Business and Industrial Economics

A.Y. 2014/2015
Prof. Luca Grilli

Price discrimination: Part 1

INTRODUCTION

Internet and digital

markets
Perfectly competitive markets
3

Many observers believe it

Information enhancements on the demand side
...The explosive growth of the Internet promises a new age of perfectly
competitive markets. With perfect information about prices and products
at their fingertips, consumers can quickly and easily find the best deals. In
this brave new world, retailers' profit margins will be competed away, as they
are all forced to price at cost..." (The Economist, November 1999).

Information improvements on the supply side

...The Internet is a nearly perfect market because information is instantaneous and buyers can compare the offerings of sellers worldwide. The result
is fierce price competition by sellers (Business Week, May 1998).

Perfect competition

5 central assumptions
atomicity
product homogeneity.
perfect information (every agent, firms and
consumers) know the price charged by every firm.
technological symmetry, every firm has access to
the available production technologies.
No entry and exit barriers (free entry and exit)

Moreover.
No menu costs: changing the price of a
good costs a click, there is no need to
print a menu
Low geographic barriers, markets become
more global and global

Has perfect competition become

more common?
6

Baye, Morgan & Scholtens project

(c.a. price of 5,000 homogenous
products over time sold in Internet)

Average difference for all these products in the time span 2000-2007
between the lowest and highest price seller range from 30-50%
HIGH PRICE DISPERSION

Why for many (homogeneous) goods sold in

the Web we do not observe an unique price
and perfect competitive outcomes?
1) Brand reputation matters
2) Service-premium strategies differentiate
homogeneous products (delivery time capability,
refund policies, ease of ordering through websites)
3) Increased possibilities for collusion
4) Increased recognizability of consumers through their
web-shopping, more possibilities of tailoring offers to
customers and propose different versions of products
(price discrimination strategies)
8

1) Brand reputation

Brynjolfsson and Smith, 2000, MS:

- TRUST (p. 578): trust is among the most important
components of any effective Internet marketing program (see,
e.g., Urban 1998). Indeed, we note that the importance of trust
may arise directly from the characteristics of the Internet.
Specifically, while the importance of factors such as search costs
may be reduced on the Internet, factors such as trust may play
an enhanced role because of the spatial and temporal
separation between buyer, seller, and product on the Internet.
Most consumers have little history or physical contact with
Internet retailers and they must be wary of a falling prey to a site
that posts low prices but is proficient only in charging credit
cards, not delivering the goods.
9

2) Services premium strategies

Internet search on price comparison portal Bizrate.com

10

The more a firm invest

in service-premium
strategies, the more it
spends, but the more is
capable to raise price

Store ratings (1-10) from Bizrate on each store about Price

convenience, customer support (CS), ability to deliver on time (DEL)
Source: Grilli (2004), Price dispersion in the Internet marketplace: are servicepremium strategies relevant?, in Global Economy and Digital Society, Elsevier

11

3) Collusion
Latcovich & Smith 2001 Pricing, sunk costs, and market structure online: evidence from book retailing Oxford Review of Econ. Pol.

This is a typical temporal

dynamics of a market
where big players are
colluding..Why????

12

Rotemberg and Saloner 1986, A supergame-theoretic

model of price wars during booms, American
Economic Review, 76, pp. 390-407
INTUITION:
Firms collude on price.
In periods of:
-High demand
High incentive to deviate from the cartel (i.e. higher profits
at the expense of the other firms)
collusive price has to be reduced in
order to reduce the incentive to deviate and make sustainable the cartel.
- Low demand
Low incentive to deviate from the cartel (i.e. lower profits
at the expense of the other firms)
collusive price can be raised since
incentive to deviate is low and the cartel is still sustainable.
13

4) Increased recognizability of consumers and possibilities for

personalized offers

PRICE DISCRIMINATION
STRATEGIES

14

PRICE DISCRIMINATION
1, 2, 3

Why do firms want to

discriminate?

16

Perfect price discrimination (I)

(Pigou, 1920):

One consumer - One price for each unit sold

Each customer is charged a different price
exactly matching exactly his/her willingness to
pay for each unit

Max producer surplus.

Max Social Welfare.
Equity problems: no consumers surplus.
Problems:
Which is the wtp of each consumer is difficult to know
Difficult to avoid arbitrage (absence of resale).

17

3 Price discrimination
Group Pricing: different prices for different
groups of consumers, same price within the
same group.
Selection by (exogeneous) indicators:
Age
Occupation
Geography

Examples: geographical market segmentation

(books in India and UK); special discounts
(senior, student, etc).
18

Trick: apply elasticity rule to each market

segment.
- In sub-market i: max i = RT(qi) CT (qi) o pi(qi) qi CT (qi)
first order condition:

1
pi 1
= MC

pi + qi

pi
= MC
qi

q pi
pi 1 + i
= MC
p

q
i
i

pi MC
1
=
pi
i

- In sub-market j repeat the same and obtain:

p j MC
pj

Implications:
Rule: different elasticities = different prices.
Specifically, higher prices in less elastic markets
19

Uniform(pricing(vs.(3(Price(discrimina5on((
(
A.(Uptown(
P(

C.(Total(

B.(Downtown(
P(

P(

aS(
P*T(

MC(
DD(

DU(
MRU(

Q*U(

Q*D(

MRU(

DT(
QS(

Qkink(

Q*(

MRTOT(

20

QTOT(

2 Price discrimination
Self-selection by consumers
- seller cannot directly identify consumer
type, but can still induce consumers to
distinguish themselves. This selection may be
based on the willingness of consumers to
consume:
- different quantities (so price paid by consumers
depends on the quantity of the good consumed:
non linear-pricing)

- Different versions of the same product

(Versioning):

21

A typical non linear-pricing technique: is the two-part tariff

Two part tariff

Hp) Identical consumers (same demand curve)
The firm may obtain the maximum surplus
possible (same as perfect discrimination)
Hp) Heterogeneous consumers
The firm will opt for multiple two-part tariffs. If
there are 2 typologies of consumers with CS2(p)
> CS1(p), we will have:
A1 < A2 e p1 > p2
22

References (for both price

discrimination part 1 and 2)
Cabral, Introduction to Industrial Organization, chapter 10.
Further reading:
Varian, Intermediate Microeconomics, chap. Monopoly
Behavior, 26.1, 26.2, 26.3, 26.4, 26.5, 26.6)
Shapiro & Varian, Information Rules, chapter 3.

23