class: center, middle, inverse, title-slide # 4.3 — Pricing Strategies ## ECON 306 • Microeconomic Analysis • Spring 2022 ### Ryan Safner
Assistant Professor of Economics
safner@hood.edu
ryansafner/microS22
microS22.classes.ryansafner.com
--- class: inverse # Outline ### [1<sup>st</sup>-Degree Price Discrimination](#15) ### [3<sup>rd</sup>-Degree Price Discrimination](#20) ### [Is Price Discrimination Good or Bad?](#40) ### [2<sup>nd</sup>-Degree Price Discrimination](#51) --- # Profit-Seeking Firms .pull-left[ <img src="4.3-slides_files/figure-html/unnamed-chunk-1-1.png" width="504" style="display: block; margin: auto;" /> ] .pull-right[ - Any firm with market power seeks to maximize profits - Wants to (1<sup>st</sup>) **create** a .blue[surplus] ] --- # Profit-Seeking Firms and Appropriability .pull-left[ <img src="4.3-slides_files/figure-html/unnamed-chunk-2-1.png" width="504" style="display: block; margin: auto;" /> ] .pull-right[ - Any firm with market power seeks to maximize profits - Wants to (1<sup>st</sup>) **create** a .blue[surplus] .hi-green[and then *appropriate* some of it as profit] - i.e. convert .hi-blue[CS] `\(\rightarrow\)` .hi-green[`\\(\pi\\)`] - Consumers are *still* better off than without the firm because it creates value (.blue[consumer surplus]) - Just not as *best*-off as under perfect competition ] --- # Most Firms Create More Value than They Can Capture! .left-column[ .center[ ![:scale 70%](../images/nordhaus.jpg) .smallest[ William Nordhaus (1941-) Economics Nobel 2018 ] ] ] .right-column[ > “We conclude that [about 2.2%] of the social returns from technological advances over the 1948-2001 period was captured by producers, indicating that most of the benefits of technological change are passed on to consumers rather than captured by producers,” (p.1) ] .source[Nordhaus, William, 2004, ["Schumpeterian Profits in the American Economy: Theory and Measurement,"](https://www.nber.org/papers/w10433) *NBER Working Paper* 10433] --- # Price Discrimination .pull-left[ - The most obvious way to capture more surplus is to raise prices - But **Law of Demand** `\(\implies\)` this would turn many customers away! - Also, we saw that if a firm wants to sell more units, it has to lower the price on all units! ] .pull-right[ <img src="4.3-slides_files/figure-html/unnamed-chunk-3-1.png" width="504" style="display: block; margin: auto;" /> ] --- # Price Discrimination .pull-left[ - Instead, if firm could charge **different** customers with *different WTP* **different** prices for **the same goods**, firm could convert more .blue[consumer surplus] into .green[profit] - .hi[“Price discrimination”] or .hi[“Variable pricing”] ] .pull-right[ .center[ ![](../images/variablepricing.png) ] ] --- # The Economics of Pricing Strategy I .pull-left[ - Two conditions are required for a firm to engage in variable pricing: .hi-purple[1) Firm must have market power] - A competitive firm must charge the market price ] .pull-right[ .center[ ![:scale 70%](../images/marketpower.jpg) ] ] --- # The Economics of Pricing Strategy I .pull-left[ - Two conditions are required for a firm to engage in variable pricing: .hi-purple[1) Firm must have market power] - A competitive firm must charge the market price .hi-purple[2) Firms must be able to prevent resale or arbitrage] - Clever customers buy in your lower-price market to resell it in your higher-price market ] .pull-right[ .center[ ![:scale 70%](../images/marketpower.jpg) ![:scale 70%](../images/notforresale.jpg) ] ] --- # The Economics of Pricing Strategy II .pull-left[ - Firm *must acquire information* about the variations in its customers' demands - Can the firm identify consumers' demands **before** they buy the product? ] .pull-right[ .center[ ![](../images/information.png) ] ] --- # The Economics of Pricing Strategy III .center[ ![:scale 60%](../images/pricingstrategy.png) (Goolsbee et al., 2013: 397) ] --- # The Economics of Pricing Strategy IV .pull-left[ - With **perfect information** `\(\implies\)` .hi[Perfect] or .hi[1<sup>st</sup>-degree price discrimination] - .hi-purple[Charge a different price to each customer] (their max WTP) ] .pull-right[ .center[ ![](../images/pricediscrimination.jpeg) ] ] --- # The Economics of Pricing Strategy V .pull-left[ - With **imperfect information** `\(\implies\)` .hi[3<sup>rd</sup>-degree price discrimination] - Separate customers into groups (by demand differences) and charge each group a different price ] .pull-right[ .center[ ![](../images/pricediscrimination.jpeg) ] ] --- # The Economics of Pricing Strategy VI .pull-left[ - .hi[2<sup>nd</sup>-degree price discrimination]: More **indirect** forms of pricing: tying, bundling, quantity-discounts - Firm does **not** have enough information to categorize customers into groups - Consumers **self-select** into their own group ] .pull-right[ .center[ ![](../images/2019holidaydiscount.png) ] ] --- class: inverse, center, middle # 1<sup>st</sup>-Degree Price Discrimination --- # 1<sup>st</sup>-Degree Price Discrimination I .pull-left[ .center[ ![](../images/perfectpd.png) ] ] .pull-right[ - If firm has *perfect information* about every customer's demand before purchase: - .hi[Perfect] or .hi[1<sup>st</sup>-degree price discrimination]: firm charges *each* customer their maximum willingness to pay - “walks” down the market demand curve customer by customer ] --- # 1<sup>st</sup>-Degree Price Discrimination II .pull-left[ <img src="4.3-slides_files/figure-html/unnamed-chunk-4-1.png" width="504" style="display: block; margin: auto;" /> ] .pull-right[ - Firm converts *all* consumer surplus into profit! - Produces the competitive amount `\((q_c)\)`! ] --- # 1<sup>st</sup>-Degree Price Discrimination: Example .pull-left[ .center[ ![:scale 100%](../images/collegepd.png) ] ] .pull-right[ .center[ ![:scale 100%](../images/collegecosts.jpg) ] ] --- # Big Data and Perfect Price Discrimination .center[ ![:scale 90%](../images/bigdatapricediscrimination.jpg) ] --- class: inverse, center, middle # 3<sup>rd</sup>-Degree Price Discrimination --- # 3<sup>rd</sup>-Degree Price Discrimination I .pull-left[ - Firms almost never have perfect information about their customers - But they can often separate customers by .hi-purple[observable characteristics] into .hi-purple[different groups] with similar demands *before purchasing* ] .pull-right[ .center[ ![](../images/variablepricing.png) ] ] --- # 3<sup>rd</sup>-Degree Price Discrimination I .pull-left[ - Firms .hi[segment] the market or engage in .hi[3<sup>rd</sup>-degree price discrimination] by charging different prices to different *groups* of customers - By far the most common type of price-discrimination ] .pull-right[ .center[ ![](../images/variablepricing.png) ] ] --- # 3<sup>rd</sup>-Degree Price Discrimination II .pull-left[ .center[ .smallest[ Business Travelers (Less Elastic) ] ] <img src="4.3-slides_files/figure-html/unnamed-chunk-5-1.png" width="504" style="display: block; margin: auto;" /> ] .pull-right[ .center[ .smallest[ Vacationers (More Elastic) ] ] <img src="4.3-slides_files/figure-html/unnamed-chunk-6-1.png" width="504" style="display: block; margin: auto;" /> ] .smallest[ Consider airlines: different groups of travelers have different demands & price elasticities ] --- # 3<sup>rd</sup>-Degree Price Discrimination II .pull-left[ .center[ .smallest[ Business Travelers (Less Elastic) ] ] <img src="4.3-slides_files/figure-html/unnamed-chunk-7-1.png" width="504" style="display: block; margin: auto;" /> ] .pull-right[ .center[ .smallest[ Vacationers (More Elastic) ] ] <img src="4.3-slides_files/figure-html/unnamed-chunk-8-1.png" width="504" style="display: block; margin: auto;" /> ] .smallest[ The firm could charge a **single price** to all travelers and earn some .hi-green[profit] ] --- # 3<sup>rd</sup>-Degree Price Discrimination II .pull-left[ .center[ .smallest[ Business Travelers (Less Elastic) ] ] <img src="4.3-slides_files/figure-html/unnamed-chunk-9-1.png" width="504" style="display: block; margin: auto;" /> ] .pull-right[ .center[ .smallest[ Vacationers (More Elastic) ] ] <img src="4.3-slides_files/figure-html/unnamed-chunk-10-1.png" width="504" style="display: block; margin: auto;" /> ] .smallest[ With **different prices**: raise price on inelastic travelers, lower price on elastic travelers, earn .hi-green[*more* profit]! ] --- # 3<sup>rd</sup>-Degree Price Discrimination: Examples I .pull-left[ .center[ ![](../images/seniordiscount.jpg) ] ] .pull-right[ .center[ ![](../images/studentdiscount.jpeg) ] ] --- # 3<sup>rd</sup>-Degree Price Discrimination: Examples II .center[ ![:scale 80%](../images/razorpd.jpg) ] --- # 3<sup>rd</sup>-Degree Price Discrimination: Examples III .center[ ![:scale 40%](../images/airlinepd.png) ] --- # 3<sup>rd</sup>-Degree Price Discrimination: Examples IV .pull-left[ .center[ ![:scale 100%](../images/gothardcover.jpg) ] ] -- .pull-right[ .center[ ![:scale 100%](../images/gotpaperback.jpg) ] ] --- # Sales .pull-left[ - .hi-purple[Price-inelastic] buyers will buy something (a necessity?) now regardless of whether or not it is “on sale” - .hi-purple[Price-elastic] buyers will be attracted to buying something when price is lower - Stores lower prices on rare occasions to attract price-sensitive shoppers (will lose profits on price-insensitive shoppers who buy during the sale!) - Black Friday: many price-insensitive shoppers stay away to avoid crowds! Better for the stores! ] .pull-right[ .center[ ![](../images/blackfridaysaletag.jpg) ] ] --- # Coupons .pull-left[ - .hi-purple[Coupons] also are designed to bring in more price-elastic shoppers - Often lower income, very sensitive to price, worth the hassle of collecting & using coupons - Store sells at higher price (to capture profit from price-insensitive shoppers who can’t be bothered with coupons) and brings in profits from price-sensitive shoppers who use coupons to pay lower price ] .pull-right[ .center[ ![](../images/coupons.png) ] ] --- # Pricing and Markup .pull-left[ .smallest[ - How much should each segment be charged? - Firm treats each segment as a *different* market 1. Find q*: `\(MR(q)=MC(q)\)` 2. Raise p* to maximum WTP (Demand) - Lerner index implies optimal markup for each segment, again: `$$\underbrace{\frac{p-MC(q)}{p}}_{\text{Markup % of Price}}=-\frac{1}{\epsilon}$$` ] ] .pull-right[ .center[ ![](../images/markup.jpg) ] ] --- # 3<sup>rd</sup>-Degree Price Discrimination: Numerical Example .bg-washed-green.b--dark-green.ba.bw2.br3.shadow-5.ph4.mt5[ .green[**Example**]: Suppose you run a bar in downtown Frederick, and estimate the nightly demands for beer from undergraduates `\((U)\)` and graduates `\((G)\)` to be: `$$\begin{align*} q_U&=18-4p_U\\ q_G&=12-p_G\\ \end{align*}$$` Assume the only cost of producing a beer is a constant marginal (and average) cost of $2. ] 1. If your bar had to charge a uniform price for beer, how much profit would the bar earn? 2. If you could price discriminate, how much profit would the bar earn? --- # 3<sup>rd</sup>-Degree Price Discrimination: Numerical Example <img src="4.3-slides_files/figure-html/unnamed-chunk-11-1.png" width="1080" style="display: block; margin: auto;" /> --- # 3<sup>rd</sup>-Degree Price Discrimination: Numerical Example <img src="4.3-slides_files/figure-html/unnamed-chunk-12-1.png" width="1080" style="display: block; margin: auto;" /> - Charging a single price: $4, .green[total profit of $20] <!--(.blue[$32.50 of CS], **[$10 of DWL])--> --- # 3<sup>rd</sup>-Degree Price Discrimination: Numerical Example <img src="4.3-slides_files/figure-html/unnamed-chunk-13-1.png" width="1080" style="display: block; margin: auto;" /> - Charging $3.25 to Undergrads; $7.00 to grads; .green[total profit of $31.25] <!--(.blue[$15.625 of CS], **[$15.625 of DWL])--> --- # 3<sup>rd</sup>-Degree Price Discrimination: Numerical Example <img src="4.3-slides_files/figure-html/unnamed-chunk-14-1.png" width="1080" style="display: block; margin: auto;" /> - Charging $3.25 to Undergrads; $7.00 to grads; .green[total profit of $31.25] --- # Ways to Segment Markets .pull-left[ - By customer characteristics - Age - Gender - Past purchase behavior - repeat customers (more price sensitive) - By location - local demand characteristics ] .pull-right[ .center[ ![](../images/variablepricing.png) ] ] --- class: inverse, center, middle # Is Price Discrimination Good or Bad? --- # Is Price Discrimination Good or Bad? I .pull-left[ - Ideal competitive market, `\(q^*\)` where `\(p^c=MC\)` ] .pull-right[ <img src="4.3-slides_files/figure-html/unnamed-chunk-15-1.png" width="504" style="display: block; margin: auto;" /> ] --- # Is Price Discrimination Good or Bad? I .pull-left[ - Ideal competitive market, `\(q^c\)` where `\(p^c=MC\)` - A pure monopolist would produce less `\(q^m\)` at higher `\(p^m\)` - reduce .blue[consumer surplus] and create **deadweight loss** - Transfer of some surplus from consumers to producers ] .pull-right[ <img src="4.3-slides_files/figure-html/unnamed-chunk-16-1.png" width="504" style="display: block; margin: auto;" /> ] --- # Is Price Discrimination Good or Bad? I .pull-left[ - A price-discriminating monopolist transfers MORE surplus from consumers to producers - But encourages monopolist to produce more than the pure monopoly level and reduce deadweight loss! - At best, also produces at competitive output level! ] .pull-right[ <img src="4.3-slides_files/figure-html/unnamed-chunk-17-1.png" width="504" style="display: block; margin: auto;" /> ] --- # Is Price Discrimination Good or Bad? II .pull-left[ - Price-discrimination creates incentives for innovation and risk-taking - Firms with high fixed costs of investment earn greater profits with price discrimination, can recover their fixed costs - Might not invest or produce if they had to charge a uniform price ] .pull-right[ .center[ ![](../images/riskprofit.jpg) ] ] --- # Is Price Discrimination Good or Bad? III .pull-left[ - As with markups in general, price discrimination has everything to do with .hi[price elasticity of demand] - If you are paying too much and losing consumer surplus, the real “problem” is that .hi-purple[your demand is not very elastic] - fewer options, a particular brand, or a necessity, limited time, etc - If you want to pay less, .hi-purple[buy generic] (more elastic) ] .pull-right[ .center[ ![](../images/cerealgeneric.jpg) ] ] --- # How to Be a Savvy Consumer .pull-left[ .smallest[ - Realize that any “sales” and “discounts” are calculated to make *the store* more money - You *can* also be better off as a consumer too - Think about your .blue[consumer surplus]! - If you were *already* planning to buy the product, a fall in price is **a good deal** for you - Your demand is less elastic - If you *weren’t* going to buy the product before, and now you do, the sale was effective for the store, and you likely don’t get much surplus - Your demand is more elastic ] ] .pull-right[ ![](3.2-slides_files/figure-html/unnamed-chunk-8-1.png) ] --- # Behavioral Economics .center[ ![:scale 50%](../images/behavioraleconomicspricing.PNG) ] --- # Price Discrimination vs. Price Differences .pull-left[ - .hi[Price discrimination] is selling *identical* goods to people at different prices - But not everytime people pay different prices means it is price discrimination - Sometimes it is truly different goods that people are paying different prices for - If *costs* to firm are *different* for different versions (color, size, etc.), it is a *different* good, *not* price discrimination ] .pull-right[ .center[ ![](../images/variablepricing.png) ] ] --- # Price Discrimination vs. Price Differences .pull-left[ - .hi-green[Example]: bottled sparkling water often higher price than Coca Cola - Could be because sparkling water drinkers have less elastic demand than Coke drinkers - Or could be that it is more expensive to package sparkling water (economies of scale with greater number of Coke drinkers) ] .pull-right[ .center[ ![](../images/cokewater.jpg) ] ] --- # Price Discrimination vs. Price Differences .pull-left[ - The best way to tell the difference is to see what happens if demand changes price elasticity (and costs do not change) - Price discrimination requires market power, firm with market power marks up price based on `\(\frac{1}{\epsilon}\)` - Competitive firm only sets `\(p=MC\)`, so change in elasticity has no effect on price - See [today’s class notes](/content/4.3-content) for a graphical demonstration ] .pull-right[ .center[ ![:scale 100%](../images/elastic.jpg) ] ] --- class: inverse, center, middle # 2<sup>nd</sup>-Degree Price Discrimination --- # 2<sup>nd</sup>-Degree Price Discrimination I .pull-left[ .center[ ![](../images/head-scratcher.jpg) ] ] .pull-right[ - If firm *cannot* identify customers' demands or types before purchase - .hi[Indirect] or .hi[2<sup>nd</sup>-degree price discrimination]: firm offers difference price-quantity bundles and allows customers **self-select** (based on preferences) ] --- # 2<sup>nd</sup>-Degree Price Discrimination: Block Pricing .pull-left[ - .hi-purple[Block Pricing/Nonlinear pricing]: offer different prices for different quantities that consumers can choose - .hi-purple[quantity discounting]: higher quantities offered at lower prices ] .pull-right[ .center[ ![](../images/quantity-discounts.png) ] ] --- # 2<sup>nd</sup>-Degree Price Discrimination: Block Pricing .pull-left[ - .hi-green[Example:] instead of one profit-maximizing monopoly price of `\(p_m\)` for `\(q_m\)` units, offer: ] .pull-right[ <img src="4.3-slides_files/figure-html/unnamed-chunk-18-1.png" width="504" style="display: block; margin: auto;" /> ] --- # 2<sup>nd</sup>-Degree Price Discrimination: Block Pricing .pull-left[ - .hi-green[Example:] instead of one profit-maximizing monopoly price of `\(p_m\)` for `\(q_m\)` units, offer: - `\(p_1\)`/unit for `\(q_1\)` units - `\(p_2\)`/unit for `\(q_2\)` units - `\(p_3\)`/unit for `\(q_3\)` units - `\(p_4\)`/unit for `\(q_4\)` units - Converts **DWL** into .blue[CS] and captures more of it as .green[Profit] ] .pull-right[ <img src="4.3-slides_files/figure-html/unnamed-chunk-19-1.png" width="504" style="display: block; margin: auto;" /> ] --- # 2<sup>nd</sup>-Degree Price Discrimination: Versioning .pull-left[ - .hi-purple[Versioning]: offer different prices for different *qualities* of a good (instead of *quantity*) - Higher (lower) prices offered for higher (lower) quality ] .pull-right[ .center[ ![](../images/versioningPD.jpg) ] ] --- # 2<sup>nd</sup>-Degree Price Discrimination: Versioning .pull-left[ .center[ ![:scale 100%](../images/gothardcover.jpg) ] ] .pull-right[ .center[ ![:scale 100%](../images/gotpaperback.jpg) ] ] --- # Tying I .pull-left[ - Firms often .hi[tie] multiple goods together, where you must buy both goods in order to consume the product - One good often the “base” and the other are “refills” that you may need to buy more of - This is actually a method of .hi-purple[*intertemporal* price-discrimination]! ] .pull-right[ .center[ ![:scale 80%](../images/printerandink.jpg) ![:scale 40%](../images/shaver.jpg) ![:scale 40%](../images/razorheads.jpg) ] ] --- # Tying II .pull-left[ - Companies often **sell printers at marginal cost** (no markup) and sell the **ink/refills at a much higher markup** - **Reduce arbitrage**: - printer requires specific ink - ink only words with that specific printer ] .pull-right[ .center[ ![](../images/printerandink.jpg) ] ] --- # Tying II .pull-left[ - Segment the market into: 1. .hi-purple[High-volume users]: buy more ink over time; pay more per sheet printed 2. .hi-purple[Low-volume users]: buy less ink; pay less per sheet printed - **Indirect** price-discrimination: firms **don't know** what kind of user you are in advance ] .pull-right[ .center[ ![](../images/printerandink.jpg) ] ] --- # Tying: Good or Bad? .pull-left[ - Again, a tradeoff: - Increased profits and reduced consumer surplus, reduced deadweight loss - Spreads fixed cost of research & development over more users ] .pull-right[ .center[ ![](../images/printerandink.jpg) ] ] --- # Tying: Good or Bad? .pull-left[ - If printers & ink were **not** tied: - **printers** would be **more expensive** - **ink** would be **cheaper** - High-volume users would keep buying ink and save money (vs. tied) - Low-volume users might not buy the (now expensive) printer at all! ] .pull-right[ .center[ ![](../images/printerandink.jpg) ] ] --- # Bundling I .pull-left[ - Firms often .hi[bundle] products together as a single package, and refuse to offer individual parts of the package - Often, consumers do not want all products in the bundle - Or, if they were able to buy just part of the bundle, they would *not* buy the other parts ] .pull-right[ .center[ ![](../images/cablebundle.jpg) ] ] --- # Bundling II .pull-left[ .bg-washed-green.b--dark-green.ba.bw2.br3.shadow-5.ph4.mt5[ .green[**Example**]: Consider two consumers, each have different reservation prices to buy components in Microsoft Office bundle ] | | Amy's WTP | Ben's WTP | |----|-----|-----| | MS Word | $70 | $40 | | MS Excel | $50 | $60 | ] .pull-right[ .smallest[ - Microsoft could charge separate prices for MS Word and MS Excel ] ] --- # Bundling II .pull-left[ .bg-washed-green.b--dark-green.ba.bw2.br3.shadow-5.ph4.mt5[ .green[**Example**]: Consider two consumers, each have different reservation prices to buy components in Microsoft Office bundle ] | | Amy's WTP | Ben's WTP | |----|-----|-----| | MS Word | $70 | $40 | | MS Excel | $50 | $60 | ] .pull-right[ .smallest[ - Microsoft could charge separate prices for MS Word and MS Excel - MS Word: both would buy at $40, generating $80 of revenues ] ] --- # Bundling II .pull-left[ .bg-washed-green.b--dark-green.ba.bw2.br3.shadow-5.ph4.mt5[ .green[**Example**]: Consider two consumers, each have different reservation prices to buy components in Microsoft Office bundle ] | | Amy's WTP | Ben's WTP | |----|-----|-----| | MS Word | $70 | $40 | | MS Excel | $50 | $60 | ] .pull-right[ .smallest[ - Microsoft could charge separate prices for MS Word and MS Excel - MS Word: both would buy at $40, generating $80 of revenues - MS Excel: both would buy at $50, generating $100 of revenues ] ] --- # Bundling II .pull-left[ .bg-washed-green.b--dark-green.ba.bw2.br3.shadow-5.ph4.mt5[ .green[**Example**]: Consider two consumers, each have different reservation prices to buy components in Microsoft Office bundle ] | | Amy's WTP | Ben's WTP | |----|-----|-----| | MS Word | $70 | $40 | | MS Excel | $50 | $60 | ] .pull-right[ .smallest[ - Microsoft could charge separate prices for MS Word and MS Excel - MS Word: both would buy at $40, generating $80 of revenues - MS Excel: both would buy at $50, generating $100 of revenues - Total revenues of individual sales: $180 ] ] --- # Bundling II .pull-left[ .bg-washed-green.b--dark-green.ba.bw2.br3.shadow-5.ph4.mt5[ .green[**Example**]: Consider two consumers, each have different reservation prices to buy components in Microsoft Office bundle ] | | Amy's WTP | Ben's WTP | |----|-----|-----| | MS Word | $70 | $40 | | MS Excel | $50 | $60 | | Bundle | $120 | $100 | ] .pull-right[ .smallest[ - Microsoft could charge separate prices for MS Word and MS Excel - MS Word: both would buy at $40, generating $80 of revenues - MS Excel: both would buy at $50, generating $100 of revenues - Total revenues of individual sales: $180 - Microsoft can instead add their individual reservation prices and bundle products together to force both consumers to buy both products - .hi-purple[Bundle]: both buy at $100, generating $200 revenue ] ] --- # Bundling: Good or Bad? .pull-left[ - Again, a tradeoff: - Increased profits and reduced consumer surplus, reduced deadweight loss - Spreads fixed cost of research & development over more users - Goods with high fixed costs and low marginal costs (software, TV, music) increase profits from bundling - increases innovation and investment in these industries ] .pull-right[ .center[ ![](../images/bundlebox.png) ] ]