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This overview explores the concept of second-degree price discrimination, where consumers are presented with a menu of price-quality options, allowing them to self-select based on their willingness to pay. We discuss various strategies, including versioning and intertemporal price discrimination, illustrated with examples from retail and airlines. The principles of inducing customers to sort themselves into high and low price groups are highlighted, emphasizing the importance of not making lower-priced options too attractive. This provides businesses with powerful pricing strategies to maximize revenue.
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Types of price discrimination • First-degree PD: charge every consumer his or her willingness to pay. • Third-degree PD: sort customers into several groups based on observable, exogenous characteristics. • Second-degree PD: present all customers with a menu of prices and allow the customers to self-select. MBA201a - Fall 2009
Second-degree price discrimination • Basic idea: Present consumers with a menu of (price, quality) pairs and let them sort themselves into groups. • A consumer’s willingness to pay for quality should be correlated with his or her willingness to pay a high price for the underlying good. • Examples: • Retail: Old Navy, Gap and Banana Republic jeans. • Airlines: first class and coach seats. MBA201a - Fall 2009
Specific types of second-degree PD • Versioning: design product lines that appeal to different consumers. • Examples: student and professional software. • Damaged goods: a particular case when the differences between products are obtained by "damaging" basic product. • Examples: Intel’s 486 chip, U.S. Postal Service. MBA201a - Fall 2009
Second-degree PD example (versioning 1.0) • Strategy 1: Offer all tickets at price $300 • Total revenue = $30010 + $3008 = $5,400 • Strategy 2: Offer only unrestricted tickets at price $800 • Total revenue = $8008 = $6,400 • Strategy 3: Offer Saturday-night-stay at price $300, unrestricted at price $800 • Will the businessperson buy the unrestricted ticket? MBA201a - Fall 2009
Second-degree PD example (versioning 2.0) • Strategy 3: Offer restricted tickets at price $300, unrestricted at price $800 • DOESN’T WORK. Businessperson wont buy the unrestricted ticket. • Strategy 4: Offer restricted tickets at price $300, unrestricted at price $699 • Total revenue = $30010 + $6998 = $8,592 MBA201a - Fall 2009
Second-degree price discrimination principles • Induce customers to select into high and low price groups themselves. • Key constraint: you can’t make the inexpensive version too attractive to those willing to pay more. • If there aren’t many customers in the low-valuation group, you may want to ignore this group, since selling to it forces you to lower the price to the high valuation group. MBA201a - Fall 2009
More types of second degree price discrimination • Intertemporal price discrimination • Idea: high valuation users are also less patient. • Quantity discounts (price per unit depends on the quantity bought). • Idea: high valuation consumers willing to pay more for more. • Multiple two-part tariffs • Examples of two-part tariffs: cell phone plans with monthly and per minute fees. • Idea: separate between low volume users and high volume users. MBA201a - Fall 2009
Takeaways • Firms would prefer to use perfect (aka first-degree) price discrimination, but this may be impossible. • Third-degree PD is one way to approximate perfect PD, but requires that firms can separately identify members of high and low value groups. • Second-degree PD induces customers to sort themselves into groups. • Recall the no arbitrage constraint—consumers can’t resell to others. • Price discrimination and other advanced pricing strategies are powerful tools; you now have the economic models to understand them. MBA201a - Fall 2009
