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 differs different amounts (elasticity of demand differs and values are different—so different and values are different—so different willingness to pay)willingness to pay)

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

consumersconsumers– Recognize the fact of some odd perceptions Recognize the fact of some odd perceptions

by most peopleby most people

The Goal: Higher ProfitsThe Goal: Higher Profits

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

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

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

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 zeroMC is zero 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 “all or Suppose there is one demander, then “all or nothing” pricingnothing” pricing– 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 (of day or day of week)Time (of day or day of week) LanguageLanguage Gender (Ladies’ night)Gender (Ladies’ night)

– Prevent resale (and be polite)Prevent resale (and be polite) Picture ID (airlines)Picture ID (airlines) Arbitrage difficult or not Arbitrage difficult or not

worthwhile (hotels)worthwhile (hotels)

Simple exampleSimple example

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)

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 “Clubcards.” Six 12 million UK customers have “Clubcards.” Six million versions of a newsletter go to customers million versions of a newsletter go to customers based on buying history and personal based on buying history and personal characteristics. Each newsletter offers slightly characteristics. Each newsletter offers slightly different discounts. Know your customers.different discounts. Know 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 store Location of products on shelves adjusted in each store and product mix changed.and product mix changed.

High-income shoppers were not buying as much, so High-income shoppers were not buying as much, so higher quality goods were increased to attract them.higher quality goods were increased to attract them.

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

Shoppers send discount coupons for good they are not Shoppers send discount coupons for good they are not now buying but are likely to buy based on patterns.now buying but are likely to buy based on patterns.

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

Result: Tesco beat Wal-Mart in UK and in South Korea.Result: Tesco beat Wal-Mart in UK and in South Korea. When entered U.S. market—small stores; fresh produce.When entered U.S. market—small stores; fresh produce.

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

Reward Loyal CustomersReward Loyal Customers

Cingular, a large cellphone company, ranks Cingular, a large cellphone company, ranks the value of customers who call to the value of customers who call to complain, to change service, etc.complain, to change service, etc.

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 new phones and more service. Bad customers are offered no special deals.customers are offered no special deals.

The company can predict expected future The company can predict expected future revenue (and cost of service) from revenue (and cost of service) from customers based on past history.customers based on past history.

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 Mail-Order Example from Mail-Order CompanyCompany

The best customers buy but do not insist The best customers buy but do not insist on extra service. 16% of customer base, on extra service. 16% of customer base, but 40% of profits.but 40% of profits.

The worst customers buy some but impose The worst customers buy some but impose high costs on company by returning high costs on company by returning goods and other service demands. 25% goods and other service demands. 25% of customers but only 15% of profits.of customers but only 15% of 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 season’s 2. Discount outlet stores that sell last season’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.

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?

Same Goods to Different Same Goods to Different Customers at Different Customers at Different PricesPrices

Tie the sale of different goods together after Tie the sale of different goods together after customer agrees to buy one. Based on sales customer agrees to buy one. Based on sales history, you know what goods are history, you know what goods are complements.complements.

Example: KFC lists one item (chicken) at Example: KFC lists one item (chicken) at $2.29. Customer buys it but does not order $2.29. Customer buys it but does not order another item (drink) listed at $1.09. KFC another item (drink) listed at $1.09. KFC knows those items are complements. The knows those items are complements. The cash register tells the clerk to offer the cash register tells the clerk to offer the second item for $0.71, so the total sale would second item for $0.71, so the total sale would be $3.00. be $3.00.

Where used, sales rise about 5% and profits Where used, sales rise about 5% and profits rise even more. Must change offer frequently.rise even more. Must change offer frequently.

Observations about Observations about Consumer PerceptionsConsumer Perceptions

People view magnitudes, not absolutes:People view magnitudes, not absolutes: A new radio is being sold for €100 at a store A new radio is being sold for €100 at a store

near you.near you. You hear it is being sold for 50% less, €50, at a You hear it is being sold for 50% less, €50, at a

store 15 kilometers away.store 15 kilometers away. Will you go there to buy it and save 50% or Will you go there to buy it and save 50% or

€50? €50? Most people will.Most people will. A new car you want to buy is being sold for A new car you want to buy is being sold for

€20,100 at a dealer near you.€20,100 at a dealer near you. The same car is being sold for €20,050 at a The same car is being sold for €20,050 at a

dealer 15 kilometers away.dealer 15 kilometers away. Will you go there to save 0.25% or €50?Will you go there to save 0.25% or €50? Most people will not.Most people will not.

Exploiting PerceptionExploiting Perception

Buyers more likely to buy an Buyers more likely to buy an apartment if first shown a dirty, apartment if first shown a dirty, overpriced apartment before overpriced apartment before shown an ordinary apartment at a shown an ordinary apartment at a fair price compared to if buyers fair price compared to if buyers are first shown a nice apartment are first shown a nice apartment at a higher price and then an at a higher price and then an ordinary apartment at a fair price.ordinary apartment at a fair price.

Exploiting PerceptionExploiting Perception

Restaurants encourage customers to Restaurants encourage customers to buy more and feel good about buy more and feel good about purchases by putting a few expensive purchases by putting a few expensive items on the menu, such as a bottle items on the menu, such as a bottle of wine for $400 or a bowl of bird nest of wine for $400 or a bowl of bird nest soup for 400RMB, followed by more soup for 400RMB, followed by more normal price wine and soup.normal price wine and soup.

The normal prices then look like a The normal prices then look like a bargain compared to reference price.bargain compared to reference price.

Perception from SalesPerception from Sales

Sales, or the perception of sales, Sales, or the perception of sales, work:work:

Identical vacation packages (A and Identical vacation packages (A and B) are offered:B) are offered:

A marked down from $600 to $500A marked down from $600 to $500

B priced at $400 that was on sale the B priced at $400 that was on sale the day before for $300.day before for $300.

A sells more than B.A sells more than B.

Humans Are Risk Avoiders: Humans Are Risk Avoiders: Evidence from Real Evidence from Real ExperimentsExperiments

You are given a 50% chance of winning You are given a 50% chance of winning $150 and a 50% chance of losing $100.$150 and a 50% chance of losing $100.

What is the expected value of this gamble?What is the expected value of this gamble?

$25 ($75 expected win - $50 expected loss)$25 ($75 expected win - $50 expected loss)

But most people refuse this bet. Most will But most people refuse this bet. Most will not accept it until the winning is raised to not accept it until the winning is raised to $200.$200.

Humans are genetically averse to losing or Humans are genetically averse to losing or what is perceived to be losing.what is perceived to be losing.

This has odd effects on decision making.This has odd effects on decision making.

Consumer PreferencesConsumer Preferences

An experiment run on e-bay: An experiment run on e-bay: 1. Offer certain goods at auction 1. Offer certain goods at auction

beginning at $0 with a $4 shipping beginning at $0 with a $4 shipping charge added if purchased.charge added if purchased.

2. Offer same goods at auction 2. Offer same goods at auction beginning at $4 because shipping beginning at $4 because shipping included (and cost of $4 shipping is included (and cost of $4 shipping is noted).noted).

More shoppers went to the first auction More shoppers went to the first auction and bought more of the good and ran and bought more of the good and ran the prices up higher.the prices up higher.

Perception and Perception and PresentationPresentation

Side-by-side comparisons matter to Side-by-side comparisons matter to consumer valuation:consumer valuation:

Group A consumers bid on new dictionary Group A consumers bid on new dictionary with 10,000 words. Average: $24with 10,000 words. Average: $24

Group B consumers bid on dictionary with Group B consumers bid on dictionary with 20,000 words and torn cover. Average: 20,000 words and torn cover. Average: $19$19

Group C consumers shown same Group C consumers shown same dictionaries side by side: Average bid dictionaries side by side: Average bid $19 for 10,000 word version and $27 $19 for 10,000 word version and $27 for 20,000 word version with torn cover.for 20,000 word version with torn cover.

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.