Topic 7: Innovative Pricing

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Topic 7 Innovative Pricing

• How to use price discrimination to raiseboth
  profits and total value
• Paul Kerin Sam Wylie
• MBS Term 3, 2004

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Car Selling

• Seller has many cars for sale. Each is worth
  1,000 (can be bought or sold at wholesale
  auction for 1,000)
• There are two kinds of buyers

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One-sided Private Information

• Seller does not know each individual buyers type
  but knows the proportion of each type
• Buyers know their own type

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Bargaining

• Seller makes take-it-or-leave-it offer to any
  potential buyer
• Must offer the same price to all
• Charge 1,040 and get expected profit of 40
• Charge 1,100 and get expected profit of 50
• These are the only two price candidates
• Seller takes a 50 chance of not realising gains
  from trade

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Opportunities
Price
Lost Opportunity
1100
1040
1000
Q
Quantity
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No market breakdown
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Examples of Price Discrimination

• Despite differences in costs of 1 per unit,
  hardcover books sell for much more than softcover
  ones
• Different prices charged for adjacent seats on
  the same aircraft
• Special coupons given for discounts on pizza
  delivery (why not just discount the price?)
• Differing arrays of mobile phone plans available
• Export market versus domestic market

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Classifying Pricing Strategies
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Linear Pricing

Triangles of Opportunity
P
MC
D
MR
Quantity
Q
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(Imperfect) Personalised Pricing

Examples B2B Negotiations, Amazon?
Consumer Surplus
Individually tailored prices
Profits
MC
Q
Quantity
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Tough Conditions

• Costly negotiations
• With large numbers of customers, it becomes
  costly to get involved in individual negotiations
• Information requirements
• Do you really know WTP?
• Re-sale and arbitrage
• If customers buy many units, then ones charged a
  low price can re-sell (at profit) to those who
  would be charged a high price

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Non-linear Pricing Variable Quantities

• We now look at price discrimination where
  consumers choose how much of a good or service to
  consume. In this situation, the average price
  that a consumer pays may differ from person to
  person
• We will also revisit price discrimination that is
  not specific to the variable quantity issue

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Non-Linear Prices

• Suppose you operate a service or sell a good.
• A customer may purchase a quantity, q.
• You can charge a price based on that quantity
  I.e., a function, P(q).
• A linear price has P(q) p

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Examples of Nonlinear Pricing

• Regulated Industries
• Per unit price depends on quantity
• Taxes depend on income
• Unregulated Industries
• Quantity discounts
• Rebates
• Take-or-pay contracts
• Credits towards subsequent purchases

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Electricity

• Electricity tariffs specify energy charges based
  on the total kwh used in the billing period, as
  well as demand charges based on the peak power
  load during the year
• Lower rates apply to successive blocks of kwh and
  in some cases the demand charges are also divided
  into blocks
• Energy rates for most industrial customers are
  further differentiated by the time of use, as
  between peak and off-peak periods

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Telecommunications

• Telephone companies offer a variety of tariffs
  for measured long distance calls, local calls and
  access
• Each tariff provides the least-cost service for a
  particular range of traffic volumes
• Rates are also differentiated by distance and
  time of use
• Mobile phone contracts have a take-or-pay quality

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Airlines

• Airline fares allow frequent flier credits
  toward free tickets based on accumulated mileage.
  The retail value of a free ticket increases
  sharply with the number of miles used to acquire
  it
• Further discounts are offered for advance
  purchase, non-cancellation, round trip, weekend
  stays, and duration

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Rental Agreements

• Rental rates for durable equipment and space,such
  as vehicles and parking spaces, are lower if the
  duration is longer
• Rates for rental cars are also differentiated by
  the size of the vehicle and the time of use

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Classifying Non-linear Prices

• Block-declining or tapered tariffs marginal
  prices decline in successive increments as
  purchases increase
• Two-part tariff comprises an initial fixed fee
  and a per-unit price for units purchased

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Graphical Representation
Three-Part
Linear
TR(P(q).q)
Two-Part
Fixed-Fee
Block
Nonlinear
q
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Two Part Tariff

• Charge consumers an entry fee (F) and a per unit
  price (p)
• F will be higher, the higher is consumer value
• If a consumer consumes q, this value is u(q)
  p.q
• As reduce p consumers choose to consumer more
• For p gt MC, reducing p increases a consumers
  value
• For p lt MC, there is over-consumption, reducing
  profits
• So choose p MC to maximise consumer value and
  set F as high as possible so that consumers
  purchase something
• Can always make more by doing this than choosing
  p gt MC.
• So long as consumers relatively similar
• If consumers are very different, may prefer a
  three or greater part tariff structure

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Two Part Tariff

Fixed fee to capture a share of this
At unit price MC, consumers choose this quantity
D
Unit Price
MC
Quantity
Q