Intermediate Microeconomics Module 16 Pricing Strategies

PRICING STRATEGIES 365 CHAPTER 16 Pricing Strategies THE POLICY QUESTION SHOULD PUBLIC UNIVERSITIES CHARGE EVERYONE THE SAME PRICE ?

Modern public universities , like their private counterparts , publish a tuition price each year that few dents actually pay . Most students receive internal grants and awards that reduce their costs well below the list price . The amount ofthis reduction in price varies dramatically and is closely related to the income ofthe student family . Unlike their private counterparts , public universities in the United States receive public funding and are expected , in return , to provide an affordable college education for residents of the states they serve . Are their pricing policies antithetical to their mission ?

Are they fair ?

Do they support the mission of the ?

These are questions we will seek to answer by studying the practice of price discrimination . EXPLORING THE POLICY QUESTION . Does charging tuition based on family income support or undermine the mission of public universities ?

Is charging tuition based on family income fair ?

LEARNING OBJECTIVES Market Power and Price Discrimination Learning Explain differentiated pricing and describe the three types of price discrimination . Perfect or Price Discrimination Learning Describe price discrimination and the challenges that make it hard . Group Price or Price Discrimination Learning Describe price discrimination and its effect on profits . 365

366 PATRICK EMERSON Quantity Discounts , or Price Discrimination Learning Objective Describe price discrimination and how it overcomes the identification problem . Tariffs and Sales Learning Objective Define tariffs and sales and how they work as price discrimination mechanisms . Bundling , and Hurdles Learning Objective Define bundling , and hurdles and how each works to increase firm profits . Policy Example Should Public Universities Charge Everyone the Same Price ?

Learning Objective Explain how the use of price discrimination can be seen as a way for public universities to accomplish their mission . MARKET POWER AND PRICE DISCRIMINATION Learning Explain differentiated pricing and describe the three types of price tion . Firms that have market power face demand curves that are downward sloping . We call such firms price makers , since the shape of the demand curve gives them choices about the prices they charge . of the type examined in chapter 15 are simple that are limited to a price at which all the output they produce is sold . This limitation leads simple to limit output so that they can maintain a higher price for all their goods or services . This limitation in output creates deadweight loss , the lost surplus from transactions that do happen but that for which positive total surplus is possible . What we will see in this chapter is that firms with market power that are able to differentiate their consumers based on their demands or willingness to pay for the goods and services may be able to charge different prices for their goods and services . This practice is called differentiated pricing selling the same good or service for different prices to different consumers . Differentiated ing can come in many forms , from a car dealership that negotiates prices with consumers , selling the same model car for different prices to different customers to a movie theater that offers a student price and an adult price to volume discounts where consumers who buy multiple units qualify for lower unit prices , such as a sale on socks that are either a pair or 10 for three pairs . Differentiated pricing can also come in the form of bundling , selling a set of goods for a single price , and product tion , selling different versions of a product for different prices that do not reflect production cost . These more sophisticated pricing strategies are the topic of this chapter , and economists call the tice of charging different prices for the same good to different consumers price discrimination . Price discrimination often leads to higher profits for firms and to higher output , as the incentive to constrain output to maintain a higher price for all units is no longer there . Price discrimination allows ing firms to capture more or all of the consumer surplus and the deadweight loss that results from a single price and is therefore a strategy that increases profits . As we will see in this chapter , price

PRICING STRATEGIES 367 can be hard because it requires firms to know information about consumers demands and to be able to prevent the resale of goods by a consumer who was charged a low price to a consumer who is being charged a high price . Price discrimination is characterized by three main categories in economics perfect price tion , group price discrimination , and quantity discounts . Perfect price discrimination , or price discrimination , is a type of pricing strategy that charges every consumer a price equal to their to pay . Firms that can do this can extract the entire consumer surplus and all the deadweight loss for themselves and can extract all potential profit from a market . This type of price discrimination is rare because it requires that firms deduce each consumer willingness to pay and change the price to equal it . Though it might be a hypothetical extreme , many firms try to charge customers a price that is based on their willingness to pay , even if they ca reach their exact willingness to pay . Car dealers that set final prices through negotiations or haggling are an example of this . When firms are unable to ascertain individual willingness to pay but know something about the age demands among different distinguishable groups , they can practice group price discrimination , or price discrimination charging different prices for the same good or service to ent groups or different types of people . Movie theater pricing is a good example of this type of price discrimination they often have different prices for kids , students , adults , and seniors . This type of price discrimination requires only that firms are able to ascertain group membership and prevent resale from one group to the other . When firms are unable to determine individuals willingness to pay or categorize individuals into groups based on average demand , they can often employ pricing strategies that get consumers to different prices based on their demands through the use of quantity discounts . Quantity discounts , or price discrimination , are when firms charge a lower price per unit to who purchase larger amounts ofthe good . It is important to understand that any firm with pricing power can potentially price discriminate , but in this chapter , we are focusing on and how these pricing strategies are potentially profit enhancing . It is also important to note that not all price differentials are evidence of price tion , such as when price differentials simply reflect the actual cost differential . For example , a store might offer a single pair of socks for or three pairs for 10 , which could be clever price discrimination ever , a retailer might make the same offer knowing that it costs to prepare the shipment regardless of how many pairs of socks are ordered . So the socks are being sold for plus the ration charge , and the price difference is simply a reflection of this fixed cost divided by the number of pairs of socks . PERFECT OR PRICE DISCRIMINATION Learning Objective Describe price discrimination and the challenges that make it hard . Imagine a firm with market power that can prevent the resale of its goods and is able to ascertain each of its customers reservation price or maximum willingness to pay . If they are able to sell their goods at individual prices , the very best they can do in each transaction is to charge each customer exactly their reservation price . This ensures maximum revenue from each transaction as well as that the entire able surplus is captured by the firm as producer surplus . Consider the example ofa firm that makes designer smartphones that has only five customers , each of whom would purchase exactly one unit if the price is at or below their reservation price .

368 PATRICK EMERSON Table Customers and their reservation Consumer Reservation price ( 51 the case ofa simple monopolist , the firm does not know the reservation prices of its consumers in this case , the firm does know the reservation prices of individual consumers . Suppose in addition that the marginal cost of producing a unit of this good is . In figure , we see that at a price of , he firm would sell exactly one unit because there is only one consumer who has a reservation price that high . 33 per unit 10 ) Demand Figure price discrimination If the firm can practice perfect or price discrimination , it means that they know each reservation price and can prevent resale , so the firm can charge consumer 10 , consumer , consumer , consumer , and even consumer . However , since consumer reservation price is below the marginal cost of production , the firm will choose not to sell to consumer . The revenue is 10 for the first unit , for the second unit , for the third unit , and for the fourth unit . The surplus created by the sale of the first unit is the difference between the reservation price and the marginal cost 10 . This surplus is captured entirely by the firm , making it all producer

STRATEGIES 369 surplus . The producer surplus is from the sale of the second good , from the sale ofthe third good , and from the sale of the fourth . Total producer surplus is the sum of these and equals 16 , which is the area above the curve and below the demand curve . Notice that the marginal revenue curve is the same as the demand curve , which means this perfect monopolist is producing at the point where marginal revenue equals marginal cost , four units . Interestingly , the amount of output the firm produces is equal to the amount a perfectly competitive firm would produce , and there is no deadweight loss . All of the surplus that is possible to create in this market is created . The difference is , of course , that the firm captures the entire surplus for itself . So consumer surplus actually falls relative to a simple monopolist , but total surplus and producer surplus increase . This is an ideal situation for a firm with market power , but does it actually pen in the real world ?

It is rare to see it in its purest , most perfect form , but some examples come close . Bargaining over price is one example . Sellers might not be able to tell the exact willingness to pay but can become skilled in making guesses . Consider the case of new car sales . When a customer walks into an auto showroom and is greeted by a salesperson , that salesperson is already making inferences about the reservation price . Casual conversations about where the customer lives , where they work , and what their family is like are all potential clues . The haggling itself is another signal , as price individuals will likely haggle quite strenuously and individuals might not haggle much at all . In the end , each customer walks out of the dealership paying a different price , where that price difference is related to the reservation price . Another good example of price discrimination is higher education . Colleges and universities are some ofthe best price around . It is estimated that less than of all US college students pay full tuition . Most students routinely fill out a form to apply for student financial aid , which reveals a lot about their family financial situation Calculus To understand the firm optimal output decision , we can start with the knowledge that a perfect price discriminator charges each customer their reservation price , where is the inverse demand curve and is the firm output . Since the is charging each customer their reservation price , their total revenue is the area under the demand curve up to the point of total output , or ( or ( Profit is total revenue minus the total cost of producing units , so the firm objective function is to maximize profit by choosing i ( max ( The condition that characterizes a maximum is ( or ( So the will choose the where the demand curve and the marginal cost curve intersect , which is the same as a perfectly competitive .

370 PATRICK EMERSON and therefore their reservation price or ability to pay . Through the use of grants , scholarships , and loans , each student is given a price of attending a college or university that is tailored to them . GROUP PRICE OR PRICE DISCRIMINATION Learning Objective Describe price discrimination and its effect on profits . In general , most firms with market power are unable to determine individual consumers reservation prices and charge them individual prices . However , firms might know something about the average reservation prices of identifiable groups . For example , it is generally true that , on average , retired have less income than prime adults and are likely to have lower reservation prices across a number of goods , like admission to movie theaters . If purchases are in person , group can be determined through identification , such as a driver license . This solves the tion problem , but the arbitrage problem remains . To maintain price differentials , firms must be able to prevent resale from members of the group to members of the group . Often such resale is prevented naturally by transactions costs , the economic costs of buying and selling a good or service beyond the price itself . For instance , in the car dealership example , it would take time and effort to find a buyer for a car that wasjust purchased , there would be bureaucratic costs associated with switching the registration of the car , and in many states , sales tax would have to be paid for both actions . Since this is a cumbersome and costly process , there is unlikely to be much arbitrage in the new car market , and differential pricing will be able to be sustained . In the case of movie theaters , however , it is not hard to imagine a group kids who purchase youth tickets and then wait outside the theater and sell them to adults at a premium over the youth price but at a discount over the adult price . This is why most movie theaters have ticket sellers and ticket takers who inspect tickets as patrons enter the theater to be sure adults have adult tickets . To understand how group price works , consider the following Calculus example of book prices in the Uni ed To understand the optimal output decisions in States versus the United Kingdom . The each market , considerthe monopolist optimization problem . Ifthe firm book Steve jobs was released in 201 ' in costs are common across markets , then we can write the total cost function as both the States and the Uni ed a function ofthe sum ofthe output for both markets , the United states the cover Thus the problem lookslike this price of the book was 30 in the Uni ed ( Kingdom , the cover price was , which at the time equaled 40 . The reason for the price differential was likely due to he ( demand for the book in the United Sta es The conditions that characterize the optimal solution are the being quite different than the demand lowing aw in the United Kingdom . To see this , pose that the marginal cost of tion was in both countries he demand for the book in the United dom was 75 and he Rearranging terms and noticing that the term is the marginal revenue demand for the book in the United Sta es and the second term is marginal cost , we get was US US Where ' quantities are expressed in the

STRATEGIES 371 sands . Publishing companies are in the publication of a specific book and therefore haVe market or the simple solution in both markets . power in the market for that book . They are also quite sophisticated , and we can safely assume they estimated the demand in both markets . They see that demand differs , and since the two markets are geographically distinct , it makes it possible to charge different prices to the two groups by charging different prices in the two markets . Arbitrage is possible , but the transaction costs associated with buying books in one market and shipping them to the other means that any attempts at arbitrage will probably be insignificant . In each individual market or to each group , the firm acts as a simple monopolist charging a single price to all consumers in the market or group . So to figure out the profit maximizing price and quantity for the two markets , we simply have to solve the monopolist profit maximization problem . We start by solving for the inverse demand functions Table Inverse demand curve equations UK market US market 75 110 75 110 PUS Because these are both linear demand curves , we know that the marginal revenue curves have the same vertical intercept as the inverse demand curves but have twice the slope . Thus the marginal revenue are the following Table Solving for marginal revenue UK market US market 75 55 75 55 To find the profit maximizing price and quantity in each market , we have to apply the profit maximization rule , which says that the profit maximizing output leve is reached when

372 PATRICK EMERSON Table Applying the profit maximization rule UK market US market 70 50 35 50 To find the price , we simply plug these quantities into the inverse demand functions Table Finding the maximizing price UK market US market 40 pUS 55 25 30 The profit maximizing price for the publisher is 40 in the UK market and 30 in the US market . Graphically , the solution is shown in figure a ) United Kingdom ) United States 75 55 40 35 35 75 Figure Group of price discrimination in book

PRICING STRATEGIES 373 The firms producer surplus is the difference between the price ofthe book and the marginal cost of the book multiplied by the number of books sold . The producer surplus in the United Kingdom is ( 40 ) 35 000 , 225 , 000 , and the producer surplus in the United States is ( 30 ) 50 , 000 , 2507 000 . Total producer surplus from the sales of the book in the two markets is . How much more producer surplus did the firm earn from practicing group price discrimination ?

We can answer this question by comparing this outcome to the outcome for a simple monopolist that charged the same price for the book in both markets . To figure out the profit maximizing price for the combined market , we have to sum the two demands together . Note that for prices above 55 , only UK consumers will purchase the book . So let begin by assuming that the final price will be below 55 , and then we can check this assumption at the end . Adding two demands together for prices below 55 begins with adding the quantities together 110 Putting this into inverse demand format yields i giving us a marginal revenue curve of i Setting yields or Solving this gives us 85 and . We see here that our assumption that the price would be less than 55 is confirmed , so consumers in both markets will purchase the book . The producer surplus in this combined market is thus ( 85 , 000 , 050 which is almost less than the monopolist . From this example , we can clearly see how offering different prices to the two sets of consumers can improve the outcomes for firms with market power . QUANTITY DISCOUNTS , OR PRICE DISCRIMINATION Learning Objective Describe price discrimination and how it overcomes the problem . A firm might know that their customers have different demands , but they are unable to tell anything about individual demands and are unable to divide them into identifiable groups . However , they might still be able to price discriminate by offering quantity discounts . The key to this type of price

374 PATRICK EMERSON nation is to offer pricing schemes so that the different types of consumers sort themselves by choosing different deals . Done well , firms can improve profits through the use of such a scheme , and the of volume discounts in markets suggests that this is a very effective profit increasing tool for firms with market power . The effect of volume discounts is to entice consumers to purchase more of the good . This increases overall sales for the producer , which improves their profit . High are better off as well since the opportunity to purchase the output at the normal price is available to them , but they choose the volume discount . This type of pricing has another name in economics , pricing , and is very common in consumer products . To understand the name , consider a linear relationship in the pricing of soft drinks . If a 10 oz . soda sells for , a 15 oz . soda sells for , and a 20 oz . soda sells for , there is a linear relationship between the amount of the good and the price . In each case , the price per ounce is . Typically , however , we see soda prices that are . A 10 oz . soda might be priced at , but then a 15 oz . soda might be and a 20 oz . soda might be , so the price per ounce declines as the volume increases . Consider the example of a college convenience store that sells soft drinks from a soda fountain and has a monopoly on soft drink sales on campus . Suppose it knows that there are two types of consumers for its soft drinks high and low . Low are less thirsty and have an inverse demand curve of where is measured in ounces of soda . High are more thirsty and have 100 an inverse demand curve of Though the manager of the store knows that these 100 two types of consumers exist , the store has no way of knowing which type a consumer is when they come into the store . The manager also knows that of the consumers on campus are of the high type . The manager also knows that each ounce of soft drink costs to provide , or the marginal cost of an ounce of soft drink is , and there are no fixed costs . Let begin the analysis by asking what the manager would do if she was able to both tell the two types apart and charge them different other words , act as a simple monopolist for both types . Because these are linear demands , the marginal revenue of both has the same vertical intercept but twice the slope , thus 50 50 ' Equating the to the yields the following set of results Table Comparison of maximum profit using pricing Law High 50 50

STRATEGIES 375 In other words , the store would sell a 10 oz . soft drink to low for and a 15 oz . soft drink to high for . The profit per customer is for the low and for the high . This is found by noticing that the profit is the difference between the price and the marginal cost and then multiplying this by the amount of each type of purchase . Since ofthe are low types and are high types , the average profit per customer is ( If the stores are unable to tell the two types apart , they could charge the single monopolist price for the low , since the high will purchase at that price but the low will not purchase at the high monopolist price . This would yield an average profit of , as all customers would buy a 10 oz . soft drink for . Alternatively , ifthey only offered the large drink , only high would buy , and though they would make in profit on those sales , only of the customers will buy , so the average profit per customer would be . It is also immediately clear that if the store offered both deals , no one would buy a 15 oz . soda at , as for the same price , they could buy two 10 oz . soft drinks or a 20 oz . soft drink . But if the store offered a volume discount on the soft drink , could they get the high to switch to a larger drink and make more money in the process ?

Consider the following deal one can buy a 10 oz . soft drink for or a 20 oz . soda for . This second offer is a volume discount , as the price per ounce has dropped from in the 10 oz . case to in the 20 oz . case . But would this work ?

Well , low types would only buy the 20 oz . ifthe price per ounce is , so they would choose the 10 oz . soft drink . What would high types do ?

Well , a 10 oz . soft drink at a price of leaves the high type with of consumer surplus , as can be seen in figure with the green area above the price and below the demand curve . A 20 oz . bottle of soft drink for leaves high with in consumer surplus , or the green area plus the areas A and In other words , the large soft drink returns more value to the customers , so they will voluntarily choose the larger soft drink , while the low will voluntarily choose the smaller soft drink .

376 PATRICK EMERSON a ) Low ) United States 13 , price per ounce 10 20 35 , ounces , ounces Figure Volume discounts with two types of consumers All that remains to be checked is whether it is better for the store to offer the two prices . If they only offered one , we have seen that it is best to offer the 10 oz . soft drink for and make in profit per consumer . With this pricing scheme , low will buy the 10 oz . soda and high will buy the large drink . The profit on the large drink is , as can be seen in figure with the areas and So getting the 20 percent of consumers to voluntarily choose the large drink increases average profit by . Graphically , this is represented in panel of figure , where the store gains area in profits and gives up area A . Since is bigger than A , this represents an increase in profits for the store . This example illustrates how firms with market power who serve customers with different demands can extract more surplus from the market by offering volume discounts , which the will choose voluntarily . TARIFFS AND SALES Learning Objective Define tariffs and sales and how they work as price tion mechanisms . There are other ways that a firm with market power can practice price discrimination other than quantity discounts . One way is through the use of pricing , and the other is through sales . In both cases , the key characteristic is the inability of the producer to identify consumers willingness to pay either as individuals or in groups . Both pricing schemes rely on consumers voluntarily choosing a price based on their demands . A tariff is a pricing scheme where a consumer pays a fee for the right to purchase an unlimited number of goods at a unit price . One example of a tariff is a nightclub that charges a to enter the establishment , and once inside , patrons are able to purchase drinks at set prices . Another example is membership retailers like Costco and Sam Club , which require patrons to purchase annual memberships to shop at the stores . tariffs are particularly relevant in the case of ple purchases , as consumers who only purchase one unit are essentially paying a single price , but those that purchase more units are lowering their price as the fee is divided across more units .

STRATEGIES 377 To understand how a tariff works , we begin by assuming identical consumers . After the case , we turn to the case of two types of consumers , high demand and low demand , to understand how tariffs can work as price discrimination . Tariff with Identical Consumers Suppose a monopolist knows the demand curve of each of its consumers and that its consumers all have identical demands . For example , suppose the only fitness club in a town knows that every single customer has exactly the same monthly inverse demand curve for visits to the club 10 , where is the quantity of visits . This fitness club is considering using a pricing scheme where it charges a monthly membership fee and a price per use . Furthermore , the club mates its marginal cost each time a client uses the club at . This includes the wear and tear on machines , cleaning , cost of towels and water in the locker room , and so on . Since the monopolist knows the demand curves of its customers , they can use the price to maximize consumer surplus and then use the monthly fee to extract the entire consumer surplus . The fitness club pricing strategy is illustrated in figure . By setting the price equal to the marginal cost of , consumers will choose to visit the fitness club sixteen times per month . The total consumer surplus generated from being able to visit the fitness club sixteen times in a month at a price of is 48 . So if the club charges a monthly membership fee of 48 on top of a price of , consumers will be willing to pay it , as they get the benefit of paying 48 to use the club at a time . The club is able to maximize and extract the entire surplus in the market , identical to a price criminator .

378 PATRICK EMERSON , price per Visit 10 16 20 , Visits per month Figure ) with identical consumers Note that this outcome extracts the maximum surplus possible from the market , and the quantity is the same as the perfectly competitive outcome . There is no possible way for a firm to do better than this . It is also a quite simple pricing mechanism but a very effective one . Pricing with Two Types of Customers Now let explore how a firm that knows it has different types of consumers but ca tell them apart can use tariffs to price discriminate and improve profits . Let return to our fitness club , but now assume that there are two types of customers fitness nuts and casual . Fitness nuts have an inverse demand curve of 24 , while casual have an inverse demand curve that is the same as the previous example 10 . How can the fitness club use a iff to practice price discrimination ?

It can offer the same prices as in the previous ple but with one further restriction a monthly membership costs 48 , but this membership entitles the purchaser up to sixteen visits in a month for each . We know that the casual will choose to purchase this , as they would choose exactly sixteen visits and gain exactly 48 in consumer surplus from consuming sixteen visits at each .

PRICING STRATEGIES 379 , price per Visit 24 16 20 24 , Visits per month Figure tariff for high But what about the fitness nuts whose demand curve is shown in ?

This deal , let call it the silver visits at yield a total of 192 in consumer surplus ( areas A ) 48 of which would be paid as the monthly membership , netting 144 in leftover consumer surplus that the fitness nuts enjoy . However , note that the fitness nuts would like to visit the club more than sixteen times in a month at the price of they would like to visit twenty times . If they were allowed to visit twenty times , they would get a total of 200 in surplus ( areas A ) So the club could offer a gold membership , a package for more frequent visitors , in addition to the silver ship . If they offered a package that included twenty visits a month , how much could they charge for this enhanced membership ?

In order to get the fitness nuts to voluntarily choose the gold membership over the silver membership , they need to leave them with as much consumer surplus as the silver leaves 144 . So 200 144 56 . If the club charged 56 for the gold membership , the fitness nuts would voluntarily choose this package . What about casual ?

They would not visit more than sixteen times in a month , even if they had the right to , and they would not generate more than 48 in consumer surplus , so a membership of 56 is too expensive , and they would not choose it . This pricing scheme is successful in getting the different types of consumers to into different pricing schemes , but is it better for the club ?

The answer is yes . The club breaks even at every visit , since the price of each visit , is exactly equal to the marginal cost of the visit . So by offering gold 380 PATRICK EMERSON ships , they collect 56 from types from whom they would otherwise have earned 48 . This difference is the improvement in profits for the club . Note that in this case , the gold membership represents a ume discount , as the average cost per visit for the silver members is , while the average cost per visit for the gold members is . Now that we have seen how tariffs can be used to increase firm profits and act as a type of price discrimination , let consider the practice of sales . Sales sales refer to situations where the purchase of one item commits the consumer to buy another product as well . A very common example is computer printers . The printers themselves are sold in quite competitive markets , but the printer requires that only the manufacturer ink can be used in the printer , creating a situation where the firm has market power in the ink market . In many ways , such programs are very similar to tariffs , where the price of the printer is like the fixed fee and the ink is the price . However , in sales , it is the printer that is priced competitively and the ink for which a monopoly price is charged . Other examples include razors and blades , automobiles and genuine parts required to keep the ranty valid , and so on . BUNDLING , AND HURDLES Learning Objective Define bundling , and hurdles and how each works to increase firm profits . Selling more than one good together for a single price is called bundling . Firms use bundling as another pricing strategy to increase profit . Pure bundling is when the goods are only sold together at a single price , and mixed bundling is when goods are available separately at individual prices and together at a single price that is typically lower than the sum of the two individual prices . Bundling is an tive pricing strategy that is similar to quantity discounts but is generally used in markets for goods where consumers do generally purchase more than one unit of each at a single time , and therefore quantity discounts are not effective . Bundling does require that resale is preventable or impractical . A good example of bundling is cable and satellite television . Most companies sell television channels in packages of channels , so , for example , if you are a sports fan that wants ESPN , you might be forced to choose a package of channels that includes the Home and Garden Network ( which you might not value very highly . On the other hand , you might be very interested in home improvement and value the channel very highly and have a low value for ESPN . By selling them together as a bundle , the cable or satellite television provider can improve its profits relative to selling them separately . To see this , consider the following simple example of an economy in which there are two types vision watchers the sports fans and the home . We will assume that there are equal numbers of both in the economy and that there is a single cable company that provides the channels but that the cable provider can not tell the two types of customers apart prior to a sale . We also assume that the cable company marginal cost ofan extra subscriber for each channel is zero . Sports fans like to watch sports and are not very interested in home improvement . Home like to watch home improvement shows and are not very interested in sports . Their reservation prices for a month to ESPN and are given in table

PRICING STRATEGIES 381 Table Reservation for television channels er month Consumer types Sports fan Home improver Given this information , what is the best pricing strategy for the cable monopolist ?

One strategy is to sel the channels separately a la carte style . If they did so , they could charge the monopoly price for each channel . In the case above , the profit maximizing price for ESPN is 30 . Since marginal cost is zero , the profit maximizing price is the same as the price that maximizes revenue . Ifthe company charges 30 , the sports fan will purchase It , but the home improver will not , so total revenue is 30 per customer pair . If instead the company charged 12 , both consumers would purchase the channel , so total revenue would be 24 . So 30 is the profit maximizing price for ESPN . Similarly , If the cable company charged 36 for , only home would buy , and the revenue per consumer pair would be 36 . Ifthey charged 14 , both consumers would buy the channel , and they would generate 28 per pair . In total , the mum profit per consumer pair from selling the channels separately is 30 , 36 , or 66 . Now if they sold the two channels only as a bundle , what is the profit maximizing price for the bundle ?

Ifthe cable company charged 48 for the bundle , home would buy , sports fans would not , and revenue per consumer pair would be 48 . If the cable company charged 44 for the bundle , both types would buy , and revenues would be 44 , or 88 . So clearly the profit maximizing price for the is 44 . Comparing the bundle revenues to the revenues , it is clear that bundling is a better choice for the company , as they earn 88 per consumer pair when they bundle versus 66 when they sell the channels separately . Why is this ?

By selling them separately , their incentive is to charge prices for individual channels and exclude the channels the consumer does prefer . By bundling , the company both forces the consumer to purchase the other , less preferred channel and offers a substantial discount for the second channel . This gets consumers to buy twice as many channels as they would otherwise , which is good for the firm because , at a marginal cost of zero , any extra sales that bring In additional marginal revenue are profit enhancing . But bundling does not always result in higher profits . Consider the same example with different prices . Table Reservation for television channels er month Consumer Types Sports fan Home improver In this example , the sports fan still has a higher reservation price for ESPN , and the home improver stil has a higher reservation price for , but now the sports fan has relatively high reservation prices for both , while the home improver has low reservation prices for both . Now , if they charge for the channels separately , the profit maximizing prices are 30 for ESPN , which yields 30 in revenue per pair because only the sports fan would purchase it , and 10 for , which yields 20 in revenue per pair , for a total

382 PATRICK EMERSON of 50 in revenue . The profit maximizing bundle price is 24 , which both consumers would pay , and they generate a total of 48 , or less than selling them separately . What has changed in these two examples ?

In the former , the reservation prices are negatively lated across the two types of customers the sports fan has a higher reservation price for ESPN and a lower reservation price for , and the opposite is true for the home improver . In the latter ple , the reservation prices are positively correlated the sports fan has higher reservation prices for both channels . Another form of price discrimination is the selling of a slightly different version of a for a different price that does not reflect cost differences . A common example of this is the sales of luxury versions of family sedans by major car companies . The Honda Accord , the , and the Ford Fusion are all family sedans . All three come in base models , with a standard set of , and luxury versions , with additional features such as more luxurious interior materials , such as leather seats more technological components , such as adaptive cruise control systems and the like . If the price differential simply reflected the extra cost to the firm of these extra features , there would be no price discrimination . However , this is not the case car companies charge a premium over additional costs . For this to be a profit maximizing strategy , it must be the case that customers with into the luxury versions because preference for luxury amenities and are correlated . They pay a higher price than do customers with . As we saw in section , being able to charge the customers a higher price than is often a profit improving strategy . Another price discrimination mechanism is through the use of hurdles a cost a has to pay in order to qualify for a lower price . The most classic hurdle is the redeemable coupon . Consider a grocery store that prints a sheet of coupons and puts them in a flyer in the local newspaper or sends them in the mail . All customers of the store have a chance to use them , but many do . Those that do pay a price to use them the time and effort of cutting them , searching for the specific good for each coupon , and redeeming them at checkout . The mechanism is that ity customers are more likely to pay the cost of dealing with coupons , and at the same time , these are the very customers to whom the stores would like to offer a lower price . Other examples of hurdles are dinner deals , rebates , matinee movie tickets , back versions of popular books , and rush tickets for theater performances only available the night of the performance . In all cases , there is some cost to purchasing the to arrive early to a restaurant or movie , not being able to be guaranteed a seat at a theater , having to wait to buy a book , having to fill out a rebate card and wait six to eight weeks for a entitles to the person paying the cost to a lower price . This cost causes consumers to into two groups , those that pay the cost to get a lower price and those that pay the higher price and avoid the cost . 167 POLICY EXAMPLE SHOULD PUBLIC UNIVERSITIES CHARGE EVERYONE THE SAME PRICE ?

Learning Objective Explain how the use of price discrimination can be seen as a way for public universities to accomplish their mission . US public universities , like the University of California at Berkeley , have a common foundational pose to provide a quality education for the students ofthe state in which they reside . Providing a quality education comes at a considerable cost , as universities are complex institutions that house , feed , and educate students . But is price discrimination antithetical to their mission ?

As entities , what STRATEGIES 383 motivates universities to charge different prices if profit is the motivation for most companies price crimination ?

To understand the rationale behind the use of price discrimination , let begin by thinking ofa demand curve for a local public state university . There are a limited number of places the university can offer each year and a selection process , so let think of the demand curve for accepted students , those that have been offered a spot . The demand curve for these admitted students is likely downward sloping , as there are probably only a few families that could potentially afford a high tuition , but as tuition declines more and more , families are able to and would choose to purchase a college education at the institution . There is also a competitive effect , as there are other colleges and universities competing for the same students , but let deliberately ignore that to focus on the questions at hand . We will also assume the marginal cost of each student is constant . The key to understanding the university situation is to think about what the excess revenues above marginal cost represent . As a institution , we can think of this as going toward paying the fixed costs of the school , much of which is represented by the tenured faculty and the research and teaching infrastructure , which we could loosely call the quality component . More or better professors , better labs , better classrooms , and so on both cost more and contribute to the quality ofthe education . A university has a number of options when thinking about the price to charge for tuition . Because they can both charge a price to each individual and , by collecting detailed information on family finances , lor that price to their ability to pay , they can overcome the two challenges to price venting arbitrage and acquiring information . So universities can engage in very sophisticated pricing strategies . But should they ?

One option is to charge a single price that allows them to break even by exactly covering their total costs . This solution is seen in figure . The tuition price , is such that at the quantity demanded at the price , the total revenue equals the total cost . In this scenario , students attend the school and all pay exactly the same price .

334 PATRICK EMERSON Tuition Demand for University Education ATC Students Figure charging a single price If instead the university practices price discrimination , they can charge each student exactly their price . This situation is illustrated in figure .

STRATEGIES 385 Tuition Demand for University Education Students Figure Universities practicing price discrimination Because the university can charge individual prices , they will continue to offer tuition prices to all dents whose reservation price is at least equal to marginal cost . This means that they will end up serving students . This is substantially more students than the strategy and is also the socially optimal number of students . In this case , the university captures the entire area beneath the demand curve and above the marginal cost as producer surplus . This is also substantially more than the producer surplus in the scenario and is money that the university can invest in improving the quality of the school . By practicing very sophisticated price discrimination , the university comes close to the price outcome , where the number of students is the socially optimal , but the school captures all the surplus for itself to cover fixed costs and invest in quality . So from an institutional level , we could argue that this is a good thing . What about for individual students ?

The answer depends on where on the demand curve the individual students lie . For wealthier students or those that otherwise had a very high reservation price , they are playing quite a bit more than they would with a single price . But for or otherwise students , with price discrimination , they can attend the university where otherwise they would have been shut out with a single price , and they pay a lower tuition than the single price . EXPLORING THE POLICY QUESTION . Explain how students might feel very differently about the price

336 PATRICK EMERSON tion by state universities than students . Do you think that price discrimination is consistent with the mission of your school ?

How do you feel about the price you pay for college ?

is it fair ?

REVIEW TOPICS AND RELATED LEARNING OUTCOMES Market Power and Price Discrimination Learning Objective Explain differentiated pricing and describe the three types of price discrimination . Perfect or Price Discrimination Learning Objective Describe price discrimination and the challenges that make it hard . Group Price or Price Discrimination Learning Objective Describe price discrimination and its effect on profits . Quantity Discounts , or Price Discrimination Learning Objective Describe price discrimination and how it overcomes the identification problem , Tariffs and Sales Learning Objective Define tariffs and sales and how they work as price discrimination mechanisms . Bundling , and Hurdles Learning Objective Define bundling , and hurdles and how each works to increase firm profits . Policy Example Should Public Universities Charge Everyone the Same Price ?

Learning Objective Explain how the use of price discrimination can be seen as a way for public universities to accomplish their mission . LEARN KEY TOPICS Terms Simple that are limited to a single price at which all the output they produce is sold . Differentiated pricing

STRATEGIES 387 Selling the same good or service for different prices to different consumers . Price discrimination The practice of charging different prices for the same good to different consumers . Perfect price discrimination A type of pricing strategy that charges every consumer a price equal to their willingness to pay , car dealerships , even though ultimately the final prices in this scenario are . price discrimination See perfect price discrimination . Group price discrimination When firms charge different prices for the same good or service to different groups or different types of people , membership rates at a movie theatre . price discrimination See group price discrimination . Quantity discounts When firms charge a lower price per unit to consumers who purchase larger amounts of the good , a grocery store sets a group of products as buy 10 spend a , in which the consumer must select 10 products to ultimately pay 10 . price discrimination See quantity discount . Transactions costs The economic costs of buying and selling a good or service beyond the price itself . pricing In which a product is discounted based on its individual volume , soft drinks If a 10 oz . soda sells for , a 15 oz . soda sells for , and a 20 oz . soda sells for , there is a linear relationship between the amount of the good and the price . In each case , the price per ounce is . Typically , however , we see soda prices that are ear . A 10 oz . soda might be priced at , but then a 15 oz . soda might be and a 20 oz . soda might be , so the price per ounce declines as the volume increases . tariff A pricing scheme where a consumer pays a fee for the right to purchase an unlimited number of goods at a unit price , retailers like Sam Club and Costco , which require an annual membership to shop at their store . sales A situation where the purchase of one item commits the consumer to buy another product as well , razors and blades printers and toner a gaming system and games . Bundling Selling more than one good together for a single price , Buy One Get One Free Dollar Shave Club . Pure bundling When the goods are only sold together at a single price gift baskets beauty products salad kits ( the specific portion of dressing , lettuce , etc . is only available bundled in that product ) Mixed bundling When goods are available separately at individual prices and together at a single price that is typically lower than the sum of the two individual prices , cable channels . Different versions of channel bundles exist depending on preferences and willingness to pay , but channels can also be purchased a la carte . The selling of a slightly different version of a product for a different price that does not cost differences , the luxury version of a car collector editions of video .

338 PATRICK EMERSON Graphs price discrimination , per unit 10 . Figure price Group or price discrimination in book publishing a ) United Kingdom ) United States 75 55 40 35 35 75 50 110 Figure Group in Volume discounts with two types of consumers PRICING STRATEGIES 389 a ) Low ) United States in , price per , price per ounce ounce I 10 20 35 , ounces , ounces Figure 763 Volume discounts with two types tariff with identical consumers , price per Visit 10 16 20 , Visits per month Figure ' with identical consumers tariff for high

390 PATRICK EMERSON , price per Visit 24 16 20 24 , Visits per month Figure for high Tables Reservation prices for television channels per month comparison Table Reservation prices for television channels per month bundling as a good choice Consumer types Sports fan Home improver Table Reservation prices for television channels per month bundling as a bad choice Consumer Types Sports fan Home improver