Pricing strategies in digital markets

[Music] welcome today we want to talk about pricing we will cover the three degrees of price discrimination and we'll consider pricing in the presence of network effects let's dig in when a firm can charge a different price to each consumer we call that first degree price discrimination depending on how much the firm knows about its customers it can extract up to the entire consumer surplus for a long time first degree price discrimination was a purely theoretical idea it was almost impossible to first know the willingness to pay of individual consumers and second to put individualized

price tags on goods digital technologies and the internet brought firms more and better data about consumer preferences and enabled one-to-one communication with consumers there are a few examples where firms got bad press for first degree price discrimination like amazon in the early 2000s consumers seem to perceive personalized pricing as unfair and you will see in a minute why that might be the case hence you don't see a lot of firms actively advertising that they charge personalized prices but then it's also difficult to know whether i see a different price than you so it could well

be that many firms are actually using personalized prices often you see personalized prices framed as discounts or promotions perhaps to make consumers feel better second degree price discrimination is when prices are set so that consumers self-select into different pricing schemes one way to achieve that is non-linear pricing non-linear pricing is common in telecommunication consumers can choose between paying per unit or a flat rate that is independent of how much they consume flat rate tariffs are particularly popular let's try to understand why firms like them in the simplest possible pricing model there is one firm and

one representative consumer say the firm is a telecom operator for simplicity we can approximate that marginal costs are equal to zero the demand function gives us the quantity demanded at a given price the simplest model is linear we can write inverse demand as p is equal to a minus v times q now what is the optimal price that maximizes the profit of the firm let's find the optimal quantity first then plug it into the inverse demand function the quantity that maximizes profits is the one where marginal revenue is equal to marginal cost revenue is price

times quantity using the demand function we can write it as a times q minus b times q squared marginal revenue is the derivative with respect to q which is a minus 2 times b times q this is interesting the slope of the marginal revenue curve is 2 times b the slope of the demand curve is b when you want to draw this in a diagram start with a demand function and then add a curve for marginal revenue that is just twice as steep the optimal quantity is where marginal revenue is equal to marginal cost we

said that marginal cost is zero so the optimal quantity is where marginal revenue hits the horizontal axis the profit maximizing price is the price that corresponds to the optimal quantity on the demand curve profit then is the area a defined by optimal quantity and price can we come up with other pricing schemes to make the firm even better off can we somehow increase profits more meaning make area a bigger the answer is yes by using a two-part tariff let's say our telecom operator is considering to offer a package with a fixed part and a variable

part the fixed part f is independent of the quantity purchased think of this as a monthly subscription fee the variable part p is just a unit price total revenue then is f plus p times q so how would the firm gain from a two-part tariff what are the optimal values of f and p let's have a look at the same graph as before the demand function in a price quantity diagram the efficient quantity where no consumer with a high enough willingness to pay to cover costs is excluded is the one where the price equals marginal

cost remember that marginal cost is zero thus the variable part induces the consumer to consume the efficient quantity that maximizes consumer surplus and that's the entire area under the demand curve with this what is the optimal fixed part the optimal f that the firm should set how can a firm extract all consumer surplus by setting f equal to the area under the demand curve this area is much bigger than the area a which is profit under monopolistic pricing part of the firm's gains come from being able to extract more consumer surplus the other part was

previously left on the table a deadweight loss because it was optimal for the firm to exclude some consumers from the market let's extend the model and assume that not all consumers are the same for simplicity let's say that there are two types of consumers consumers with a low demand and consumers with a high demand their demand curves have the same slope but different intercepts in the simplest model let's say that the firm can identify whether a consumer is of the load type or the high type the best thing to do is to offer a different

price to each consumer to do first degree price discrimination the firm can extract all consumer surplus by offering the low type a low tariff at price a and a high type a high tariff at price a plus b plus c what if the firm does not know whether a consumer is of a high type or low type can the firm still extract all consumer surplus by offering the low tariff at price a and the high tariff at price a plus b plus c the answer is no the load type would still prefer the low tariff

at price a but the high type would make the following calculation if she consumes the high quantity this would give her a utility of a plus b plus c but since the firm would charge a price of a plus b plus c her consumer surplus would be zero in contrast if she consumes the low quantity she would get a utility of a plus b and since the firm would charge a price of a her consumer surplus would be equal to b as a result the high type prefers the low tariff over the high tariff in

that case the firm fails to extract the entire consumer surplus if the firm sells the load tariff to both consumer types it earns a profit of 2 times a does this sound too theoretical think of high types and low types in the context of air travel some consumers that could afford business class tickets will still buy economy class tickets hence the airline fails to extract the entire surplus is this something the airline can do to make it more attractive for high types to buy business class tickets can we change the incentives for high types by

offering a different pricing scheme what is the price that would make the high type consume more than ql one way to achieve this is to give a discount to the high type worth the exact value of b to make sure that the high type is indifferent between choosing the high or low tariff so charging the low tariff at price a and the high tariff at price a plus c the consumer still has the same surplus but now the firm earns a with the low type and a plus c with a high time thus the firm

is better off but can we make the firm even better off yes we can we cannot only make the high type indifferent between the two tariffs but we can make sure that the high type is in favor of the high tariff we are not giving a discount worth exactly b anymore but slightly more than b such that the high type always has an incentive to choose the high quantity we can do this by decreasing the low quantity by just a small amount and then offer the low tariff at price a prime and the high tariff

at price a prime plus c prime for the firm this means that it will lose d but gain e but d is smaller than e so it can be optimal to decrease the quantity offered to low types to induce self-selection by high types back to our example of airlines one way to incentivize consumers to buy business class tickets is to make economy class less appealing that leaves only consumers who cannot afford business class to buy economy tickets this brings us to the concept of 3rd degree price discrimination a technique that uses different prices for different

groups of consumers while it may sound similar to business class versus economy class it is not with group pricing we are not trying to make people self-select by setting a different price but we are using the information that we have about customers on a group level and price according so because we can identify different consumer groups and their willingness to pay we can charge different prices the classical example is the price discount that students get in museums here's another example orbitz a travel website realized that mac users spend 30 more on hotels and thus started

to show these users more expensive options this can be considered as third degree price discrimination because since apple computers are more expensive apple users are likely to have a higher income a user's computer setup can be a good indicator for their willingness to pay nevertheless this price technique caused a bit of bad press and orbits quickly clarified that it did not charge higher prices to mac users but only displayed more expensive hotels as according to their seeming preferences finally let's talk about dynamics in strategic pricing does the optimal pricing strategy change over time the answer

is yes especially when you're operating in a setting where network effects are important the idea is that a consumer's decision to buy your product does not only depend on the price but also on how many other consumers have already bought it you may want to start with a low price even though it's initially not profit maximizing because this will increase the quantity sold more customers are better because they create demand side externalities network effects by setting a low price your network grows in the next period you may or may not increase the price this will

depend on the network size once the network is large enough network effects are strong enough in their own right to provide value to consumers they are willing to pay a higher price you might get away with increasing prices and still being able to add consumers to the network with network effects optimal pricing is dynamic setting prices becomes more complex because we need to trade off profits today with profits in the future to sum up we've seen the three types of price discrimination and some notion of how and when to implement them in practice we have

recognized that network effects force you to think about pricing strategies as dynamic decisions thanks for watching