Road Map for Prices and Markets Demand and Supply Analysis Demand and Revenue • Elasticity of demand TOOLS Costs • Marginal costs; fixed costs; variable costs Monopoly Pricing • Pricing by a monopolist (MR = MC) – finishing today with franchising case. Price Discrimination (Exotic pricing strategies) • Not all gains from trade realized or extracted – today • Explicit market segmentation – today • Implicit market segmentation – next, in session 8 • Bundling – next, in session 8 McDonald’s “Behind the Arches” John F. Love “ He soon realized that while McDonald’s might not produce a windfall for the franchiser, it could be a lucrative proposition for the franchisee.[…] Capital investment in those operations typically started at $250,000, but an early McDonald’s – including land, building, and equipment – could be opened for as little as $80,000. When the franchisee found a landowner willing to rent the space to Ray Kroc Founder of the him and a bank willing to provide a mortgage on the building, his McDonald’s franchise investment amounted to no more than the $30,000 needed for the equipment, the sign, the start-up inventory, and even that could be borrowed.” […] “The Rolling Green group was arguably, from McDonald’s point of view, the worst collection of McDonald’s operators in the chain’s thirty year history.” “Dondanville justified it on financial grounds; like […] most other early McDonald’s units in California, the Reseda store was barely breaking even, and “Ray was very much against remote control.” […] Dondanville was becoming desperate. `We ate hamburgers at home for 27 days in a row, and we “[…] what irritated Kroc the most was when got sick of it [sic],” Dondanville recalls. `That’s when I Dondanville raised his hamburger price from 15 to decided to raise prices.’” 18 cents.[…]” What’s going on??
McDonald’s vs the Franchisee The franchisee gets his total profit McDonald’s gets a share of revenues � He would set a price that maximizes � sets a price that maximizes total sales ($) P P his profit. P Revenue maximizing point Profit maximizing point MC P + P = 2 Marginal cost Demand curve Demand curve Q Q (i) McDonald’s (ii) The Franchisee You can now answer this You write a self-help book called ` Five steps to have more free time .’ You sign a contract with a book publisher: • You get a lump sum of $100,000 plus 7% of the wholesale value of all sales of the book. • The publisher has a fixed production cost of $200,000 (inc. $100,000 royalty) for the book, plus a cost of $5 per copy for printing and distribution. • Each party (you, the author, & the publisher) cares about only her/his profit for this book’s sale. Each party has a preferred price. Which one is higher?
Prices and Markets Session 7 Exotic Pricing Strategies: Explicit Market Segmentation Prof. Amine Ouazad This Session Explicit Price Discrimination 1. Perfect Price Discrimination and why it cannot be achieved 2. Explicit Price Discrimination, a.k.a. Explicit Market Segmentation 3. The Roxy Case Next Session Implicit Price Discrimination
Heaven: Perfect Price Discrimination High valuation P P customers Lower valuation customers Op5mal# price# Variable#profit# Variable# “No$money$is$le,$ profit# on$the$table”$ MC# MC# Demand# Demand# MR# Q Q Uniform'Pricing' Perfect'Price'Discrimina.on' “A key step is to avoid uniform pricing. Pricing to specific customer groups should reflect the true competitive value of what is being provided. No money is left on the table...” A. Miles, Pricing , Boston Consulting Group. The Treasury plans to auction The $1 trillion question $30 billion Tuesday. -- January 28, 2013 ! World-wide, every year, governments sell multiple trillions of dollars worth of securities to bank and large institutional investors. ! Banks’ willingness to pay for particular security depends on its portfolio needs and information about the state of the economy … banks differ along these two dimensions ! A bank’s valuation is private information: it is not known to the government How should governments sell securities to maximize revenues?
Uniform price auction Example : 5 bids In this auction form, all bidders P Supply simply pay the market clearing Bids price for all units they purchase B 1 B 2 B 3 Market clearing B 4 price B 5 Government Revenue Q Can we do better? Could we collect more? With a uniform market clearing P price, winning banks make a Supply Demand V 1 consumer surplus equal to the difference between their valuation V 2 and the uniform price. V 3 V 4 Market clearing price V 5 Q Consumer surplus Banks have a consumer surplus .
Discriminatory Treasury Price Auction Example : 5 bids P In most countries, governments Supply Demand proceed as follows: V 1 B 1 V 2 1. Banks submit price-quantity B 2 pairs as bids V 3 B 3 V 4 B 4 2. Treasury officials sort the offers Volume of This bid in descending order of price. 3. The highest bids are fulfilled until Q supply is exhausted This bid is partially fulfilled Is this better?? Priceline.com: « Name your own price » also known as opaque pricing How does Priceline’s business model addresses the fundamental problem of price discrimination: ! Consumer identification: Ask consumers to name their own price! Consumers give some information about their valuation. Does this really achieve some PPD?? ! Captures only part of the remaining consumer surplus: Make obtaining the discounted products such a pain in the #&& in order to discourage high-valuation buyers from switching (this is necessary to convince sellers to use Priceline’s site).
Perfect Price Discrimination • Perfect price discrimination is a useful benchmark, but never achieved in practice. • Informational problem : It is very difficult to know the valuation of a customer. • However : it should not lead you to revert to uniform pricing . • You may partially achieve the goal of PPD. � Exotic pricing strategies !! • Today: Explicit market segmentation. Take a market, divide it into segments, and charge a different price for each segment. • Session 8: Implicit market segmentation . This Session Explicit Price Discrimination 1. Perfect Price Discrimination and why it cannot be achieved 2. Explicit Price Discrimination, a.k.a. Explicit Market Segmentation 3. The Roxy Case Next Session Implicit Price Discrimination
Spot the Difference Explicit Market Segmentation Segment the market by observable characteristics. Charge customers in different segments different prices, according to their elasticity. Condition #1: Market Power • Must have ability to set prices Condition #2: Observability (No deception) • Use an easily observed trait which is correlated with elasticity of demand. • Customer cannot masquerade as someone else. Condition #3: No arbitrage/resale • Customers from one segment cannot sell good to others.
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