a firm selling to two distinct customer
  groups, so

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Third Degree Price Discrimination
p P1Q1 P2Q2 C (Q) mr1 p1(1 1/e1) and
mr2 p2(1 1/e2) And profit maximization
requires mr1 mc and mr2 mc, so p1(1 1/ e1)
p2(1 1/ e2) mc , or p1/p2 (1 1/ e2) /
(1 1/ e1) So, say e1-6 and e2 -4
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Third-Degree Price Discrimination

• Practice of sorting consumers into groups based
  on observable characteristics associated with
  willingness to pay and charging different prices
  (a.k.a. group pricing)
• Examples of 3rd degree p.d.
• Senior/student discounts
• Drycleaners and haircuts
• AAA and AARP discounts
• Spatial groupings
• (Canadians at DisneyWorld)

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Implications

• If it is possible to identify separate
  elasticities, it is desirable to set different
  prices.
• How might firms identify elasticities?
• Travelling tomorrow?
• Number of substitutes
• Self-identify (coupons)

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Third-degree price discrimination

• Advantages
• Generally produces higher total revenue than a
  one price constraint
• Sorting mechanism is observable/verifiable
• Disadvantages
• Lower total revenue than 1st degree
• Risk consumer backlash

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The Policy of Price Discrimiation

• Price Discrimination Clayton Act, Sec. 2
• It shall be unlawful for any person engaged in
  commerce, to discriminate in price between
  different purchasers of commodities of like grade
  and quality, where the effect of such
  discrimination may be substantially to lessen
  competition or tend to create a monopoly in any
  line of commerce, or to injure, destroy, or
  prevent competition with any person who either
  grants or knowingly receives the benefit of such
  discrimination, or with customers of either of
  them
• Provided that nothing herein contained shall
  prevent differentials which make only due
  allowance for differences in the cost of
  manufacture, sale, or delivery resulting from the
  differing methods or quantities in which such
  commodities are to such purchasers sold or
  delivered
• Section 2(b) permits good faith meeting of
  competition

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Peak Load Pricing

• Suppose that demand is predictably volatile
• Variation may be daily, seasonal
• Pricing response?

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Intertemporal Price DiscriminationPeak Load
Pricing
P
mc
p2
D2
p1
mr2
D1
mr1
q1
q2
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Pizza for 2.99???
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Examples of Peak-load pricing

• Pricing power by the hour
• Average rate .11/kwh
• Peak rate .81/kwh
• Off Peak .09/kwh
• Reservations?
• How is this different than paying by the gig
  for Internet downloads?

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Necessary conditions for Price discrimination

• 1. Monopoly power
• 2. Ability to identify different customers
• 3. Ability to prevent arbitrage

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European Commission Finds against Topps

• Facts?
• Should government concern itself with something
  as trivial as trading cards?
• Is Topps pricing policy consistent with the
  establishment of the EU?

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The Economics of Price Discrimination
Finland
Portugal
Combined Market
/Q
/Q
/Q
PF
D
P
PP
mc
mr
mr
d
d
MR
Q
Q
Q
Q
QF
QP
With linear demand and costs, price
discrimination fails to benefit consumers
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Dynamic Pricing

• Dynamic pricing
• is sometimes meant to connote price changes over
  time for the same commodity or service
• E.g., Caps pricing within a season
• Coca-cola vending machines that adjust price
  depnding on temperature
• Is sometimes meant to connote third degree price
  discrimination
• E.g., Amazon.com (setting different prices to
  different consumners for the same commodity (e.g.
  book or CD)
• Orbitz has discovered that Mac users pay on
  average 30 more for hotel rooms per night than
  PC users modify showing

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Orbitz Pricing PC Search (July 6, 2012)
1PC 103
3PC129
2PC 134
4PC159
But if Mac-based search???
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Hyatt Regency Crystal City
October 19- Oct 21
103 per night
Hyatt Regency Crystal City
October 26- Oct 28
169 per night
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Takeaways

• When firms have market power, simple pricing can
  leave a lot of value on the table
• Price discrimination strategies can help firms
  increase profits
• Extract consumer surplus from existing high
  willingness-to-pay customers
• Make additional profitable sales to low
  willingness-to-pay consumers
• Be aware of legal restrictions