Module 2

Introduction
Advanced Competitive Strategy
Tobias Kretschmer
Professor of Management, LMU Munich
Module 2

Price Discrimination I:
Reasons to Discriminate
 Why Price Discrimination? (I/III)
Example: Magazine subscription

Student Non-student
with reservation price with reservation price
pS* = 300 pN* = 470

No price discrimination:

p (€) 470
p = € 300 300

 both buy 0 Q
0 1 2

 U = € 600
 Why Price Discrimination? (II/III)
Example: Magazine subscription

Student Non-student
with reservation price with reservation price
pS* = 300 pN* = 470

No price discrimination:

p (€) 470
p = € 470 300

 only non-students buy 0 Q

0 1 2

 U = € 470
 Why Price Discrimination? (III/III)
Example: Magazine subscription

Student Non-student
with reservation price with reservation price
pS* = 300 pN* = 470

Price discrimination:

p (€) 470
pS = € 300 and pN = € 470 300

 both buy 0 Q
0 1 2

 U = € 770
Advanced Competitive Strategy
Tobias Kretschmer
Professor of Management, LMU Munich
Module 2

Price Discrimination II:

Alignment with Product
Differentiation
 Prices & Products (I/IV)
Blurred border between price discrimination and product differentiation

without with
price discrimination price discrimination Example:
cost price cost price Student magazine subscription
 Prices & Products (II/IV)
Blurred border between price discrimination and product differentiation
without with
price discrimination price discrimination Example:
cost price cost price Free delivery of cement
 Prices & Products (III/IV)
Blurred border between price discrimination and product differentiation
without with
price discrimination price discrimination Example:
cost price cost price Airline classes
 Prices & Products (IV/IV)
Blurred border between price discrimination and product differentiation
without with
price discrimination price discrimination Example:
cost price cost price Student version of software
Advanced Competitive Strategy
Tobias Kretschmer
Professor of Management, LMU Munich
Module 2

First Degree Price

Discrimination
 First Degree Price Discr. (I/IV)

ƒ Firms can observe each consumer’s willingness-to-pay (WTP) perfectly

ƒ Each consumer can be charged a different price

 First Degree Price Discr. (II/IV)
Example: Aircraft manufacturers

ƒ Publish list prices for their airplanes

ƒ But actually negotiate prices with airlines individually

 First Degree Price Discr. (III/IV)
First degree price discrimination on the internet:

ƒ Firms communicate with consumers on a one-to-one basis

ƒ Information (demographics, interests) on each consumer through

registration and clickstream
 First Degree Price Discr. (IV/IV)
First degree price discrimination on the internet:

ƒ Opportunity to offer different prices to consumers (based on buying

habits)

ƒ Promotions can be used to estimate the individual price sensitivity

Î First degree price discrimination easier through the web

Advanced Competitive Strategy
Tobias Kretschmer
Professor of Management, LMU Munich
Module 2

Second Degree Price

Discrimination
 Second Degree Price Discr. (I/II)
Second degree or indirect price discrimination:

 Firms offer different deals, e.g. combinations of price and quality /

quantity
 Consumers self-select according to their willingness-to-pay and
preferences
 Firms do not need to know the consumers’ characteristics and
preferences
 Second Degree Price Discr. (II/II)
Second degree or indirect price discrimination:

 Firms construct prices so that consumers “self-select”

 Types:
• Nonlinear pricing
• Versioning
• Bundling
 Non-Linear Pricing (I/V)
Non-linear pricing / Quantity discount

 Consumers’ willingness-to-pay is highest for the 1st unit and decreases

subsequently

 Firms charge the highest price for the first unit and lower prices for the
following units
 Non-Linear Pricing (II/V)
Non-linear pricing / Quantity discount

 Simplest form:
Two-part tariff including a fixed part each consumer must pay
regardless of quantity and a variable part, proportional to the
quantity purchased
 Non-Linear Pricing (III/V)
Non-linear pricing / Quantity discount

Example: Telephone tariffs

Tariff A: Fixed cost + 12 cents per unit Tariff B: 30% cheaper after 10 min

€ €
84.80
2.86

1.68
24.80
units length
0 0 (min)
0 500 0 10 20
 Non-Linear Pricing (IV/V)
A cautionary note:

 Nonlinear pricing is used regularly and can improve profits

 Offering several nonlinear tariffs can be even more attractive

 However: Corresponding costs need to be taken into account

(development, billing, educating sales force, etc.)
 Non-Linear Pricing (V/V)
Empirical study on mobile calling plans in the US (Miravete 2004)

 The benefits of additional tariffs decreases very quickly

 With high costs firms should offer only a few tariffs

Average profit ($)

per subscriber

Number
of plans
 Versioning (I/VI)

 Firms offer several versions of a product at different price levels

 These versions differ in their quality / functionality / flexibility / etc.

 Versioning (II/VI)
Example: Flight tickets

 Business travellers require flexibility to rebook / cancel flights

 Again: No clear boundary to product differentiation

 Versioning (III/VI)
Extreme form – damaged goods

 Firms reduce the quality of initial product in order to exploit

price discrimination

 The version with reduced quality is sold to consumers with a

lower willingness-to-pay

 This incurs additional cost for reducing the quality of the initial product
 Versioning (IV/VI)
Extreme form – damaged goods
without with
price discrimination price discrimination
cost price cost price
Example:
Student version of software
 Versioning (V/VI)
Extreme form – damaged goods
Example: Intel processor 486

 DX version - price: $588

 SX version (exactly same as DX but disabled math coprocessor) - price:

$333
 Versioning (VI/VI)
Extreme form – damaged goods
Example: Mathematica 4

 Standard version - price: $1000

 Student version (with a flag preventing use of a math coprocessor) -

price: $180
 Bundling (I/VIII)
Problem of consumer heterogeneity for firms:
 Some consumers value product A more than product B
 Other consumers value product B more than product A
 Bundling (II/VIII)
 To sell products separately, firms have to decide on a single price for
each product
 Better strategy: Sell product A and B in a bundle

 Both consumer groups should value bundle of product A and B

the same

 Bundling can decrease consumer heterogeneity for firms

 Bundling (III/VIII)
Example: Audio CDs

 Some users want tracks from Erol Alkan, others want tracks from Mylo

 What price to set for individual tracks?

 Better: Sell Erol Alkan and Mylo songs on a sampler as a bundle

 Bundling (IV/VIII)
Example: Increasing revenues by bundling software

Willingness-to-pay for
User Type No. Users Word Processor Spreadsheet
Writer 40 50 0
Number-Cruncher 40 0 50
Generalist 20 30 30
Strategy 1: High price
• Both apps are sold for 50
• Writers and Number-Crunchers buy at
50
• Revenue is 4000
 Bundling (V/VIII)
Example: Increasing revenues by bundling software

Willingness-to-pay for
User Type No. Users Word Processor Spreadsheet
Writer 40 50 0
Number-Cruncher 40 0 50
Generalist 20 30 30
Strategy 2: Low price
• Both apps are sold for 30
• Everybody buys at 30 (sales of 60 units
per application)
• Revenue is 3600
 Bundling (VI/VIII)
Example: Increasing revenues by bundling software

Willingness-to-pay for
User Type No. Users Word Processor Spreadsheet
Writer 40 50 0
Number-Cruncher 40 0 50
Generalist 20 30 30
Strategy 3: Bundling
• Bundle is sold for 60, individual
applications are sold for 50
• Writers and NC buy at 50, Generalists
buy bundle for 60
• Revenue is 5200
 Bundling (VII/VIII)
Firms often fiercely compete for valuable consumers

 Video Consoles: Hardcore Gamers

 Mobile Telephony: Businesswomen / -men
 Airlines: Business Travelers

Problem: Simply lowering prices will attract both valuable and invaluable
consumers

Solution: Offer additional services bundled with basic product that

increase only utility of high value consumers
 Bundling (VIII/VIII)
Example: Video console market (Zegners & Kretschmer 2013)

Video console manufacturers often do not decrease their prices

during peak seasons such as Christmas, but try to attract valuable
consumers by adding bundled games to consoles
Advanced Competitive Strategy
Tobias Kretschmer
Professor of Management, LMU Munich
Module 2

Third Degree Price

Discrimination
 Third Degree Price Discr. (I/III)
Third degree price discrimination or group pricing:

 Firms observe consumer characteristics that allow them to infer WTP

and price accordingly

 Consumer characteristics can include geography, timing, job

 Third Degree Price Discr. (II/III)
Third degree price discrimination or group pricing:

 Different prices for different consumer groups

 Lower price for the consumers with greater price elasticity
 Seller needs to identify each consumer’s group by observable
characteristics
 Third Degree Price Discr. (III/III)
Third degree price discrimination or group pricing:

Observable characteristics Examples

Work status Student subscription to newspaper

Location Coke in supermarket / at the airport

Region Gasoline in Munich / Cologne

Country VW Golf in Germany / Denmark

Time Travel in peak or off-peak season

Advanced Competitive Strategy
Tobias Kretschmer
Professor of Management, LMU Munich
Module 2

Intertemporal Pricing
 Intertemporal Pricing (I/III)

 Initially setting high prices to sell to consumers with the highest

willingness to pay

 Lowering prices at a later point in time to appeal to those consumers

with a lower willingness to pay
 Intertemporal Pricing (II/III)
Problems with intertemporal pricing

Durable goods:

 Durable goods last for a long time

(e.g. computers)

 Consumers may strategically delay

purchase to avoid high initial price

 This erodes advantage from pricing

strategy and leads to slower sales
 Intertemporal Pricing (III/III)
Problems with intertemporal pricing

Consumer perception:

 Consumers may perceive later

price reductions as unfair

 This may even make them not

buy the product at all
Advanced Competitive Strategy
Tobias Kretschmer
Professor of Management, LMU Munich
Module 2

Wrap Up
Advanced Competitive Strategy
Tobias Kretschmer
Professor of Management, LMU Munich