This Session

1
Sessions 67
Uniform pricing (one price for all
consumers and we let them buy any quantity at
that price)
Last Session
Explicit Market Segmentation (Different
Prices for different customers)
This Session
Implicit Market Segmentation (Screening)
(Different Choices for different customers)
A Classic Pricing Dilemma You know composition
of market, but cannot identify valuation of
individual customers propose
different options for different consumers.
2
Understanding Cost (session 3)
Revenue Understanding Demand (session 2)
Profit Revenue Cost
Pricing
Monopoly Trade off b/w high P and low Q
(session 6)
Perfect Competition Supply and entry decisions
(session 4 5)
What if we can price discriminate? (i.e.,
different consumers pay different
prices) (session 9 10)
How pricing depends on demand through the
elasticities (session 7)
Strategic Competition Solving for the NE
price and quantity competition (session 12)
How timing matters Stackelberg (session 14)
Exotic topics Strategic Demand Network
externalities and Auctions. (session 15)
Tools Games Theory (session 11)
Externalities and Strategic interaction
Collusion (session 13)
3
Mid Term
The midterm is graded out of 49 which is the
number of potential answers. Midterm Average
44 Standard Deviation 2.8 No significant
difference between two sections Congratulations!
Very good show!! Keep in Mind Objectives of
midterm Correction at the end of your handout.
4
Today

• Explicit market segmentation
• Back to the Roxy Theater problem
• Implicit market segmentation
• Different choices for different consumers
• Market power games
• Midterm exam correction

5
Roxy Theater

• Capacity constraint 95 seats
• Current prices
• General public 6.00
• Students 4.80
• Following the elimination of the university movie
  series , students demand is expected to increase
  drastically. The manager estimates that total
  demand will exceed capacity.
• Should Roxy eliminate student discount
• and charge the same price to all?

6
Roxy Theater

• Capacity constraint K 95 seats
• Demand General public Qg and Students Qs
• Goal Maximize revenue under constraint of
  selling at capacity,.

P
Pu Revenue maximizing price under uniform
pricing that fill up capacity Pq price for
general public Ps price for student
Qs Qg K
Green Loss Red Gain Gain Loss
Qs Qg K
Pg
Pu
Ps
Revenue is maximized under Price discrimination
Qs
Qg
Qg
Qs
Q
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Summary Roxy theater

• Agree Es EGP (as in the past)
• Recall MR P(1-1/E)
• So if same price (say 6) MRS MRGP
• Same price MRs ? MRGP ? profits are not
  maximized
• To equate sell more to students less to general
  public till MRs MRGP
• Cut prices to students from 6 Raise prices to
  General Public above 6
• Lessons
• Do not ignore other market segments
• Price to maximize profits
• Segmenting market and price discrimination can
  raise profits

8
Wrap Up session 8

• Uniform pricing
• The monopolist concedes some surplus to the
  consumer and some surplus is lost
• No arbitrage and partial information about
  consumer valuations enable the monopolist to
  price discriminate and grab more surplus.
• Perfect Price Discrimination
• A benchmark of what you could do if you had
  perfect information and could offer each buyer
  a fixed quantity.
• Imperfect/Explicit Market Segmentation
• Charge different prices to different groups of
  customers if possible and if the groups have
  different elasticities of demand.
• Charge inelastic market segment higher price.

9
Priceline.com We finally got a piece of the
pie Captain Kirk
Is this uniform pricing? Is this explicit market
segmentation?

• How does Pricelines business model addresses the
  fundamental problem of price discrimination
• Consumer identification
• Ask consumers to identify themselves! Consumers
  reveal their own valuation through their bids.
• Screening Mechanism
• Make obtaining the discounted products such a
  pain in the in order to discourage
  high-valuation buyers from switching (this is
  necessary to convince sellers to use Pricelines
  site).

10
A Requisite for Screening

• Options cannot differ only by price you need
  another dimension or
• product characteristic about which customers have
  different preferences.
• Called Screening Mechanism
• Must be correlated with willingness to pay
• We discuss several examples of implicit market
  segmentation
• We consider in more details two screening
  mechanisms
• Product differentiation
• Bundling

Road map for session 9
11
Basic Terms and Concepts
The composition of the market is known, but you
can not identify who is who. Menu The set of
options you offer your customers. Objective
Customize trades in the menu such that consumers
reveal to you who they are via their choices
(i.e., high valuation consumers freely choose the
more expensive option on the menu.) Make sure
menu satisfies two constraints Participation
constraint Customer prefers the deal over not
trading at all. Self-selection constraint
Customer prefers the deal you have designed for
him/her over other deals in menu.
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Limitations of our analysis

• Our goal is NOT to ask which menu design is the
  best. This is a hard and possibly intractable
  problem.
• We present some examples of menu designs used in
  practice and we try to see the logic behind them.

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A Simple Example Coupons

• Focus on coupons and rebates that require an
  effort on the part of the consumer to redeem
  (usually, must be mailed in for refund)
• Coupons and rebates appear to be a rather
  expensive way to cut prices
• Coupons must be printed and circulated
• Redeeming them is expensive applications must
  be processed, checks cut and mailed
• So why issue coupons? Wouldnt it be easier to
  just cut prices?

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Coupons (cont.)

• Consumers are not equally likely to redeem
  coupons
• Correlation between a consumers willingness to
  pay
• and the likelihood that he/she redeems
• What is the likely direction of this
  correlation?
• Rebates discriminate among consumers according
  to the value they
• attach to their time
• ...and for this to work it is essential that
  redemption is made to be a
• time-consuming hassle

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Coupons As a Screening Device
With rebates and no coupons, MR C A B. This
may not be optimal because the firm gives up AB
to sell additional output. With coupons, only
some consumer redeem, so MR C A, and a price
cut is more attractive. Note that here there are
effectively two prices in the market.

Demand
Old price P0
B
A
New price P1
C
dont redeem
redeem
Q
Q0
Q01
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Price Elasticity of Demand for Users Vs.
Nonusers of Coupons

• Cat food 0.49 1.13
• Frozen entrée 0.60 0.95
• Gelatin 0.97 1.25
• Spaghetti sauce 1.65 1.81
• Shampoo/conditioner 0.82 1.12
• Soup 1.05 1.22
• Hot dogs 0.59 0.77
• Cooking oil 1.21 1.32

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Other Examples of Implicit Price Discrimination

• Hardcover vs. Softcover Books
• Versioning
• Super Thursday Regular Thursday sales in
  supermarkets
• Bulk Discounts nonlinear pricing
• Damaged Goods
• Mathematica student versions degrade math
  coprocessor in order
• to slow down calculations
• Federal Express offers both morning and
  afternoon delivery. FedEx does
• not deliver afternoon packages in the morning,
  even if they arrive in time
• for morning delivery. Instead they will make
  two trips to the same location.

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The Mother of All Discriminatory Pricing Airline
Pricing

• Airlines like to segment the market based on
  valuations, but valuations are not observed
• On the other hand, valuations are correlated
  with time sensitivity.
• In general consumers with higher valuation are
  less likely to accept
• Saturday night stay
• A 14-day advance ticketing ,..etc.
• Solution Create a product line based on
  artificial restrictions.
• These annoy customers, and have little or no
  bearing on their cost of operation

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Screening with Differentiated Products
Scenario Airline has B business customers and L
leisure customers.
Cost per ticket 300 (Same for restricted and
unrestricted tickets)
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Screening with Differentiated Products Exercise
10.2 10.5

• 0. Explicit market segmentation
• Sell unrestricted to both (for a low price)
• Sell unrestricted to business travelers only (for
  a high price)
• Sell unrestricted to business and restricted to
  leisure travelers

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Screening with Differentiated Products Exercise
10.2 10.5 (cont.)
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Comparison of 3 Options
(A) sell only unrestricted tickets at a price of
___________ to business travelers
only Profit (B) sell only unrestricted
tickets at a price of ____________ to all
travelers Profit (C) sell unrestricted
tickets to business travelers for ____________
and restricted tickets to leisure travelers for
__________. Profit
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(No Transcript)
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Bundling

• Selling several goods in one bundle
• Hardware and software
• Software suites
• Sports/Concert tickets
• Auto accessories

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Exercise 10.6 Screening via Bundling
Pricing of a two-concert mini season (Wagner and
Harbison) at a theater. Highly segmented, with
only three types of customers
A customer may go to one or both of the concerts.
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Benchmark Explicit Market Segmentation
No Bundling
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Pure Bundling
Mixed Bundling
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Bottom Line

• Even if you cannot explicitly segment the market
  dont lose heart. You can still price
  discriminate if you know the composition of the
  market
• Construct menus of deals which make costumers
  reveal to you their type via their choice of
  deals
• Find products and design mechanisms where you
  can effectively prevent high-end consumers from
  buying the low-end product
• Try product differentiation, versioning,
  inter-temporal pricing, damaging, bundling, that
  achieves price discrimination

Do not ignore the composition of your market!
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• If a 5 increase in income leads to a 12
  increase in the quantity demanded of mobile
  phones, ceteris paribus, the value of the income
  elasticity of demand for mobile phones is
• a. 2.4 and mobile phones are a normal good.
  b. 0.42 and mobile phones are a normal
  good.c. 2.4 and mobile phones are an inferior
  good.d. 0.42 and mobile phones are an inferior
  good.
• The existence of profit in a perfectly
  competitive industry means that
• a. new producers will seek to enter the
  industry.b. the current price exceeds marginal
  cost.c. consumers will switch to substitute
  goods.d. each producer is charging a different
  price.e. the current price exceeds average
  cost.

30

• What is meant by the "deadweight loss" caused by
  a tax?a. The surplus that results.b. The
  inefficiency that results from the loss of
  potentially
• beneficial transactions.
• c. The transfer of wealth from taxpayers to the
  government in
• the form of tax revenue.
• d. The shortage that results.
• One difference between monopoly and perfect
  competition is that a. a perfect competitor
  seeks to maximize profit a monopolist does not.
• b. the marginal revenue curve for a monopolist
  is downward-sloping,
• and for a perfect competitor it is
  horizontal.c. a monopolist seeks to maximize
  profit a perfect competitor does not.
• d. the marginal revenue curve for a perfect
  competitor is downward-
• sloping, and for a monopolist it is horizontal.

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5. The profit-maximizing rule for a monopoly firm
is to produce at the output rate where
a. price is maximum b. MR MC/1 (1/Ed)
c. P exceeds ATC by the greatest amount
d. all of these e. none of these 6. A firm
producing in the short run uses two inputs,
capital and labor. The quantity of capital is
fixed and generates a monthly cost of 6,000. The
quantity of labor can be varied, and the
wage rate per hour of labor is 20. If 400
hours of labor are hired for the month, and 140
units of output are produced, what is the
firms average total cost for the month?
a. 100.00 b. 2.80 c. 123.00
d. 43.00
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• The monopolist's marginal revenue curve is
  downward-sloping because a. his total revenue
  declines as he sells more.b. he operates in the
  range where ATC is downward-sloping.c. he
  operates in the range where MC is
  downward-sloping.d. the monopolist must lower
  his price in order to sell more.
• Suppose a seller is considering entering a new
  market. Demand for the
• product is given by Q80-p. Marginal cost is
  equal to 10 and the seller also
• has a fixed entry cost equal to 600. A
  price set at the level of 30 is
• a. above the profit maximizing price for the
  seller.
• b. equal to the profit maximizing price for the
  seller but, as the seller does
• not cover his fixed cost, he should
  not enter.
• c. below the profit maximizing price but allows
  the seller to make profit.
• d. maximizing the sellers revenue.
• e. below the profit maximizing profit and does
  not allow the seller to
• make profit.

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9. If a firm experiences economies of scale as
it expands production, a. then its
marginal cost curve is not upward-sloping in that
range. b. then it is not subject to
diminishing returns. c. then its average
total cost curve is downward-sloping in that
range. 10. Suppose an industry
initially had been perfectly competitive and
then became a monopoly. Which of the
following would occur? a. The deadweight
loss would be eliminated. b. Producer
surplus would decrease c. Consumer surplus
would increase. d. Consumer surplus would
decrease.
34

• A perfectly competitive firm is currently
  selling its product at the market
• price of 6. Its average fixed cost is
  0.75 and its average total cost is
• 5.50. How much would the market price
  have to decline in order for the
• firm to choose to shut down in the short
  run? a. The price would have to fall below
  4.75. b. The price would have to fall below
  0.75 c. The firm should shut down now, at the
  price of 6.00 d. The price would have to fall
  below 5.50.
• 12. For a firm with market power the more
  inelastic the demand for a firm's
• product, the
• a. smaller the markup of price over cost
• c. larger the price
• d. more likely it is that the firm must price
  as if it were in a perfectly
• competitive market