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Understanding Third-Degree Price Discrimination in Cell Phone Pricing Strategies

This lecture focuses on third-degree price discrimination as a strategic pricing tool within the cell phone industry. It covers key principles such as consumer elasticity of demand, market segmentation, and pricing strategies to maximize profits by charging different prices to distinct consumer groups. Case studies, including market examples from the U.S. and Europe, illustrate how firms can leverage price discrimination to optimize revenue while considering the unique characteristics of each market. The discussion also emphasizes the importance of understanding marginal revenue and cost in achieving an effective pricing strategy.

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Understanding Third-Degree Price Discrimination in Cell Phone Pricing Strategies

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  1. AEM 4160: Strategic PricingProf.: Jura LiaukonyteLecture 6 – THU, FEB 10th3rd degree price discriminationCell phone Pricing

  2. Lecture Plan • 3rd degree price discrimination • Virgin Mobile Pricing

  3. Third Degree PRICE DISCRIMINATION

  4. Third-degree price discrimination • Consumers differ by some observable characteristic(s) • A uniform price is charged to all consumers in a particular group – linear price • Different uniform prices are charged to different groups • subscriptions to professional journals [library/student] • airlines • the number of different economy fares charged can be very large indeed! • early-bird specials; first-runs of movies

  5. Third-degree price discrimination • The pricing rule is very simple: • consumers with low elasticity of demand should be charged a high price • consumers with high elasticity of demand should be charged a low price

  6. Third degree price discrimination: example • Harry Potter volume sold in the United States and Europe • Demand: • United States: PU = 36 – 4QU • Europe: PE = 24 – 4QE • Marginal cost constant in each market • MC = $4

  7. The example: no price discrimination • Suppose that the same price is charged in both markets • Use the following procedure: • calculate aggregate demand in the two markets • identify marginal revenue for that aggregate demand • equate marginal revenue with marginal cost to identify the profit maximizing quantity • identify the market clearing price from the aggregate demand • calculate demands in the individual markets from the individual market demand curves and the equilibrium price

  8. The example United States: PU = 36 – 4QU Invert this: QU = 9 – P/4 for P< $36 At these prices only the US market is active Europe: PU = 24 – 4QE Invert QE = 6 – P/4 for P< $24 Aggregate these demands Q = QU + QE = 9 – P/4 for $24 <P< $36 Now both markets are active Q = QU + QE = 15 – P/2 for P < $24

  9. The example Invert the direct demands $/unit P = 36 – 4Q for Q <3 36 P = 30 – 2Q for Q > 3 30 Marginal revenue is MR = 36 – 8Q for Q< 3 17 MR = 30 – 4Q for Q> 3 Demand MR Set MR = MC MC Q = 6.5 6.5 15 Quantity Price from the demand curve P = $17

  10. The example Substitute price into the individual market demand curves: QU = 9 – P/4 = 9 – 17/4 = 4.75 million QE = 6 – P/4 = 6 – 17/4 = 1.75 million Aggregate profit = (17 – 4)x6.5 = $84.5 million

  11. The example: price discrimination • The firm can improve on this outcome • Check that MR is not equal to MC in both markets • MR > MC in Europe • MR < MC in the US • the firms should transfer some books from the US to Europe • This requires that different prices be charged in the two markets • Procedure: • take each market separately • identify equilibrium quantity in each market by equating MR and MC • identify the price in each market from market demand

  12. The example $/unit Demand in the US: 36 PU = 36 – 4QU Marginal revenue: 20 MR = 36 – 8QU Demand MR MC = 4 4 MC Equate MR and MC 4 9 Quantity QU = 4 Price from the demand curve PU= $20

  13. The example: $/unit Demand in the Europe: 24 PE = 24 – 4QE Marginal revenue: 14 MR = 24 – 8QE Demand MR MC = 4 4 MC Equate MR and MC 2.5 6 Quantity QE = 2.5 Price from the demand curve PE= $14

  14. The example • Aggregate sales are 6.5 million books • the same as without price discrimination • Aggregate profit is (20 – 4)x4 + (14 – 4)x2.5 = $89 million • $4.5 million greater than without price discrimination

  15. Some additional comments • Suppose that demands are linear • price discrimination results in the same aggregate output as no price discrimination • price discrimination increases profit • For any demand specifications two rules apply • marginal revenue must be equalized in each market • marginal revenue must equal aggregate marginal cost

  16. Price discrimination and elasticity • Suppose that there are two markets with the same MC • MR in market i is given by MRi = Pi(1 – 1/hi) • where hi is (absolute value of) elasticity of demand • From rule 1 (above) • MR1 = MR2 • so P1(1 – 1/h1) = P2(1 – 1/h2) which gives Price is lower in the market with the higher demand elasticity

  17. 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 different 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.

  18. Issue • Pricing decision: • Entering a highly saturated cell phone service industry, while targeting an unsaturated market segment • Attempting to earn a profit from a limited income market • Target market is: • Young (15-29) • Trendy • Different than traditional cell phone users • Different spending habits • Different usage • Different needs • Limited purchasing power • “According to marketing research, target market does not trust industry pricing plans.” -Dan Schulman, CEO, Virgin Mobile USA

  19. Objectives • Create value and profitability in cell phone service industry • Target market ages 15-29, opportunity for growth with this market segment • 1 million subscribers by year 1, 3 million by year 4 • “By focusing on the youth market from the ground up, we’re putting ourselves in a position to serve these customers in a way they have never been served before” -Dan Schulman, CEO, Virgin Mobile USA

  20. Options • Clone Industry Prices: contracts • Set prices below competition: contracts • A whole new plan: prepaid pricing

  21. Clone Industry Prices • Pros • Give customers more features for the same price • Easy to promote, use current models • Limited spending power on promotion may be a justifiable factor • Viable with Virgin Mobile’s limited advertising budget • Cons • May drive margins down if additional features are costly • Reduces competitive advantage • Difficult to penetrate saturated market with similar offer as competitors • Competitive with other cell phone providers and packages; does not support strong market differentiation

  22. Price Below Competition • Pros • Drive sales and market share • Accounts for limited spending power of target market • Cons • Margins and profitability will be driven down • Inconsistent with company goal of profitability • Cannot compete in price wars • Not a long term solution

  23. A Whole New Plan: Prepaid Pricing • Pros • Differentiate from competition • Cater to the needs of target market • Flexibility is attractive to target market • Profitability is key • Eliminates risk of missed payments • Cons • Risk of limited returns and loyalty • Churn rate may increase

  24. Pricing Structure from the Carrier Perspective • Contracts: • Annual churn rate WITH contracts =2% * 12 months = 24% (p.8) • Annual churn rate WITHOUT contracts =6% * 12 months = 72% (p.8) • The difference: 72% - 24% = 48% Take AT&T example: customer base = 20.5 million If AT&T abandons the contract based plan how many new customers would it need to acquire to offset customers from an increased churn rate? • Additional customers lost to churn: __________________ • Acquisition cost per customer: $370 (case p.2) • Total cost of offsetting higher churn rate: __________________ Not surprising that major players still continue to hold the contracts.

  25. “Menu” pricing: Actual Usage

  26. Bucket/”Menu” pricing • In reality most consumers are paying more than their optimal rate = if they new exactly how much they will consume • “industry makes money from consumer confusion” • Pricing menus allow carriers to advertise low per minute rates • But most consumers end up choosing the wrong menu.

  27. Hidden Fees • Able to promote low per minute prices, but still collect additional revenues

  28. Acquisition costs • Advertising per gross add: from $75 to $100 (p.5) • Sales commission paid per subscriber: $100 (p.5) • Handset subsidy provided to the subscriber: $100 to $200 (p.9) • Total: from $275 to $405 • (let’s assume somewhere in the middle = $370)

  29. Break Even point • Monthly ARPU (average revenue per unit): $52 (p.3) • Monthly Cost-to-Serve: $30 (p.3) • Monthly Margin: $22 • Time required to break even on the acquisition cost = __________________ • In the cellular industry the monthly margin is relatively fixed across periods, therefore the traditional LTV can be simplified (assuming infinite horizon): M = margin the customer generates in a year r = annual retention rate = (1-12*monthly churn rate) i = interest rate (assume 5%) AC = acquisition cost

  30. LTV with contracts • The annual retention rate in the industry = ______________

  31. LTV without contracts • Eliminate contracts -> churn rate increases to 6% • Calculate the LTV:

  32. Eliminate Hidden Costs • $ 29 cellular bill becomes $35 due to hidden costs • Increase of 21% • If these costs were eliminated, the $22 margin would be reduced to _______________ • Break even would become _________= __________

  33. What happens to LTV? • Without hidden costs, but with contracts • Without hidden costs and without contracts • Elimination of contracts drives LTV below zero • Hidden costs boost the bottom line

  34. Option 3: different pricing approach • Target audience: Youth • Loathe contracts • Fail credit checks • Ideal plan: no contracts, no menus, no hidden fees… • How to differentiate itself, and have a positive LTV • Look at the factors that affect LTV

  35. Options for Lowering Acquisition Costs • Advertising costs per customer • Industry=from $75 to $100 • Virgin planned ad costs = 60 mil/1min= $60 (p.5) • Handset subsidies: • Current industry handset cost: $150 to $300 (assume $225) (p.5) • Current industry handset subsidy: $100 to $200 (assume $150) (p.9) • Current industry handset subsidy as a %: 67% • Virgin’s handset cost: $60 to $100 (assume $80) • Assume Virgin’s subsidy around 30% = $30

  36. Acquisition costs • Then Virgin’s AC would be just ____vs. industry average $370 • Sales commission: $30 • Advertising per gross add: $60 • Handset Subsidy $30 • Total: _______

  37. Consumer friendly plan: how to achieve profitability • Break Even analysis: at what per minute price would Virgin break even: • Virgin’s monthly ARPU: ______________ where p=price per minute • Monthly cost to serve: ______________ • Monthly margin: _______________ p > ________

  38. Other price points • What if Virgin charged per minute price comparable to other industry prices, somewhere in between 10 and 25 cents: • At 10 cents: • At 25 cents:

  39. Virgin’s Pricing Plan: What happened • A prepaid plan • No contracts • No hidden charges • No peak off peak hours • Very low handset subsidies • No credit checks • No Monthly bills • Price: 25 cents per minute for the first 10 minutes; 10 cents/minute for the rest of the day • No exact numbers, but churn rate lower than 6%

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