Review n Own price elasticity n Empirical estimation

Review n Own price elasticity n Empirical estimation of demand curve n n Linear and log-log model Interpretation of coefficient and computation of price elasticity.

Introduction n Price dispersion – different prices for the same product - is prevalent in the marketplace n The “law of one price” is dead n Example: Microsoftware version and upgrade prices n Example: Prices of 1/3 liter Coca-Cola cans in Germany

Prices of 1/3 liter Coca-Cola cans Point of Sale 1. Large supermarket 2. Grocery store 3. Bakery 4. Vending m/c – university 5. Gas station 6. Vending m/c – street 7. Newsstand - street 8. Newsstand – airport 9. Newsstand – Train station Price (DM) 0. 64 0. 69 0. 80 Index 100 108 125 0. 90 1. 20 1. 50 1. 60 2. 00 2. 20 141 188 243 250 312 344

Example: Student Rates n n n Why do software manufacturers have lower rates for students? One explanation is that they have lower willingness to pay & higher elasticity than business users. Charging two prices is more profitable

Example: Airline Pricing n n Why do airlines have “first class” rates often 2 -3 times higher than cabin? There is a small group of “elite” customers who are less price elastic than “regular” customers It is more profitable to charge two prices The “elites” must be “fenced in” from buying cabin seats by making cabin seats uncomfortable

Illustration of Benefits of Price Customization Price ($) 100 Demand curve Gross Margins (p-c)*q p c=10 0 1000 q

Remember the Meaning of Demand Curve The demand curve is an aggregation of the demands of individual or segment, who have different reservation prices (max. willingness to pay) Price ($) 0 q Ideally, charge each customer their reservation price (as long as it is above c) – (i) no profitable customer is excluded from buying and (ii) no money left on table.

A Single Price is Inefficient Money left on the table Price ($) 100 Profit (p*-c)q* No trade – deadweight loss p* c=10 0 1000 q

Calculation n n The demand function is p = 100 – 0. 1 q The profit-maximizing price is p* = (a+c)/2 = $55 n The demand at the profit maximizing price is q* = (a-c)/2 b = 450 n The profit (gross margins) is (p*-c)q* = $20250

Demonstration of Benefits Using 2 Price Points Price ($) Rule of 1/3 for linear demand functions – 33% higher profits! 100 p 1* p 2* c 0 q 1* q 2* 1000

p = a – bq Calculation n q = A – Bp Assume that we can put a “fence” that prevents higher price customers from paying the lower price, also, c=$10 The demand function is q= D(p) = 1000 – 10 p Profit at prices p 1 and p 2 are (p 1 -c)D(p 1)+(p 2 -c)(D(p 2)-D(p 1)) n The profit-maximizing prices are p 2* =$40, p 1*=$70 n The maximized profit is (70 -10)*300+(40 -10)(600 -300)=$27000

p = a – bq Calculation n q = A – Bp In general, in the case of the linear demand, constant variable cost and two prices, the profit-maximizing prices are n p 2* = (2 c + a)/3, or p 2* = (2 c. B + A)/3 B n p 1* = (2 a + c)/3, or p 1* = (2 A + c. B)/3 B

This is Price Discrimination n Charging different prices to different people for the same (or similar) product. Since “discrimination” has a negative connotation, call it “price customization” A useful result - Most of the benefit of price customization may be realized with relatively few price points

Implementation n n Key problem: How do we prevent higher willingnessto-pay customers from paying the price meant for lower willingness-to-pay customers? Place “fences” that corral customers

Methods of “Fence-Building” n Product-line sort n Controlled availability n Sort on buyer characteristics n Sort on transaction characteristics

Product-line sort n n n Airlines – first class and economy class seats Proctor-Silex irons ($54. 95 top of line model versus $49. 95 same model without a LED light) Encyclopedia Britannica (Utilitarian cover, $999, Leather bound, $4000) Cars (same engine Acura $30, 000, Accord $25, 000) Based on impatience n n Books appear first in hardcover then paperback Movies appear first in theaters, then in discount cinema, then in video stores

Examples Product-Line Sort Standard SRP $219. 99 Basic SRP $199. 95 Professional SRP $299. 99 All in Standard + MS Access Pro SRP $279. 95 All in Basic + Create Customized forms, Tools to Track add’l items Developer SRP $529. 99 Development Tools to Build Own Applications Premier SRP $399. 99 All in Pro + Daily Sales Summary, Retail Specific Reports

Sort on Transaction Characteristics n n n Airline seats are more expensive closer to the takeoff date CD player purchased with car is more expensive than one installed later Quantity discounts n n Water Buying clubs Season discounts Idea is that users value incremental quantities less. Alternatively, large users have good outside options hence have lower willingness to pay

Controlled Availability n n n n Victoria’s Secret offered catalogs with higher discounts to male consumers GM gave $1500 (nontransferable) coupons only to Oldsmobile consumers who expressed dissatisfaction Manufacturers frequently negotiate better rates for larger customers French Telecom gave non-advertised lower prices only when subscribers called and asked, thereby revealing their price sensitivity Consumers in Japan, UK pay more for identical clothes, cosmetics, electronics than US consumers, but less for pharmaceuticals Consider arbitrage, gray market issues Consider fairness considerations Legal implications

Sort on Buyer Characteristics n Kids free/ discount n Families with Kids are willing to pay less person. Kids age can be easily verified (i. e. , at low cost) n Senior citizens discount n Software upgrade discount n n Current users have less incentive to renew software Student discount n Students willing/able to pay less

Novell Netware Pricing – An Example of Quantity Discounts No. of users Site license fee Price/user 5 $396 $79. 60 10 $796 $79. 20 25 $1196 $37. 84 50 $1596 $31. 92 100 $2236 $22. 36 250 $3996 $15. 98

Price Customization Across Markets Charge higher prices at places where less price sensitive buyers purchase n n Price sensitive and price-insensitive buyers naturally purchase at different locations or… Insensitive buyers will not change purchase location to take advantage of the price difference

Implementation of Price Customization n n Devil lies in the details! Specific steps of price customization n n Identify customers who are price-sensitive Give price discount to them Reduce stockpiling for those who do get discounts Make sure that price-insensitive customers do not take advantage of the discount offer Do not overstep the legal boundaries

Identifying the Price-sensitive Customers n Which segments are more price sensitive? n Personal vs. Business Travelers n New to Market vs. Experienced Buyers n Light Users vs. Heavy Users n Students/Retired vs. Employed

A department store has the following discounting policy for brand-name quality clothing n The ticket on each item is dated and lists a number of prices. n The first price is the one that a customer pays if the merchandise is bought within the first eleven days after arrival. n The next price is discounted an additional 25% and applies to merchandise that is 12 to 17 days old. n The third price is discounted 50% and applies to merchandise 18 to 23 days old. n The fourth price is discounted 75% and applies to merchandise that is 24 to 29 days old. n On the 30 th day, the merchandise is turned over to charity. Since most of the merchandise is surplus, there is generally a limited supply in each style, color, and size.

Price Customization - Implementation n n What does this strategy accomplish? Describe the customers whom you suspect make up the different retail segments. A number of stores in other cities adopted this strategy for surplus merchandise, but no store had adopted it for new merchandise. Can you suggest why? For what other types of products would you consider this a profitable pricing tactic?

Price Customization - Implementation Peak-load pricing is used to segment markets by the cost of serving them at different times? n Name types of businesses, other than public utilities, that could effectively use peak-load pricing. Describe how a peak -load strategy might be implemented in each case. n Yield management represents a more sophisticated version of peak-load pricing. What kinds of companies use yield management?

Price Customization - Implementation n A fancy steak house in a shopping mall offers a 20% discount to employees of other stores in the mall, provided that they eat before 6: 00 PM or after 8: 00 PM n Can you explain the rationale for this strategy? (Your explanation should both account for why the 20% discount is not offered to everyone and why it is restricted in the hours when it is offered. )

Price Customization - Implementation n A deli in a college town has an interesting pricing strategy for students. The dinner specials at the restaurant are normally $4. 95. Students, however, can buy weekly "meal tickets" that give them three meals for $13. 90, 5 meals for $22. 25, or seven meals for $29. 90. The tickets expire at the end of each week and they are not transferable. n Can you explain this pricing strategy?

Price Customization - Implementation n The local outlet of a fast food chain charges $2. 60 for a salad from its salad bar if ordered a la carte. When ordered with a sandwich, however, the salad bar costs only $1. 99. In either case, the customers are permitted to fill their bowls just once. n Can you explain this segmented pricing technique?

Price Customization - Implementation n Most hotels will lend guests an iron and an ironing board free of charge, despite the fact that this service competes with the hotel's valet service, for which it does charge. Those same hotels usually charge outrageously to supply glasses, ice, and mixers for those who wish to have alcoholic drinks in their rooms. n Can you explain this anomaly?

Next Lecture § Pricing and Competition