Basic Pricing Principle & the Internet

Basic Pricing Principle & the InternetRefer to Ch5-7 of “Pricing Communication networks”

Today’s Agenda

The QUESTION: How to set the price?

A.Basic requirements

B.What Competition Model the Business in

C.Common pricing methods in the internet

D.Ways to grasp the max profit from customers

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How to Set a Price?

A. Basic requirements (in normal cases):

1. the price <= utility of customers

2. the price is sustainable (7.1.2)I. There is no way that the potential entrant can post

price that less than the incumbent’s for some service and the serve all of part of the demand without incurring loss

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Welfare Maximization (5.4)

The ideal case: welfare maximization (5.4)

• Aim: to max total welfare of both customers and providers

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Welfare Maximization (5.4)

The ideal case: welfare maximization (5.4)Lagrange multiplier

Optimal price:

Marginal cost pricing

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Today’s Agenda






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How to Set a Price?

B. What Competition Model the Business in

1. MonopolyI. Unregulated monopolyII. Regulated monopoly

2. Oligopoly3. Perfect Competition

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Unregulated monopoly

Basic criteria: maximize total profit of the business (6.2.1)

differentiate r.w.t. pi, we have

compared to the welfare maximization curve: (5.5.1)(will mention in Ramsey pricing)

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Basic criteria: maximize total profit of the business

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maximize total profit of the business (6.2.1)

Xm

dxxcPmXm0

)('Profit for business:

Social benefit:

Welfare lost: Xmc

Xmdxxcxu )](')('[

Xm

dxxcxu0

)](')('[

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Regulated monopoly

Probably by negotiation

• The baseline is to allow them to earn some profit while to maximize social welfare•eg. Scheme of Control Agreement ( 管制計劃協議 ) applied in power generating

companies in Hong Kong• One possible method:

Ramsey-Boiteux pricing (5.5.1)

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Ramsey-Boiteux Pricing (5.5.1)

Two ways of thinking:1. Allow a fixed profit margin between revenue

and costMax

s.t.

2. Weight supplier’s profit heavier then customer’s surplus

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By differentiation wrt p, we have

If services are independent, we have

ie. price markup over marginal cost is inversely proportional to the elasticity of demand

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How to Set a Price?


1. Monopoly I. Unregulated monopoly II. Regulated monopoly

2. Oligopoly3. Perfect Competition

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Oligopoly

Game theory is wildly used to study interactions between a small number of competitive firms

1. Cournot game2. Bertrand game3. Stackelberg game

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Perfect Competition

Some attributes of the perfect market

1. perfect competition - no individual can affect the market

2. Perfect information - everyone participant is fully informed

3. everyone has equal access to the market4. everyone acts selfishly5. homogeneous commodity

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Perfect Competition

Some attributes of the perfect market

6. Strong network externalities effectEg. Free SMS for intra-provider users

7. no transaction costs – no lock-in effectEg. Bring phone number to other mobile service

providerEg. The pain to fill search for another provider

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How to Set a Price?


1. Monopoly I. Unregulated monopoly II. Regulated monopoly

2. Oligopoly 3. Perfect Competition

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Today’s Agenda






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How to Set a Price?

C. Common pricing methods in the internet

1. Dynamic pricing2. Two part tariff (5.5.2)

I. Optional two-part tariff (5.5.3)3. Flat-rate pricing (7.5)4. Bargaining (7.2)5. Shapley value (7.1.3)6. Paris Metro pricing

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Dynamic Pricing

Principle: to ask the customers using the service in the peak hours to pay more

A. Peak-load Pricing (5.4.4)Charge an extra premium in peak hours

B. Time-of-day pricingDivide time into different section, charge

with different priceseg. Free night/weekend mobile phone minutes in

USC. Real-time pricing

Charges varies depending on real-time traffic

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Peak-load Pricing (5.4.4)

Principle: ask customers using the busiest timeslots to pay a premium of yt

K: demand at the busiest timeslotsXt: demand timeslot ta: marginal cost

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utility price s.t. Xt <= KTo reach welfare maximization:

Two-part tariff (5.5.2)

Principle: charge customers with a. fixed charge &b. usage charge

eg. 荔園 (amuement park in HK) - pay a low entrance fee, and pay separately for each ride

eg. pubs - pay fixed cover fee, and pay separately for each drink (if your main purpose to a pub is merely drinking :P )

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Two-part tariff (5.5.2)

Advantage: providers could recover cost no matter no much a customer use the service

Disadvantages: 1. social welfare decreases2. some users with low usage will be kicked out

Others: low usage customers would pay more relatively

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Two-part tariff (5.5.2) 25

Demand = u’(x)F = 900

F = 300

MC

$

x

Observations: 1.Demand changes depends on utility 2.Social welfare decreases

Optional two-part tariff (5.5.3)

Principle: set up varies fixed charges and usage charges, customers picket charging scheme that fit most to their usageeg. Mobile plans (a partially correct example)

1. $98/1000 mins, $1.0/min onwards2. $150/1200 mins, $0.5/min onwards

Implementation: A set of K optional two-part tariffs, specified by pairs (ak, pk),

where ak <= ak+1 , pk >= pk+1

Observation:Given a K-part optional tariff, we can always construct a K+1

part tariff that is not Pareto inferior (explain later)

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Optional two-part tariff (5.5.3)

Advantages:1. Users with different utility could choose

among combinations

Disadvantages:1. Some users might take arbitrages (if plan set

badly)

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Flat-rate pricing (7.5)

Principle: all-you-can-eat for a fixed priceeg. Countless examples…

Advantages:1. Easy to implement2. Appealing to customers3. Make the Internet ‘dumb-er’

Disadvantages:1. Produce high social waste2. Lost low-profile customers3. Not subsidy-free

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Flat-rate pricing (7.5)

marginal cost = 0waste=

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xflat

xdxxumcxflat

*)(

How to Set a Price?


1. Dynamic pricing 2. Two part tariff (5.5.2)

I. Optional two-part tariff 3. Flat-rate pricing (7.5) 4. Bargaining (7.2)5. Shapley value (7.1.3)6. Paris Metro pricing

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Bargaining (7.2) 31

Table rule: 1. The bargain ends when both ‘players’

accept the price2. Utility of both ‘players’ discounts by time

Could talk about this at later presentations!

Is >= ?

Else propose

…….

Shapley value (7.1.3)

Principle: a mechanism to distribute revenue/cost among several actors in the systemEg. No example….

Intuitive meaning: for each permutation of the actors, find the marginal utility gain for each additional player added into the system. The resultant value is then normalized

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Permutation

A B C D

A B C D 0 0 0 2A B D C 0 0 1 1A C B D 0 0 0 2A C D B 0 1 0 1A D C B 0 1 1 0A D B C 0 1 1 0B A C D 0 0 0 2B A D C 0 0 1 1B C A D 0 0 0 2B C D A 2 0 0 0B D A C 1 0 1 0B D C A 2 0 0 0C A B D 0 0 0 2……

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AB

CD

Mission: AD

33%

33%16.5%

16.5%


Axioms:1. Dummy if v(S U i) – v(S) = 0, then

φi(v) = 0

2. Symmetry if i, j symmetic, then φi(v) = φj(v)

3. Additively φi(v + w) = φi(v) + φi(w)

4. Efficiency

There exists a unique value that satisfy the above four axioms, which is the Shapley value

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Advantages:1. Fair (supposingly)

Disadvantages:1. Value must be calculated centrally2. Impossible to implement in large scale

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How to Set a Price?



I. Optional two-part tariff 3. Flat-rate pricing (7.5) 4. Bargaining (7.2) 5. Shapley value (7.1.3) 6. Paris Metro pricing

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Paris Metro pricing

Principle:by dividing the internet into different separate channels with different prices, channels with higher price would attract less traffic and hence provide better service

Intuition:• first class in trains always have seats

(more expensive)• if first class run out of seats, you simply

take standard class.

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Paris Metro pricing

Implementation:• Divide physical channel into several logical

channels• Fixed capacity for each channel, all best effort,

no QoS• Set different prices for each channel, flat-rate

perhaps

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How to Set a Price?



I. Optional two-part tariff 3. Flat-rate pricing (7.5) 4. Bargaining (7.2) 5. Shapley value (7.1.3) 6. Paris Metro pricing

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Today’s Agenda






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How to Set a Price?

D. Ways to grasp the max profit from customers

1. Price discrimination (6.2.2)I. Individual pricing II. VersoningIII.Group pricing

2. Bundling (6.2.3)3. Service differentiation (6.2.4)

I. Coffee in starbucks4. Others

I. TaxationsII. Equilibrium Modeling

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Individual Pricing (6.2.2)

Principle: charge each user individually such that the price of each user = utility of the userEg. Coorperate bandwidth wholesale (if the provider is a monopoly)

Properties:1. Maximize welfare2. No customer surplus

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Versoning (6.2.2)

Principle: provider posts offers and allow customers to select their best planeg. Communication: time-of-day, duration, location, distance (from the book)

Advantage:1. Welfare better than flat-pricing

Disadvantages:1. Welfare worse than individual pricing2. Users might select the ‘wrong’ plan

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Individual Pricing (6.2.2) 44

User 1 might switch to the plan for user 2 to gain customers surplus B

By having discount of B’, user 1 is motivated to use plan 1.

How provider could maximize total revenue by providing discounts

Group Pricing

Principle: divide customers into classes and provide different chargesEg. I. Adult / student / elderly tickets

II. Coupon system

Intuitive reasoning:To divide customers with different elasticity

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How to Set a Price?

D. Ways to grasp the max profit from customers

1. Price discrimination (6.2.2)I. Individual pricing II. Versoning

A. Bundling (6.2.3)III.Group pricing

2. Service differentiation (6.2.4)I. Coffee in starbucks

3. OthersI. TaxationsII. Equilibrium Modeling

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Service differentiation

Principle:Add costless difference in service/product for differenciation

Eg. Menu in starbucks:Latte: 20 / 23 / 26Cappuccino: 25 / 28 / 31Mocha: 30 / 33 / 36

Eg. Popcorns in cinemas:Small: $30Medium: $35Large: $40

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Today’s Agenda






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Backup Slides


If services are dependent, we have

The price might be lower than marginal cost when the services are complements to each others

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Documents

Basic Pricing Principle & the Internet