Price discrimination: Part 1

Business and Industrial Economics A.Y. 2014/2015

Prof. Luca Grilli

INTRODUCTION

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Internet and digital markets

Perfectly competitive markets

Many observers believe it Information enhancements on the demand side ...The explosive growth of the Internet promises a new age of perfectly competitive markets. With perfect information about prices and products at their fingertips, consumers can quickly and easily find the best deals. In this brave new world, retailers' profit margins will be competed away, as they are all forced to price at cost..." (The Economist, November 1999). Information improvements on the supply side ...The Internet is a nearly perfect market because information is instanta- neous and buyers can compare the offerings of sellers worldwide. The result is fierce price competition by sellers (Business Week, May 1998).

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Perfect competition

5 central assumptions

atomicity product homogeneity. perfect information (every agent, firms and consumers) know the price charged by every firm.

technological symmetry, every firm has access to the available production technologies.

No entry and exit barriers (free entry and exit)

Moreover.

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No menu costs: changing the price of a good costs a click, there is no need to print a menu

Low geographic barriers, markets become more global and global

Has perfect competition become more common?

Baye, Morgan & Scholtens project (c.a. price of 5,000 homogenous

products over time sold in Internet)

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Average difference for all these products in the time span 2000-2007 between the lowest and highest price seller range from 30-50%

HIGH PRICE DISPERSION

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Why for many (homogeneous) goods sold in the Web we do not observe an unique price

and perfect competitive outcomes?

1) Brand reputation matters 2) Service-premium strategies differentiate

homogeneous products (delivery time capability, refund policies, ease of ordering through websites)

3) Increased possibilities for collusion 4) Increased recognizability of consumers through their

web-shopping, more possibilities of tailoring offers to customers and propose different versions of products (price discrimination strategies)

1) Brand reputation Brynjolfsson and Smith, 2000, MS: - TRUST (p. 578): trust is among the most important

components of any effective Internet marketing program (see, e.g., Urban 1998). Indeed, we note that the importance of trust may arise directly from the characteristics of the Internet. Specifically, while the importance of factors such as search costs may be reduced on the Internet, factors such as trust may play an enhanced role because of the spatial and temporal separation between buyer, seller, and product on the Internet. Most consumers have little history or physical contact with Internet retailers and they must be wary of a falling prey to a site that posts low prices but is proficient only in charging credit cards, not delivering the goods.

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2) Services premium strategies

Internet search on price comparison portal Bizrate.com

11 Source: Grilli (2004), Price dispersion in the Internet marketplace: are service-premium strategies relevant?, in Global Economy and Digital Society, Elsevier

Store ratings (1-10) from Bizrate on each store about Price convenience, customer support (CS), ability to deliver on time (DEL)

The more a firm invest in service-premium strategies, the more it spends, but the more is capable to raise price

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3) Collusion

Latcovich & Smith 2001 Pricing, sunk costs, and market structure on-line: evidence from book retailing Oxford Review of Econ. Pol.

This is a typical temporal dynamics of a market where big players are colluding..Why????

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Rotemberg and Saloner 1986, A supergame-theoretic model of price wars during booms, American Economic Review, 76, pp. 390-407

INTUITION: Firms collude on price. In periods of: -High demand High incentive to deviate from the cartel (i.e. higher profits at the expense of the other firms) collusive price has to be reduced in order to reduce the incentive to deviate and make sustainable the cartel.

- Low demand Low incentive to deviate from the cartel (i.e. lower profits at the expense of the other firms) collusive price can be raised since incentive to deviate is low and the cartel is still sustainable.

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4) Increased recognizability of consumers and possibilities for

personalized offers

PRICE DISCRIMINATION STRATEGIES

PRICE DISCRIMINATION

1, 2, 3

Why do firms want to discriminate?

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Perfect price discrimination (I) (Pigou, 1920): One consumer - One price for each unit sold Each customer is charged a different price

exactly matching exactly his/her willingness to pay for each unit

Max producer surplus. Max Social Welfare. Equity problems: no consumers surplus. Problems:

Which is the wtp of each consumer is difficult to know Difficult to avoid arbitrage (absence of resale).

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3 Price discrimination

Group Pricing: different prices for different groups of consumers, same price within the same group. Selection by (exogeneous) indicators:

Age Occupation Geography

Examples: geographical market segmentation (books in India and UK); special discounts (senior, student, etc).

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Trick: apply elasticity rule to each market segment.

- In sub-market i: max i = RT(qi) CT (qi) o pi(qi) qi CT (qi) - In sub-market j repeat the same and obtain: Implications:

Rule: different elasticities = different prices. Specifically, higher prices in less elastic markets

first order condition: MCqpqpi

iii =

+ MCqp

pqp

i

i

i

ii =

+1

MCpi

i =

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ii

i

pMCp

1=

jj

j

pMCp

1=

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Uniform(pricing(vs.(3(Price(discrimina5on((((

DU( DD( DT(

A.(Uptown( B.(Downtown( C.(Total(P( P( P(

QS( QTOT(MRU( MRU( MRTOT(

MC(

Q*U( Q*D( Q*(

P*T(

Qkink(

aS(

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2 Price discrimination Self-selection by consumers - seller cannot directly identify consumer

type, but can still induce consumers to distinguish themselves. This selection may be based on the willingness of consumers to consume:

- different quantities (so price paid by consumers depends on the quantity of the good consumed: non linear-pricing)

- Different versions of the same product (Versioning):

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Two part tariff

Hp) Identical consumers (same demand curve) The firm may obtain the maximum surplus

possible (same as perfect discrimination) Hp) Heterogeneous consumers The firm will opt for multiple two-part tariffs. If

there are 2 typologies of consumers with CS2(p) > CS1(p), we will have:

A1 < A2 e p1 > p2

A typical non linear-pricing technique: is the two-part tariff

References (for both price discrimination part 1 and 2)

Cabral, Introduction to Industrial Organization, chapter 10.

Further reading:

Varian, Intermediate Microeconomics, chap. Monopoly Behavior, 26.1, 26.2, 26.3, 26.4, 26.5, 26.6)

Shapiro & Varian, Information Rules, chapter 3.

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