Price DiscriminationPrice Discrimination

The law of demand tells us that demanders The law of demand tells us that demanders are different, and so are willing to pay are different, and so are willing to pay different amounts (elasticity of demand different amounts (elasticity of demand differs and values are different—so differs and values are different—so different willingness to pay)different willingness to pay)

What it means:What it means:– Charge different prices to different Charge different prices to different

consumers in an effort to increase market consumers in an effort to increase market and profitsand profits

It Is Done Everywhere It Is Done Everywhere (Especially to Foreigners)(Especially to Foreigners)

Closer to Home: P&G products for upper income & middle income customers

The Goal: Higher Profits by The Goal: Higher Profits by Serving the CustomerServing the Customer

““Whether itWhether it’’s a deli or SAP, its a deli or SAP, it’’s always about s always about differentiating and serving the customers differentiating and serving the customers so they want to come back to you.so they want to come back to you.””

Bill McDermott, CEO of SAP AmericasBill McDermott, CEO of SAP Americas

SAP Americas tripled market share in four years by: SAP Americas tripled market share in four years by: segmenting customers into different groups based segmenting customers into different groups based on their size, industry, location and needs—by on their size, industry, location and needs—by getting to know their customers better.getting to know their customers better.

The Grand MasterThe Grand Masterof Price Discrmination! of Price Discrmination!

Google runs a continuous auction where Google runs a continuous auction where demanders (advertisers) bid against demanders (advertisers) bid against each other and Google adjusts price each other and Google adjusts price based on results.based on results.

E.g., surfer who googles E.g., surfer who googles ““digital cameradigital camera”” and then clicks - $0.75 charge. Surfer and then clicks - $0.75 charge. Surfer who googles who googles ““digital camerasdigital cameras”” and then and then clicks - $1.08. Based on experience—clicks - $1.08. Based on experience—different likelihood of a purchase.different likelihood of a purchase.

A simple exampleA simple example

Suppose demand for your productSuppose demand for your productis Q = 100 - Pis Q = 100 - P

Could beCould be– One demander with One demander with

declining willingnessdeclining willingnessto pay, orto pay, or

– Different demanders withDifferent demanders with different willingness todifferent willingness to

pay for one unit eachpay for one unit each MC is zero (all fixed costs)MC is zero (all fixed costs) The single price solution isThe single price solution is

P = $50, Q = 50P = $50, Q = 50So thatSo that

TR = $2500TR = $2500

$

Q0

100

50

D

MR

10050

The ideal solutionThe ideal solution

Charge a different price for each unit (assume MC = Charge a different price for each unit (assume MC = $0)$0)

Thus, P = $100, $99, $98, $97, ……, $1Thus, P = $100, $99, $98, $97, ……, $1

Yields an average price of $50 per unit; 100 units Yields an average price of $50 per unit; 100 units soldsold– Then, TR = $5000 (think of a real world example)Then, TR = $5000 (think of a real world example)

Suppose there is one demander, then Suppose there is one demander, then ““all or nothingall or nothing”” pricingpricing– Take all 100 at a fixed fee of $5000, or take Take all 100 at a fixed fee of $5000, or take

nothing nothing (a bag of diamonds at de Beers)(a bag of diamonds at de Beers)

In practice, multiple pricing classes are commonIn practice, multiple pricing classes are common– For example, an airplane with 100 seats may have For example, an airplane with 100 seats may have

43 different prices43 different prices

A common problem…A common problem…How to change different prices?How to change different prices?

There are two key issues:There are two key issues:– Correctly identify demandersCorrectly identify demanders

Age (retired or students)Age (retired or students) Appearance (local or not; rich or Appearance (local or not; rich or

poor)poor) Time (day of week—airline tix cost Time (day of week—airline tix cost

less on T,W,Th; iPhone prices cut less on T,W,Th; iPhone prices cut over time)over time)

Cookie informationCookie information– Prevent resale (and be polite)Prevent resale (and be polite)

Picture ID (airlines)Picture ID (airlines) Arbitrage difficult or not worthwhile Arbitrage difficult or not worthwhile

(hotel rooms)(hotel rooms)

Been There; Done That

http://disneyworld.disney.go.com/florida-resident-tickets-passes/

* 1-Day Magic Your Way Ticket– Special online savings for Florida Residents**

* 3-Day Play Pass (Save 39% off the price of a 3-Day ticket†)

Proof of a Florida residential address for each Guest age 18 or older is required for purchase and use.

Moving a went away from it Moving a went away from it does not produce good does not produce good resultsresults

Delta tried Delta tried ““simple faressimple fares””—no fare over $499 one —no fare over $499 one way and most restrictions eliminated. Result: way and most restrictions eliminated. Result: Delta ended up earning only 86% of industry Delta ended up earning only 86% of industry average revenue per aircraft mile-seat.average revenue per aircraft mile-seat.

JC Penney went to no coupons, no sales—used JC Penney went to no coupons, no sales—used ““fair and squarefair and square”” fixed pricing. No 99 cent fixed pricing. No 99 cent prices—round prices at 00. Result: Profits/sales prices—round prices at 00. Result: Profits/sales fell, stock price fell from $42 to $22 in six fell, stock price fell from $42 to $22 in six months.months.

People People saysay they want clear pricing—not so in they want clear pricing—not so in practice.practice.

Example from Belkin

Ethernet cables made in a factory in Ethernet cables made in a factory in China for a U.S. company sold for:China for a U.S. company sold for:

$29.95 with brand name wrapper$29.95 with brand name wrapper

$19.95 with chain store wrapper$19.95 with chain store wrapper

$15.95 on eBay under no name$15.95 on eBay under no name

Exact same product (purchased for Exact same product (purchased for $3)$3)

Cost Is Not Pricing:iPhone 4S

$188 parts for 16-GB model, $649$188 parts for 16-GB model, $649

$207 parts for 32-GB model, $749$207 parts for 32-GB model, $749

$245 parts for 64-GB model, $849$245 parts for 64-GB model, $849

($30-40 cost differential relates to ($30-40 cost differential relates to $100 higher price—other costs $100 higher price—other costs assumed same)assumed same)

* Carriers may cover $450 of price * Carriers may cover $450 of price with 2-year contractwith 2-year contract

A Successful PracticeA Successful Practice

Tesco, the largest supermarket in UK with 31% share Tesco, the largest supermarket in UK with 31% share of grocery sales. Third largest retailer in the world; of grocery sales. Third largest retailer in the world; $91 billion sales. It uses barcode information from $91 billion sales. It uses barcode information from sales to learn how to improve service and profits.sales to learn how to improve service and profits.

What goods are complementary? Diapers and beer. What goods are complementary? Diapers and beer. High quality toilet paper and skin care products.High quality toilet paper and skin care products.

12 million UK customers have 12 million UK customers have ““Clubcards.Clubcards.”” Six million Six million versions of a newsletter go to customers based on versions of a newsletter go to customers based on buying history and personal characteristics. Each buying history and personal characteristics. Each newsletter offers slightly different discounts. Know newsletter offers slightly different discounts. Know your customers.your customers.

After annual minimum purchase made, 1% discount After annual minimum purchase made, 1% discount received for using Clubcard.received for using Clubcard.

Tesco: Data UsesTesco: Data Uses

Location of products on shelves adjusted in each Location of products on shelves adjusted in each store and product mix changed.store and product mix changed.

High-income shoppers wanted higher quality High-income shoppers wanted higher quality goods.goods.

Asian customers wanted large sacks of rice and Asian customers wanted large sacks of rice and certain spices. The spices attracted non-Asian certain spices. The spices attracted non-Asian upper-income buyers, so were then added in upper-income buyers, so were then added in upper-income area stores.upper-income area stores.

Database is sold to Tesco suppliers such as Coca-Database is sold to Tesco suppliers such as Coca-Cola and Procter & Gamble so they can study Cola and Procter & Gamble so they can study data.data.

Result: Tesco beat Wal-Mart in UK and in South Result: Tesco beat Wal-Mart in UK and in South Korea.Korea.

How to differentiate in U.S.?How to differentiate in U.S.?““Big Box Discounts without the Big Big Box Discounts without the Big BoxBox””Note Note ““freshfresh”” terminology. terminology.

2007 launch in Southern California, 2007 launch in Southern California, Arizona, and Nevada—just as crash Arizona, and Nevada—just as crash hit.hit.

2010—announced plans to open 400 2010—announced plans to open 400 stores by 2013.stores by 2013.

Dynamic Pricing:Dynamic Pricing:Follow the Internet LeaderFollow the Internet Leader

Cost-Side Data UseCost-Side Data Use

Wal-Mart and other large retailers use Wal-Mart and other large retailers use sales data (15 minute increments) from sales data (15 minute increments) from one year to forecast for the next year one year to forecast for the next year when peak customer loads will occur.when peak customer loads will occur.

Employee schedules are set based on Employee schedules are set based on when they are likely to be most needed, when they are likely to be most needed, getting away from traditional eight hour getting away from traditional eight hour shifts. shifts.

Customers served better; higher output Customers served better; higher output per employee.per employee.

Price Discrimination:Price Discrimination:Get Higher ProfitsGet Higher Profits

Coke customers can buy one Coke for $1 (the Coke customers can buy one Coke for $1 (the profit maximizing price) or a pack of six cans profit maximizing price) or a pack of six cans for $3. Why would Coke offer the six cans for for $3. Why would Coke offer the six cans for $3?$3? $

$1

Quantity

MC

D

Q* MR0

$0.25

Price DiscriminationPrice Discrimination

Why would Coke offer the 6 pack for $3?Why would Coke offer the 6 pack for $3?

It sells to all customers at $1 for one can, but also It sells to all customers at $1 for one can, but also moves down the D curve and sells 5 more cans moves down the D curve and sells 5 more cans for $0.40 each. Extra consumer surplus (profit) for $0.40 each. Extra consumer surplus (profit) captured.captured.$

$1

Quantity

MC

D

Q*MR

0

$.25

$.40

Potato Chips—Ones focusing on Potato Chips—Ones focusing on ““naturalnatural”” and other so-called health and other so-called health claims cost more, even when identical claims cost more, even when identical to regular chips.to regular chips.

Reward and Keep Loyal Reward and Keep Loyal CustomersCustomers

Cellphone companies rank the value of Cellphone companies rank the value of current customers to decide on price to current customers to decide on price to charge.charge.

Based on history of revenue and problems, Based on history of revenue and problems, loyal customers are offered better deals on loyal customers are offered better deals on new phones and more service. Bad customers new phones and more service. Bad customers are offered no special deals.are offered no special deals.

The company can predict expected future The company can predict expected future revenue (and cost of service) from customersrevenue (and cost of service) from customers’’ history. history.

Sophisticated customers order over Internet—Sophisticated customers order over Internet—get better price than in-store customers.get better price than in-store customers.

Dump High Cost Customers?Dump High Cost Customers?

When we sell products for the same When we sell products for the same price to all customers we price price to all customers we price discriminate because some customers discriminate because some customers cost more to service. It may be more cost more to service. It may be more profitable to charge higher-cost profitable to charge higher-cost customers more or get rid of them. customers more or get rid of them.

Does the additional (marginal) revenue Does the additional (marginal) revenue justify the additional (marginal) cost?justify the additional (marginal) cost?

Example from website company

Websmith Group develops and Websmith Group develops and maintains websites for various firms.maintains websites for various firms.

Some were Some were ““high-maintenancehigh-maintenance”” and and others were chronic late payers.others were chronic late payers.

Eliminating 5% of its clients reduced Eliminating 5% of its clients reduced time costs by 20%, leading to 10% time costs by 20%, leading to 10% growth in 2009 during the recession.growth in 2009 during the recession.

Example from Mail-Order Example from Mail-Order CompanyCompany

The best customers buy the most. 16% of The best customers buy the most. 16% of customer base, but 40% of profits.customer base, but 40% of profits.

The worst customers buy a little and The worst customers buy a little and impose costs on company by returning impose costs on company by returning goods and other service demands. 25% goods and other service demands. 25% of customers generated minimal profits.of customers generated minimal profits.

Other customer groups in between these Other customer groups in between these two.two.

Management must decide—should the Management must decide—should the worst (high cost) customers be dropped worst (high cost) customers be dropped or made to bear more of their costs by or made to bear more of their costs by price discrimination? Is that possible?price discrimination? Is that possible?

Some Customers More Costly to Some Customers More Costly to Serve: Price Discriminate Between Serve: Price Discriminate Between the Twothe Two

High maintenance customersHigh maintenance customers Low maintenance Low maintenance customerscustomers

impose greater costs on seller.impose greater costs on seller. impose fewer costs on impose fewer costs on seller.seller.

D

Higher cost customers

Lower cost customers

DMC

MC

MRMR

Q high Q low

P

P

Q/timeQ/time

£ £

ExampleExample

Coach, a maker of expensive leather Coach, a maker of expensive leather handbags and other goods, has two methods handbags and other goods, has two methods of sale:of sale:

1. Full price at its own stores and at selected 1. Full price at its own stores and at selected retailers (and on the web). Full price only; retailers (and on the web). Full price only; never any discounting. Average age of never any discounting. Average age of shopper is 35; average expenditure is $1,100.shopper is 35; average expenditure is $1,100.

2. Discount outlet stores that sell last season2. Discount outlet stores that sell last season’’s s products for less. Stores usually 100 km away products for less. Stores usually 100 km away from nearest full-price retailer. Average age of from nearest full-price retailer. Average age of shopper is 45; average expenditure is $770.shopper is 45; average expenditure is $770.

Example: Jewelry RetailingExample: Jewelry Retailing

Signet Group (U.K.) operates two sets of Signet Group (U.K.) operates two sets of jewelry stores in the U.S.:jewelry stores in the U.S.:

Kay Jewelers focuses on middle class with Kay Jewelers focuses on middle class with lower price diamonds, etc. lower price diamonds, etc.

781 stores average $1.65 million sales.781 stores average $1.65 million sales.

Jared focuses on upper income with Jared focuses on upper income with expensive diamonds and Swiss watches.expensive diamonds and Swiss watches.

110 stores with $5.6 million avg. sales.110 stores with $5.6 million avg. sales.

Kindle: Price Discrimination Over Time

Kindle 1Kindle 1, 11/07, , 11/07, $399, $399, ““sold outsold out”” instantlyinstantlyKindle 2, 2/09, , 2/09, $399; 7/09, $299$399; 7/09, $299

10/09, $25910/09, $259

6/10, $1896/10, $189Kindle 3, 8/10, , 8/10, $139, sold out $139, sold out instantly,instantly,

9/11, $799/11, $79

Avoiding consumers using price apps such as RedLaser

Smartphones allow instant price Smartphones allow instant price comparisons. How do politicians see it?comparisons. How do politicians see it?

““an attack on Main Streetan attack on Main Street”” and and ““anti-anti-competitivecompetitive””—Senator Olympia Snowe —Senator Olympia Snowe (Maine)(Maine)

How to avoid? Private label goods and How to avoid? Private label goods and variations on a theme from major variations on a theme from major suppliers.suppliers.

Computer Jocks Call It Dyanmic Pricing (Data Mining)Robert Phillips, Director, Center for Pricing Robert Phillips, Director, Center for Pricing and Revenue Management, Columbia and Revenue Management, Columbia University, created a formula that mixes a University, created a formula that mixes a consumerconsumer’’s credit score with his or her s credit score with his or her likelihood to shop around. Banks use that likelihood to shop around. Banks use that score to know whether to offer that score to know whether to offer that consumer a competitive rate of interest or consumer a competitive rate of interest or a higher one. Bottom line?a higher one. Bottom line?

Phillips: Phillips: ““It can increase operating profit on It can increase operating profit on the order of 7-12 percent.the order of 7-12 percent.””

Be Careful About Internal Competition

Common form of price discrimination—different brands from same company.

Presume a parent company has three brands of shampoo.

If one is a discount brand, or if discounts offered on one brand, how much will that cut sales of other brands?

Suppose price is cut 10% on one brand and result is 30% increase in sales. Is that good? How much does that add to the net revenue of the parent company? If sales of two other brands fall as customers move to cheaper brand, may be a net loss. Know your elasticities.

BundlingBundling

Consumer A will pay $100 a year for the Consumer A will pay $100 a year for the Disney channel on cable or satellite TV.Disney channel on cable or satellite TV.

Consumer B will pay $10 a year for the Consumer B will pay $10 a year for the Disney channel on cable or satellite TV.Disney channel on cable or satellite TV.

Consumer A will pay $10 a year for ESPN.Consumer A will pay $10 a year for ESPN.

Consumer B will pay $100 a year for ESPN.Consumer B will pay $100 a year for ESPN.

Solution: bundle Disney & ESPN for $109 per Solution: bundle Disney & ESPN for $109 per year ($218 revenue from A&B). If sell year ($218 revenue from A&B). If sell Disney and ESPN for $99 per year, then Disney and ESPN for $99 per year, then only $198 revenue.only $198 revenue.

Does Papa Know Best?Does Papa Know Best?

CEO Robert Nardelli (later at Chrysler) centralized buying for Home Depot in 2001. Local managers could not order what they believed customers wanted. Lock step for stores: too many snow shovels in Arizona; not enough power tools. Good managers left; Lowe’s moved in.

Mixing buying power and standardization with local interests is tough.

How Do You Want Your How Do You Want Your Drink?Drink?

Starbucks menu:Starbucks menu:Regular coffeeRegular coffee $2.05$2.05Tall (small) cappuccinoTall (small) cappuccino $2.55$2.55Caffe MochaCaffe Mocha $2.75$2.75Grande (medium) latteGrande (medium) latte $3.35$3.35Venti (large) cappuccinoVenti (large) cappuccino $3.60$3.60Venti mocha w/ vanillaVenti mocha w/ vanilla $3.85$3.85

Cost difference to make these different Cost difference to make these different drinks?drinks?

Why would they do that?Why would they do that?

Travelers, Farmers and others Travelers, Farmers and others announce they will discount up to announce they will discount up to 10% on car insurance rates for 10% on car insurance rates for hybrids.hybrids.

Applauded for being sensitive to Applauded for being sensitive to the environment. Are they really?the environment. Are they really?

Coupon QuestionCoupon Question

When Disney sells a new DVDs of a When Disney sells a new DVDs of a movies, it often has a mail-in movies, it often has a mail-in coupon that allows the customer to coupon that allows the customer to get a rebate (price discount). On a get a rebate (price discount). On a $20 DVD, there may be a $5 mail-in $20 DVD, there may be a $5 mail-in coupon. These are expensive to coupon. These are expensive to process, so why does Disney not process, so why does Disney not just sell the movies for $15?just sell the movies for $15?

Common MistakesCommon Mistakes ( (Thanks to Peter Drucker)Thanks to Peter Drucker)

1. Short term high profit margins.1. Short term high profit margins.Remember—the competition is coming. Remember—the competition is coming.

Xerox dominated copier market in early Xerox dominated copier market in early 1970s. High prices and profit margins. 1970s. High prices and profit margins. Canon entered with simpler, cheaper Canon entered with simpler, cheaper machines and swept the market away machines and swept the market away from Xerox.from Xerox.

High profit margins today do not mean High profit margins today do not mean maximum profits over time. Price maximum profits over time. Price elasticity of demand drops over time due elasticity of demand drops over time due to alternatives.to alternatives.

Common MistakesCommon Mistakes

2. Cost-Driven Pricing.2. Cost-Driven Pricing.Many companies derive prices based on Many companies derive prices based on

cost recovery plus profit margin.cost recovery plus profit margin.

The goal should be The goal should be price-led costingprice-led costing. . What will customers pay, given current What will customers pay, given current and future competition? That is, what is and future competition? That is, what is the demand? Can your costs fit within the demand? Can your costs fit within those prices? Toyota and Nissan use those prices? Toyota and Nissan use that model and have taken larger and that model and have taken larger and larger market shares away from German larger market shares away from German and American auto makers.and American auto makers.

Common MistakesCommon Mistakes

3. Using revenues to feed problems 3. Using revenues to feed problems and starve opportunities.and starve opportunities.

Many firms incur high costs trying to solve Many firms incur high costs trying to solve problems (often assigning the best problems (often assigning the best people to solve problems). Problems are people to solve problems). Problems are usually due to changes in competition usually due to changes in competition and changes in technology—a sign that and changes in technology—a sign that demand has changed. Opportunities demand has changed. Opportunities should be the focus—look forward. GE should be the focus—look forward. GE dumps weak products rather than trying dumps weak products rather than trying to fix them.to fix them.