PowerPoint Slides © Michael R. Ward, UTA 2014

iPhone Pricing• In July 2007, Apple released two versions of the iPhone: 8-

GB for $599 and 4-GB for $499. In the first weekend alone Apple sold around half a million iPhones

• Two months later, however, Apple discontinued the 4-GB model and cut the 8-GB model’s price to $399• Why cut prices when demand is so high?

• Apple used the lower price to attract additional customers. • This would have been a great pricing move, BUT many loyal Apple

customers were upset by the price cut, suddenly early purchasers found themselves “the schmucks,” and Apple had to give $200 rebates to early customers to avoid negative publicity

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iPhone Pricing• Apple was using indirect price discrimination• Apple did not know who had a high WTP or a low WTP,

but it did know that there was variation in WTP• Could not identify groups

• Let the customers self-sort into the groups!• Need something correlated with willingness-to-pay

• Early adopters tend to have higher WTP• Later adopters tend to have lower WTP

• Start with high price to capture high WTP• Reduce price to capture rest• What happens if this is reversed?

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Self Sorting• Exploiting early adoption is common

• Ex Hardcover books versus paperbacks• Ex Music albums versus “best hits of” albums• Ex Movies in theater, then pay per view, DVD, network TV

• Other self sorting mechanisms• Grocery coupons – require time and effort clipping that high WTP

won’t exert• Outlet Malls – Usually inconveniently located, offers ‘seconds’• Generic versions – Usually lower quality version• Souvenir stands – Tourists versus Natives

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iPhone Pricing II• Iphone 5S• Demand for phone related

to demand for memory

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Art Fair Items• You sell collectable glass ornaments at art fairs. You get a

lot of "just lookers" but about half of all potential customers will purchase your most popular ornament for $10. Furthermore, about one-half of these would be willing to pay $15 but you cannot tell them apart by looking at them. If your marginal cost is $5, is there a strategy that yields an expected contribution margin of more than $5 per ornament?

• Catch them on the way out

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Requirements• With indirect price discrimination design products or

services that:• Appeal to different consumer groups• Still limit arbitrage

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Entry as Arbitrage• Price discrimination can also invite entry from competitors• United Airlines had been able to set much higher prices

for different classes of seats• Between 1997 and 2005 competition drove United Airlines

to reduce prices on its business class tickets on the Philadelphia to Chicago flight.

• In 1997, the highest-priced tickets were 3 times higher than the lowest priced tickets. By 2005, the highest-price was less than twice the low price.

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Entry as ArbitrageEcon 5313

Metering• 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.

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Metering• HP identifies high- and low-value consumer groups by the

number of ink cartridges purchased• Low volume buy one cartridge and value printing at $100• High volume buy two cartridges and value printing at $200 • Have to worry about arbitrage (cartridge compatibility?)

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Low volume customers

High volume customers

Strategy 1: $50 printer & $50 cartridge $100 = ($50+$50) $150 = ($50+2×$50)Strategy 2: $0 printer & $100 cartridge $100 = ($0+$100) $200 = ($0+2×$100)

Metering• The low margin on printers and high margin on ink

cartridges works best because demand for number of cartridges ‘measures’ WTP for service

• Sometimes called “metering”• Similar to pricing schemes used for many complementary

products• Razors and razor blades • Barbie dolls and accessories• Movies and popcorn• Computer and punch cards

• “Give away the razor to sell the blades”

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Tying• Tempted to contractually tie the sale of base good to the

metered good• Often illegal• Can be OK if required for the effective functioning of the

equipment• But this is a hard sell because it is often claimed

• Example IBM and punch cards• Example AT&T and hush-a-phone

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Leaving Money on the Table• 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, while selling a full-featured model (aimed at businesses) for $1,195. • The threat of cannibalization is clear and to avoid losing money

the price and/or design the two versions must be 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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Leaving Money on the Table• In practice, this usually means disabling some features on

the “academic” version• The important aspect is that the value of the disabled

features must be higher to the high value customers• Students were not willing to pay for things they did not

need for classes but businesses were• Suppose we have the following values for WTP

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Students BusinessFull Featured $175 $500 Disabled $150 $200

Leaving Money on the Table• If there are no costs, what are profits if:• We try to get both customers with full-featured version?

• Set price at $175 get profits of $350 from both customers

• We target only business customers?• Set price at $500 get profits of $500 from only business

customers

• We sell full-featured at $500 and disabled at $150?• Get profits of $300 from both customers because business

customers get more surplus from the disabled version

• We sell full-featured at $450 and disabled at $150?• Get profits of $600 because now they self-sort into the right

versions

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Leaving Money on the Table• The lesson is that you have to make it worth their while

for the high types to self-select into the version designed for them

• This means that you typically cannot extract all of their surplus

• You have to make the offers “incentive compatible”• Otherwise the disabled version can “cannibalize” the full-

featured version• Might be optimal to drop the low-valued version so as to boost

sales for the high-valued version• Example VW Beetle?

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Volume Discounts• So far we have been talking about exploiting differences in

WTP across customers or customer types• But for some products or services, an individual consumer

may buy multiple units and value each unit differently• How can you exploit this variation in WTP across the

volume of purchases?• Usually WTP falls with volume• Can you find a way to have price fall with volume?

• Volume discounts

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Volume Discounts• Some volume discounts schemes:• Ex Buy 10 get 1 free• Ex Detergent price per ounce falls with package size• Ex Costco “vat-o-mayonnaise”• Ex Minute bundles in mobile phone plans• Ex Loyalty programs

• Scene from “Up in the Air”

• Typically induce customers to purchase more units than with a single price

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Two-Part Pricing• Often volume discounts schemes are difficult to

implement and do not capture much of the surplus• Instead, try “two-part pricing”• First, set the unit price equal to the MC

• This way the consumer purchases all units that add any value• This also generates the most consumer surplus possible

• Second, only allow customers to get this privileged pricing scheme if they pay some up front fee• How big of a fee? • Up to the total surplus available

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Two-Part Pricing• Some examples of “two-part pricing”• Ex Buying club memberships• Ex Six Flags• Ex Monthly telephone subscriptions with the price of a call

set to $0 (=MC)• Along with different minute allotments to “meter” customers

• Ex Monthly health club membership with the price of a visit set to $0 (=MC)

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Bundling• Sometimes even “two-part pricing” schemes are difficult

to implement• Especially, if you have to keep track of usage

• Not a problem with “free”

• Instead, simply sell units in bundles instead of individually• Your bundle size has to approximate how many units you

think consumers would purchase at price = MC• Ex Fast-food combo meal (sandwich, side & drink)• Ex Rhapsody music subscriptions versus iTunes• Ex Cable TV channel line-ups in basic packages• Ex Rights to logging on a tract of land

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Bundling• German brothels recently began offering a monthly

subscription service for multiple purchasers. If you thought that the brothels’ encouragement of prostitution was immoral to begin with, would you consider this pricing plan to be even more immoral?

• What effect does this have on ‘patronage?’• This is bundling mechanism. Pricing per ‘visit’ means that

a customer’s WTP for the next visit in a month is les than the price. But now, the marginal dollar price of another visit is zero. Visits should increase.

• If you think some visits are bad, then more are worse.

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Blockbusters• Why do they call them “blockbusters”?• In the old days, studios had contracts with theaters to

show two specific movies, one after the other• Couples would go to see a “double feature”• One movie appealed to him and the other to her• Usually, one was a big budget and the other was a “B Movie”

• Couples would purchase a ticket block to see both movies • Bundling induced increased demand

• Every so often the “A Movie” was a big hit and the theater could sell out every showing if it did not have to show the “B Movie”

• So they would violate the contract and “bust the block”

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From the Blog• Chapter 14• Concert Seats• Skipping lines at Disneyland• Multi-Day Passes at Disneyland• CATV channel bundling• Barbie Discrimination

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Main Points• Can tell high WTP from Low WTP?

• Devise a scheme in which they self-sort e.g., early adoption

• Metering• High usage are high WTP• P<MC for appliance P>MC for usage

• Leave “Money on the Table” to limit cannibalization• A customer’s WTP usually falls with additional units

• Quantity Discounts• Two-Part Pricing• Bundling

• Bundle different goods so long as WTP is negatively correlated across customers

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