GSBS6410

Economics of Competitive Advantage

Week 8
Price Discrimination
 OUTLINE
1. Readings
2. Direct Price Discrimination
3. Indirect Price Discrimination
4. Questions for discussions

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 GSBS6410
Readings for this lecture

• Froeb et al 2018, Managerial Economics, Chapters 13 & 14,

and one of the following
1. Arnold, Roger A., (2016) Microeconomics, 12th Edition,
Cengage. Chapter 10 (if you think our text is too simple).
2. Layton A, Robinson T, and Tucker I. (2016) Economics
For Today, Fifth Asia Pacific Edition, Cengage Learning
Australia, Melbourne. Chapter 8 (if you think our text is
too hard).
 Introduction: Pricing schemes
• This lecture looks at ways of (profitably)
designing and implementing price
discrimination schemes.
• So that sellers can charge different prices to
different consumers based on differences in
consumer demand.
• This allows sellers to increase profit above the
profit available from setting a single, uniform
price.
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 Price Discrimination
• Price discrimination is the practice of charging different
people or groups of people different prices that are not
cost-justified. Typically more people are served under
price discrimination than under a uniform price.
• If a seller can identify two groups of consumers with
different demand elasticities, and it can prevent
arbitrage between two groups, it can increase profit by
charging a higher price to group with the less-elastic
demand.
• Arbitrage can defeat a price discrimination scheme if
enough of those who purchase at low prices re-sell to
high-value consumers. This can force a seller to go back
to a uniform price.
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 Direct Price Discrimination
• A direct price discrimination scheme is one in which we can
identify members of the low-value (more price elastic)
group, charge them a lower price, and prevent them from
re-selling their lower- priced goods to the higher-value
group.
• It can be illegal for business to price discriminate when
selling goods (not services) to other businesses unless
– price discounts are cost-justified, or
– discounts are offered to meet competitors’ prices.
• Price discrimination schemes may annoy customers who
know they’re paying more than others and can make them
less willing to buy because they know someone else is
getting a better price. If you can, keep them secret.
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 Cell Phone Pricing
• In 1997 a global cell phone manufacturer (IRK) was
losing sales in the Philippines because competitors
offered a better, lower price.
– The company charged a world-wide uniform price of
$120
– It sold most of its phones in wealthy countries
– Important future markets, such as the Philippines, were
ignored because demand was lower in less wealthy
countries.
– Competitors were underpricing IRK in these future
markets and were selling more. 7
 Cell Phone Pricing
• The Philippine market was quickly approaching
the crucial 10% penetration point.
– At which this Rule of Thumb applies: the firm with
the largest share at 10% penetration will grow to
40% without marketing
• The company considered charging a lower
price in the Philippines to generate more sales
before the 10% point

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 Cell Phone Pricing (cont’d)

100%
90%
Mobile phone penetration .

80%
70%
Philippines in 1997
60%
50%
40%
30%
20%
10%
0%
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Time in years from opening of first digital network

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 Pricing tradeoff & discrimination
• Frequently there is a pricing tradeoff based on
simple demand curves:
– Lower priceg sell more, but earn less on each unit sold
– Higher priceg sell less, but earn more on each unit sold
– Marginal analysis tells us how to optimize around this
tradeoff: MR=MC 1 (P-MC)/P=1/|e|
• Price discrimination allows sellers to avoid the
tradeoff
– Higher prices for some
– Lower prices for others

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 Why (price) discriminate?
• Example: a simple demand curve
– Seven consumers willing to pay {$7,$6,$5,$4,$3,$2,$1}
– Marginal Cost of the good= $1.50
– Optimal price is $5
• At a price of $5, low-value consumers, {$4, $3, $2,
$1}, don’t purchase
– Even though their values are above the MC
– This leaves unconsummated wealth-creating transactions!
• If a separate price is set for this group, i.e. price at $3
and sell 2 extra units, firm profit increases, and more
customers are served.
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 Price discrimination
• Motivation: price discrimination allows a firm to sell items to
low-value customers who otherwise would not purchase
because the price is too high (the firm consummates a wealth-
creating transaction!)
• Definition: Price discrimination is the practice of charging
different prices that are not cost-justified to different people
P1/MC1  P2/MC2

• Price discrimination allows two optimal prices to be set for

two groups with different levels of price elasticity:
(P1-MC1)/P1=1/|elasticity1| (P2-MC2)/P2=1/|elasticity2|

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 Price discrimination (cont’d)
• The bigger the difference between group elasticities, the
more profit there is in designing a price discrimination
scheme.
• To price discriminate
– ID different groups with different price elasticities or different
values
– Find a way to prevent arbitrage
• Direct Price Discrimination occurs when you can:
– ID members of the low-value group can be identified
– Charge low-value costumers a lower price
– Prevent resale (arbitrage) to higher-value consumers.

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 Price discrimination (cont’d)
• Indirect Price Discrimination occurs when you:
– Cannot ID members of groups; OR cannot prevent arbitrage
– Instead, discriminate by offering two products, a higher-priced,
higher-quality good and a lower-priced, lower-quality good .
Direct or indirect pricing schemes?
– Tickets to a movie theaters (senior citizen discount, student
discount, etc.)
– Grocery stores (discount coupons, in-store or in weekly
newspaper inserts)
– Airlines (business vs. economy tickets)
– Describe a price discrimination opportunity facing your
company

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 The Robinson-Patman Act (US)
• Robinson-Patman Act
– Prohibits providing a price discount on a good sold to
another business
– The Robinson-Patman act was designed to protect
independent retailers from chain-store competition by
preventing the chains from receiving supplier discounts.
– Defenses against a Robinson-Patman lawsuit are:
• That the price discount was cost-justified; or
• The price discount was given to meet the competition
• Europe has similar, and stronger, laws
• Promotional allowances or vertical integration
may avoid Robinson-Patman liability
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 Pricing for laptops
• Computer companies often sell to a wide variety of
users with a wide variety of price sensitivities.
– To identify the price sensitivity of on-line customers Dell’s
website has different categories in which users can shop (such as
home & home office, small & medium business, large business,
etc.)
– Under the “Small and Medium Business” category, a laptop was
listed as $1,197
– Under the “Large Business” category, the same computer was
$1,339 a 12% increase
– This pricing scheme allows Dell to sell identical computers at
different prices based on the consumers’ price sensitivity.

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 Back to cell phone pricing
• The cell phone manufacturer, IRK, reduced prices in
Philippines to $90
• PROBLEM: the Philippine phones used the same
standard (GSM) as higher-priced European phones
– Thus, arbitrage threatened sales in other countries (15
million units annually)
– To prevent this, the company sold models with SIM-locks,
which allow calls only in the local operators’ networks
• Turkish hackers broke the SIM-lock
– 15,000 phones were sold to Western Europe by the
hackers before IRK changed the SIM-lock algorithm and
again prevented arbitrage
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 IRK’s cell phone pricing (cont.)
• In 1998, IRK sold 200,000 phones to Philippines
– much better than the 50,000 units they would
have sold without price discriminiation
• IRK’s market share went from 10% to 25% in
one year
• 1999, IRK returned to global uniform pricing
– Competitors followed, and raised prices as well.
– In 2000, the Phillipines cell phone penetration
reached 12% and IRK market share rose to 34%
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 Warning: only schmucks pay retail
• Consumers do not like knowing they are paying
higher prices than others.
• For example, when shown a box for a
promotional code on a website, click-through
rates decline.
– Online shoppers were less likely to complete their
transactions once they realized a coupon existed that
they didn’t have.
• People don’t like knowing they are schmucks
• So, if you are price discriminating, it is important
to keep the scheme secret if you can. 19
 Medical Test Strips
• In Northern Europe (Ger., Holland and Scandinavia)
– Machines sell for $25
– 50 test strips sell for $22
– 12 million boxes of test strips
• Southern Europe
– Italy and Spain: insurance companies’ reimbursement
rates are 50% lower
– Firm has capacity to produce additional 6 million
• Potential market for test strips is $200 million per year
– If they acquire 30% of the market, they can make an
additional $60 million in revenue
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 Medical Test Strips (cont’d)
• North/South Europe price discrimination implementation
– Lower prices to Southern Europe
• Test strips at $11
• Measurement devices at $12.50
• To prevent arbitrage
– ROM key ensures north/south incompatibility
• Also reduce the measurement speed of the Southern
devices from 11 to 25 seconds. It is important that these
slower devices cost less, so that the price difference has
some cost justification (so it wont violate antitrust laws).

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 Conference Pricing
• The American Association for Clinical Chemistry (AACC)
sponsors 3-day conferences
• 90% of the attendees from same city or surrounding region
• Foreign participants
– Greater travel costs
– Longer travel times
– Applying and interviewing for travel visas
– The majority attend conferences in own countries
• To increase attendance, the AACC proposed reducing price
to foreign participants
• QUESTION: HOW DID THEY PREVENT ARBITRAGE?
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 Indirect Price Discrimination
• When a seller cannot identify low- and high-value consumers or
cannot prevent arbitrage between two groups, it can still
discriminate, but only indirectly, by designing products or
services that appeal to groups with different price elasticities of
demand, who identify themselves based on their purchasing
behavior.
• Metering is a type of indirect discrimination that identifies high-
value consumers by how intensely they use a product (e.g., by
how many cartridges they buy). In this case, charge a big markup
on the cartridges and a lower markup on the printer.
• If you offer a low-value product that is attractive to high-value
consumers, you may cannibalize sales of your high-price product.

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 • continued
Indirect Price Discrimination
• When pricing for an individual customer, do not
bargain over unit price. Instead, you should
– Offer volume discounts;
– Use two-part pricing; or
– Offer a bundle containing a number of units.
• Bundling different goods together can allow a seller
to extract more consumer surplus if willingness to
pay for the bundle is more homogeneous than
willingness to pay for the separate items in the
bundle.
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 Airlines
• Airlines cater to both business and leisure travelers
• Business travelers have less elastic demand
– Don’t pay for own ticket, more time sensitivity
• Airlines can’t determine between these two groups
of customers, but can analyze their buying habits
– Leisure= vacation, planned well in advance
– Business= last-minute, often on short notice
• Airlines price tickets higher as the date of travel
gets closer
• How could businesses take advantage of this?

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 Hewlett-Packard printers
• HP identifies high- and low-value consumer groups by the
number of ink cartridges purchased
• To charge high-value customers higher prices, HP charges a
50% markup over MC on ink cartridges while only charging a
15% markup on printers.
• In 2003, HP sold $10 billion worth of printers and $12 billion
in ink cartridge sales, HP’s actual profit off of ink cartridges
was three times greater than the profit from printer sales.
• The low margin on printers and high margin on ink cartridges
is similar to pricing schemes used for many complementary
products: razor blades and razors, movies and popcorn, etc.

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 Complementary pricing
Low-Value Consumers High-Value Consumers Total
$100 value, 1 cartridge $200 value, 2 cartridges Revenue

Strategy 1: $100 $150 $250

$50 printer +
$50 cartridge
Strategy 2: $0 $100 $200 $300
printer + $100
cartridge

• This strategy works because high-value costumers

use more cartridges than low-value costumers.
• “Metering” schemes, such as this, are used to
identify high-value consumers and allow for indirect
price discrimination.
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 Indirect price discrimination
• When arbitrage cannot be prevented; OR when high- and
low-value groups cannot be identified, sellers can still use
price discrimination by designing products or services that
appeal to different consumer groups.
– Discount coupons: grocery stores allow more price sensitive
consumers (shoppers with a lower income) to use coupons to
receive lower prices, high-income/value shoppers are less price
sensitive and less likely to clip coupons.
– This pricing scheme can be dangerous, though. High-value
customers have the option of clipping coupons, and if too many
do the scheme will become unprofitable.
– A second risk is creating profitable entry opportunities for rivals.
For example, HP’s ink cartridges, unless HP can prevent rivals from
selling lower-priced ink cartridges or refills, HP will lose sales.
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 Indirect price discrimination (cont’d)
• In some cases, businesses can increase profit by
“tying” the sales of one product to another, e.g.,
new ink cartridges to sale of printers.
– BUT such ties may violate antitrust laws.
• In fact, a former antitrust prosecutor advises:
– “Do not tie the sale of one product to another. Such
arrangements are only legal in a few rare instances—to
ensure effective functioning of complicated
equipment, to name one. But they are generally
against the law.”
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 Price discrimination in software
• Software manufacturers discriminate between high- and low-
value consumers by offering different versions of software
designed, and priced, to appeal to different groups.
• For example, the software MINITAB, sold an “academic”
version (aimed at students) for $50 in March 2009, while
selling a full-featured model (aimed at businesses) for $1,195.
– Here the threat of cannibalization is clear and to avoid losing money
the manufacturer must price and/or design the two versions so that
high-value customers really do prefer the more expensive version.

– For MINITAB this meant putting limits on the number of observations

and omitting some statistical tests in the academic version

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 Price discrimination in software
(cont’d)
Software Version Home Users Commercial Users
Full-featured version $175 $500
Disabled version $150 $200

Strategy Implementation Total Profit

1. Sell only to Price full-featured version at $500

commercial users at a $500, do not sell home
single high price. version
2. Sell to all users at a Price full-featured version at $175 + $175 = $350
single low price. $175.
3. Price discriminate: Price disabled version at $150 + $449 = $599
Price high to the $150; price full-featured
commercial users; price version at $449.
low to the home users

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 Volume discounts
• Volume of purchase can also be used to
discriminate between buyers.
• For example: a single customer willing to pay $7
for the first unit purchased, $6 for the second, $5
for the third, etc.
– A price of $7 means the consumer will buy only one
unit. But a price of $6 means the consumer will buy
two units.
– The price represents the value the consumer places
on each unit consumed. This is known as an
individual demand curve.
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 Volume discounts (cont’d)
• If a seller sets a single price, she will sell all
units where MR > MC.
– For this example, 3 units at a price of $5 – but if
MC is just $1.50 this leaves unconsummated
wealth-creating transactions (the remaining three
units valued at $4, $3, and $2).
– To increase profitability the seller must find a way
to sell the additional units at a lower price without
lowering the price of the first three units sold.

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 Volume discounts (cont’d)
This can be done in a number of ways:
• Offer volume discounts; for example, price the first good at $7, the
second at $6, the third at $5, and so on.
• Use two-part pricing (fixed price plus a per-unit price). Charge a per-
unit price low enough to consummate all wealth-creating
transactions (set it at MC = $1.50).
– The consumer’s total value for six units is $27 ( =$7+ $6+ $5 + $4+
$3 + $2), and six units cost just $9 (=6*$1.50) to produce. Bargain
over how to split the remaining surplus ($18 = $27 – $9) created
by the transaction. This is the “fixed price” part of the transaction.
• Bundle the goods. The consumer’s total value for six units is $27.
With enough bargaining power, the entire consumer surplus can be
captured, if not, then bargain over how to split it. 34
 Bundling
• When selling bundled goods don’t forget: When
bargaining with a customer, do not bargain over unit
price; instead, bargain over the bundled price.
• Sellers can bundle like items where consumer value
decreases with each additional unit OR sellers can
bundle different items with different consumer demands.
– For example: a movie theatre – two group of customers prefer
two different types of film (romantic comedy and SciFi). The
theatre owner cannot directly price discriminate but in
bundling the two picture together into a double feature, the
problem is avoidable.

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 Bundling
– Suppose there are 50 customers willing to pay $3
for the SciFi film but only $2 for the romantic
comedy, and 50 willing to pay $3 for the chick flick
but only $2 for the SciFi.
– If the theatre sets a single price for a ticket to any
movie, it must face the pricing trade-off – sell to
all consumers at $2 (total revenue $200 per film)
or sell to half the movie goers at $3 (total revenue
$150 per film). Pricing low is more profitable,
earning $400 on the two films combined.
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 Bundling (cont’d)
• BUT if the theatre combines the movies into a double
feature it can sell to all customers at a price of $5
increasing total revenue for the two films to $500
• Bundling in this way makes consumers more
homogeneous (both consumer groups are now willing
to pay the same price).
• This also allows sellers to earn more if willingness to
pay is more homogeneous for the bundled good than
separate goods
– For cable TV, providers make 65% more selling bundled
packages than if each channel were sold separately.
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 Questions for Discussion

1. Why might Mattel set a much lower margin on the

Barbie dolls than on the accessers for the dolls?
2. The pricing model for iTunes has been to price songs
individually. Instead, Spotify opted to offer unlimited
song playing for a monthly fee. Would Spotify’s
pricing model likely yield more profit than pricing
songs individually?

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