Lecture 6

Other Pricing Strategies

List of content
Two-part tariffs
Bundling and tying
Peak-load pricing


Type Information Surplus Examples
1st Degree Producer has perfect
information on consumers
WTP
All surplus go to
producer
No real world
example?
2nd Degree Producer has imperfect
information (unable to
identify customers) and
uses self-selection on the
part of buyers
Not all surplus
are expropriated
Flat telephone rentals
frequent
users pay lower
price, taxi fares
fixed initial payment
& charge
vary according to
distance
3rd Degree Producer has imperfect
Information (aware of
inter-group differences
but not intra-group
differences) and uses
indicators/signals to
distinguish buyers
Not all surplus
go to producer
Different prices
depending
on age, occupation,
location etc
Nonlinear Pricing
Total expenditure on an item does not rise
linearly (proportionately) with the amount
purchased.
Or
The price per unit varies with the number of
units the customer buys.
Methods of Nonlinear pricing are used to
practice 2
nd
degree price discrimination. Why?
Nonlinear Pricing
The producer offers a non-
linear price schedule and let
consumers choose any
combination of quantity and
total expenditure on that
schedule.
The producer need not
identify the customer groups
explicitly. High demand
customers will self-select
into buying a large quantity,
and low demand customers
will self-select into buying
fewer units.
T(q) = pq
T(A, q) = A + p q
T(q)= p
i
q
i
A single Two-part tariff
It charges consumers
T: A lump-sum fee for the right to purchase
p: A usage charge per unit
Popular in retail, entertainment, sports, utility, etc. For
example
Membership discount retailers
Amusement park admission fees and per-ride fees
Cover charge for bars combined with per drink fees
Personal seat licenses in professional sports, in which fans of a
team pay an up-front lump sum fee for the right to purchase
tickets at face value
Two-part tariff
The lump-sum fee
enables the firm to
capture all the
consumer surplus and
deadweight loss areas
(T=A+B+C, p=MC)
Two-part tariff with more than one demand
Question: If the seller faces two different demands,
can she use the pricing as (T1=A, p1=MC) and
(T2=B, p2=MC) to extract all consumer surplus?
Two-part tariff with more than one demand
Answer: If the seller knows the type of every
consumer, yes. If not, no.
Because T1 is lower than T2, all consumers will
buy as if they have a low demand.
Question: What can the seller do to improve the
pricing?
Example: Pricing of local phone calls
The inverse demand for local phone calls by two
groups: households and business




The marginal cost is zero and no fixed cost.
Suppose both charges (p and T) can only be
integers.




12
H H
p q
10 / 2
B B
p q
Example: Pricing of local phone calls
How much can the monopoly earn by using a uniform two-part
tariff (p1=p2=p, T1=T2=T)?
If p=0, the total willingness to pay by the households is 72, the
total willingness to pay by the business is 100. By selling to the
households only at T=72, the profit is 144.
Can the firm do better than 144?
Lets try p=1, p=2, and p=3.
If p=1, households buy 11, business buy 18. Their
remaining willingness to pay is 60.5 and 81, respectively.
By setting T=60.5, the total profit is 1(11+18)+260.5=150.
If p=2, the total profit is 152.
If p=3, the total profit is ___.
Try to fill the above blank.



Let the firm offer two pricing schemes
To beat 152, we offer (p1=2,T1=50) and (p2=0,T2=85).
The households will not choose (p2=0,T2=85).
Because its total willingness to pay is 72<85.
Instead, they choose (p1=2,T1=50) and buy 10. The
firm earns 70 from them.
The business prefer the second scheme. Because their
consumer surplus is higher: Under the first scheme, it
is 64-50=14. Under the second scheme, it is 100-
85=15. The firm earns 85.
In total, the firms earns 70+85=155.

Conclusions
Although the firm is not sure which consumer type it is
faced with, by using incentive pricing schemes, it can
differentiate them
High demand consumer generally pays a large T and a
small p, while low demand consumer pay a small T and a
high p.
By adjusting the parameters of pricing scheme, the firm
can improve its profit
The optimal schemes are not easy to find even under
simple assumptions.
Real-world Example
Some video stores offer customers two ways to
rent movies:
(i) Pay an annual membership fee and then pay a small
fee for the daily rental of each movie
(ii) Pay no membership fee, but pay a higher daily
rental fee
Question: Compare the high demand consumer
and the casual consumer. Who prefers the
simple rental fee?
Bundling and tying
Bundling- packages containing multiple units
E.g.: Buy one get one free
Tying - packages containing different products
Cell phone services with cell phones
TV networks-MTV and CNN are tied together
Software like MS Office include WORD and
EXCEL
Apartment with utilities

Reasons
Efficiency- make things easy for both buyers and
sellers
Evade regulation-circumvent price control
Secret price discount-avoid being criticized by
other members in the same industry
Assure quality- incompatible parts reduce
quality
Price discrimination. But how?
How bundling works
It works like a perfect price discrimination.
Compare selling 2 units at $2 each vs selling a 4-unit bund at a
total price $7.99.
Which way generates a higher profit if the unit cost is 0

Pure Bundling
Consumers must buy both goods together; the
choice of buying one good without buying the
other is NOT given.
Example: How to sell movie DVDs A and B?
Consumer 1 Consumer 2
Willingness to pay for A
9 10
Willingness to pay for B
3 2
Total willingness to pay
12 12
When can pure Bundling work?
Price discrimination is not possible (inability to offer
different prices to different customers or segments)

Demand for two or more goods to be sold is
negatively correlated (the more consumers demand
one good, the less they will demand of the other good)

Resale is limited. Why?
Mixed Bundling
Consumers can buy individual goods or a bundle. For
example, restaurants often do this.
Sometimes, it works even better. In the example below,
if only the $12 bundle were offered, consumer 3 would
buy nothing. By charging $11 for movie A, the seller
gains.
Consumer 1 Consumer 2 Consumer 3
Willingness to pay for A
9 10 11
Willingness to pay for B
3 2 0
Total willingness to pay
12 12 11
Peak-load pricing
Setting Prices that vary over the day in
proportion to the variation in MCs is a form of
peak-load pricing.
In many markets, demand is seasonal
Hotels, restaurants, transportation,
Firms in these markets also need to invest in
capacity which is not adjustable in the short run
How to set prices across seasons for a monopoly
in this type of market?
Example- an airline company
Consider an airline company serves passengers in a low
season and a high season.
Suppose the unit capacity cost is 4. The marginal cost is
1.
The total cost of serving q
L
passengers in a low season and q
H
in
a high season is q
L
+q
H
+4K. K is the capacity. K q
L
,q
H
0.
Suppose the demands are p
L
=4-q
L
and p
H
=16-2q
H

What are the optimal prices?
Example- an airline company
Lets assume at the optimal quantity, q
L
<q
H
.
It does not have to be true. We can check if the results is
consistent with the assumption.
Then the capacity K=q
H
to save the capacity cost.
Also, in the low season, q
L
<K. That means the capacity cost is
irrelevant in the low season.
Therefore, in the low season, the firm makes MR=MC, or 4-2q
L
=1.
In the high season, the firm should cover the capacity cost, then
MR=MC, or 16-4 q
H
=1+4.
The optimal outputs are q
L
=1.5 and q
H
=2.75.
The assumption q
L
<q
H
is satisfied.
The prices are p
L
=2.5 and q
H
=10.5

Conclusion
In the low season, passengers pay a much lower
price.
The capacity cost is essentially covered by
passengers in the high season.
The difference in prices, 10.5-2.5=8, is also
higher than the unit capacity cost, 4.

Limitation of our analysis: What if a high season
passenger decide to change her travel plan?