Demand and Supply Analysis Demand and Revenue •  Elasticity of demand Costs •  Marginal costs; fixed costs; variable costs Monopoly Pricing •  Pricing by a monopolist (MR = MC) – finishing today with franchising case.

Price Discrimination (Exotic pricing strategies) •  Not all gains from trade realized or extracted – today •  Explicit market segmentation – today •  Implicit market segmentation – next, in session 8 •  Bundling – next, in session 8

Road Map for Prices and Markets

TOOLS

McDonald’s “Behind the Arches” John F. Love

Ray Kroc Founder of the

McDonald’s franchise

“ He soon realized that while McDonald’s might not produce a windfall for the franchiser, it could be a lucrative proposition for the franchisee.[…] Capital investment in those operations typically started at $250,000, but an early McDonald’s – including land, building, and equipment – could be opened for as little as $80,000. When the franchisee found a landowner willing to rent the space to him and a bank willing to provide a mortgage on the building, his investment amounted to no more than the $30,000 needed for the equipment, the sign, the start-up inventory, and even that could be borrowed.” […] “The Rolling Green group was arguably, from McDonald’s point of view, the worst collection of McDonald’s operators in the chain’s thirty year history.”

“[…] what irritated Kroc the most was when Dondanville raised his hamburger price from 15 to 18 cents.[…]”

“Dondanville justified it on financial grounds; like most other early McDonald’s units in California, the Reseda store was barely breaking even, and Dondanville was becoming desperate. `We ate hamburgers at home for 27 days in a row, and we got sick of it [sic],” Dondanville recalls. `That’s when I decided to raise prices.’”

What’s going on??

[…] “Ray was very much against remote control.” […]

McDonald’s vs the Franchisee

PP

Q

Profit maximizing point

Demand curve

Marginal cost

P

Q

Revenue maximizing point

Demand curve

(i) McDonald’s (ii) The Franchisee

McDonald’s gets a share of revenues �sets a price that maximizes total sales ($)

The franchisee gets his total profit �He would set a price that maximizes

his profit.

2PMCP +

=

You can now answer this

You write a self-help book called `Five steps to have more free time.’

You sign a contract with a book publisher:

•  You get a lump sum of $100,000 plus 7% of the wholesale value of all sales of the book.

•  The publisher has a fixed production cost of $200,000 (inc. $100,000 royalty) for the book, plus a cost of $5 per copy for printing and distribution.

•  Each party (you, the author, & the publisher) cares about only her/his profit for this book’s sale.

Each party has a preferred price. Which one is higher?

Prices and Markets

Session 7

Exotic Pricing Strategies: Explicit Market Segmentation

Prof. Amine Ouazad

This Session Explicit Price Discrimination

1.  Perfect Price Discrimination

and why it cannot be achieved

2.  Explicit Price Discrimination, a.k.a. Explicit Market Segmentation

3.  The Roxy Case

Next Session Implicit Price Discrimination

Q

P

MC#

Demand#

Variable#profit#“No$money$is$le,$on$the$table”$

High valuation customers

Lower valuation customers

Perfect'Price'Discrimina.on'

Q

P

MC#

Demand#MR#

Variable#profit#

Uniform'Pricing'

Op5mal#price#

“A key step is to avoid uniform pricing. Pricing to specific customer groups should reflect the true competitive value of what is being provided. No money is left on the table...”

A. Miles, Pricing, Boston Consulting Group.

Heaven: Perfect Price Discrimination

!  World-wide, every year, governments sell multiple trillions of dollars worth of securities to bank and large institutional investors. !  Banks’ willingness to pay for particular security depends on its portfolio needs and information about the state of the economy

… banks differ along these two dimensions !  A bank’s valuation is private information: it is not known to the government

How should governments sell securities to maximize revenues?

The $1 trillion question The Treasury plans to auction $30 billion Tuesday. -- January 28, 2013

Market clearing price

Bids Supply

In this auction form, all bidders simply pay the market clearing price for all units they purchase

Government Revenue

Can we do better?

Q

P

Uniform price auction

B1 B2

B4 B3

Example: 5 bids

B5

Demand Supply With a uniform market clearing price, winning banks make a consumer surplus equal to the difference between their valuation and the uniform price.

V1

V2

V4

V3

Consumer surplus

P

Q

Banks have a consumer surplus.

Could we collect more?

Market clearing price V5

Volume of This bid

Example: 5 bids

Demand Supply

This bid is partially fulfilled

In most countries, governments proceed as follows: 1. Banks submit price-quantity pairs as bids 2. Treasury officials sort the offers in descending order of price. 3. The highest bids are fulfilled until supply is exhausted

Q

P

V1

V2

V4

V3

Discriminatory Treasury Price Auction

B1 B2

B4 B3

Is this better??

How does Priceline’s business model addresses the fundamental problem of price discrimination: !  Consumer identification: Ask consumers to name their own price! Consumers give some information about their valuation. Does this really achieve some PPD?? !  Captures only part of the remaining consumer surplus: Make obtaining the discounted products such a pain in the #&& in order to discourage high-valuation buyers from switching (this is necessary to convince sellers to use Priceline’s site).

Priceline.com: « Name your own price » also known as opaque pricing

•  Perfect price discrimination is a useful benchmark, but never achieved in practice. •  Informational problem: It is very difficult to know the valuation of a

customer.

•  However: it should not lead you to revert to uniform pricing. •  You may partially achieve the goal of PPD. �Exotic pricing strategies !!

•  Today: Explicit market segmentation. Take a market, divide it into segments, and charge a different price for each segment.

•  Session 8: Implicit market segmentation.

Perfect Price Discrimination

This Session Explicit Price Discrimination

1.  Perfect Price Discrimination

and why it cannot be achieved

2.  Explicit Price Discrimination, a.k.a. Explicit Market Segmentation

3.  The Roxy Case

Next Session Implicit Price Discrimination

Spot

the

Diff

eren

ce

Explicit Market Segmentation

Condition #1: Market Power •  Must have ability to set prices

Condition #2: Observability (No deception)

•  Use an easily observed trait which is correlated with elasticity of demand. •  Customer cannot masquerade as someone else.

Condition #3: No arbitrage/resale •  Customers from one segment cannot sell good to others.

Segment the market by observable characteristics. Charge customers in different segments different prices, according to their elasticity.

Explicit Price Discrimination - Condition #2: Observability •  Tourists pay more for kilims in Istanbul than locals. •  Students get discounts on air/rail tickets. •  Californians pay $97; non-Californians pay $151 for a 2-day park

hopper •  Dell Inspiron 580, Base Configuration: Home:$749 Small Business:

$899 •  Victoria�s secret?

Coke’s smart vending machine: Price on a hot day is higher than the price on a cold day. �A cynical ploy to exploit the thirst of faithful customers�

(San Francisco Chronicle) �Lunk-headed idea� (Honolulu Star-Bulletin) �Soda jerks� (Miami Herald) �Latest evidence that the world is going to hell in a handbasket� (Philadelphia Inquirer) �Ticks me off� (Edmonton Sun)

9/24/09 5:16 PMFT.com print article

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Close

GSK wins battle in ‘parallel’ drugs caseBy Tobias Buck in Brussels and Andrew Jack in LondonPublished: September 27 2006 19:52 | Last updated: September 27 2006 19:52

GlaxoSmithKline on Wednesday won a potentially far-reaching victory in a long-running legal battlethat has pitted Europe’s pharmaceuticals industry against competition regulators and traders that shipdrugs between European Union member states.

GSK has long tried to curb “parallel trading”, which involves the shipment of drugs from low-costcountries, including Spain and Greece, to countries such as Britain and Germany, where the price ofmedicines is fixed at higher levels.

Parallel trade accounts for about 5 per cent of Europe’s !80bn ($101.6bn, £54bn) pharmaceuticalsmarket, and is growing fast. In Britain, the traders account for almost a fifth of the market.

The drugs industry argues that such arbitrage undermines their incentive to invest in research anddevelopment. But parallel traders say exploiting price differences helps national health providers savemoney, and must be allowed under the terms Europe’s internal market.

The European Commission, the EU’s top antitrust regulator, in 2001 ruled that the curbs GSK imposedon parallel traders in the Spanish market violated EU competition rules.

On Wednesday, in the European Court of First Instance, that decision was partially annulled. The EU’ssecond highest court found that the Commission had failed properly to consider the specific nature ofthe industry, in which prices are determined more by government intervention.

The Commission was also told to pay more attention to the effect that parallel trade may have oninnovation.

Lawyers and antitrust experts said it was the first time a court had acknowledged the special characterof the drugs industry.

However, some in the parallel trade industry stressed that the judges had upheld the Commission’sfinding that GSK’s actions had restricted competition.

Copyright The Financial Times Limited 2009. Print a single copy of this article for personal use. Contact us ifyou wish to print more to distribute to others.

"FT" and "Financial Times" are trademarks of the Financial Times. Privacy policy | Terms© Copyright The Financial Times Ltd 2009.

Financial BRUSSELS

Condition #3: No Arbitrage

Why are drugs priced differently in different

countries?

Undermines their incentives to invest in

R&D?

Helps health providers save money?

Explicit market segmentation means . . . not all customers have same trading opportunities.

Which of the following are examples of explicit market segmentation? 1.  Child, student, and senior-citizen discounts.

2.  Different airline economy class prices for flights with a Saturday night stay.

3.  Different prices for medicine in different countries or for different uses.

4.  Different utility rates for residential and business customers.

5.  Academic discounts on hardware/software.

6.  Coupons that can be redeemed by mailing them in.

Examples

Principles of Explicit Market Segmentation

Let QA and QB be quantities sold in segments A and B. Main point: Given total output, maximize total revenue

→ MRA = MRB

MCQMRMCQMRMC

BB

AA

=

=

)( )(:Constant

)()( )()(: Varying

BABB

BAAA

QQMCQMRQQMCQMRMC+=

+=

MC

MRC

PC

MRC = 90-20QC = 10 = MC QC = 4 PC = $50

MRG

PG

MRG = 60-10QG = 10 = MC QG=5; PG = $35

Coal PC = 90 - 10 QC

Grain PG= 60 - 5 QG

90

60

Railroad freight pricing

U.S. railroads charge 1.5-2 times as much to move coal as they do to move grain MC = $10 per ton;

10

Higher choke price → Less Elastic → Higher price

This Session Explicit Price Discrimination

1.  Perfect Price Discrimination

and why it cannot be achieved

2.  Explicit Price Discrimination, a.k.a. Explicit Market Segmentation

3.  The Roxy Case

Next Session Implicit Price Discrimination

Roxy Theater: The Question

•  “Several members of the management team want to eliminate excess demand by eliminating the student discount. After all, they note that it is the increase in student demand that is causing the excess demand problem.”

Roxy Theater

Does the manager�s forecast make sense that student demand will average 33 seats per showing? !  No! Fall in demand for general public due to VCRs. Students own VCRs too. !  % change in general public demand = (80 – 96)/96*100 = 16.7%

!  Worst-case scenario: Student demand in 1997 = 33*(1-0.167) = 27.5

!  Public demand in 1998 = 80*0.967 = 77.4 Student demand in 1998 = 27.5*0.967 = 26.6

!  Total demand = 104 < 113. But still more than capacity (95)

!  At the profit-maximizing price, the theater is either at- or under- capacity.

!  Partial conclusion: The price of $6 for all should be increased.

Student Discount in Roxy Theater

Roxy can sell out at $6. So is student discount necessary? Should Roxy eliminate student discount and charge $6 to all?

Explicit Market Segmentation

Agree: Es > EGP (as in the past) Recall MR = P(1-1/E) So if same price (say $6) MRS > MRGP Same price: MRs ≠ MRGP → profits are not maximized To equate: sell more to students; less to general public till MRs = MRGP Cut prices to students from $6; Raise prices to General Public above $6 Lessons: !  Do not focus on eliminating excess demand !  Do not ignore other market segments !  Price to maximize profits !  Segmenting market and price discrimination can raise profits

0 95 General Public Quantity

DemandGP

MRGP

PriceGP

$0

$8

$0

Demand from General Public

AS TOTAL QUANTITY IS FIXED, X-AXIS MEASURES BOTH GENERAL PUBLIC AND STUDENT QUANTITIES Student Quantity = 95 – GP Quantity

0 95

95 0

General Public Quantity

Student Quantity

DemandGP

MRGP

PriceGP

$0

$8

… SO WE CAN PLOT STUDENT DEMAND CURVE ON THIS “REVERSE” AXIS

0 95

95 0

General Public Quantity

Student Quantity

PriceGP PriceStudents

DemandGP

MRGP

MRStudents DemandStudents

$0

$8

$6

POINT OF PROFIT MAXIMISATION OCCURS AT POINT WHERE TWO MARGINAL REVENUE LINES MEET

0 95

95 0

General Public Quantity

Student Quantity

Profit Maximizing Point

DemandGP

MRGP

MRStudents DemandStudents

PriceGP

PriceStudents

$0

$8

$0

Profit Maximizing GP Price

Profit Maximizing Student Price

Optimal quantity split

$6

This Session Explicit Price Discrimination

1.  Perfect Price Discrimination

and why it cannot be achieved

2.  Explicit Price Discrimination, a.k.a. Explicit Market Segmentation

3.  The Roxy Case

Next Session Implicit Price Discrimination

Wrap up – Explicit market segmentation

Main point 1.  Perfect price discrimination captures the entire consumer surplus…

but charging a different price to each customer is hard! 2.  Charge different prices to different groups of customers identifiable with

observable characteristics. •  Charge a higher price in the market segment with less elastic demand. •  Condition #1: Market Power •  Condition #2: Observability (no deception). •  Condition #3: No arbitrage.

Next Session

•  We will start with the baldness case “Baldness drug is an old product at a premium price.”

•  The Saturday night stay is making a comeback, New York Times, 2008.