Professor Preston McAfee on Price Discrimination

(you must have RealPlayer to view this video. Mac users can download it here)

CalTech Economics professor Preston McAfee is an expert on prices. His research spans three decades and examines the pricing behavior of firms in various market structures. In the lecture linked above the professor shares several examples of firms practicing price discrimination. I was surprised to see that many of the examples he discusses are ones that I have been using in my own lectures on price discrimination for the last few years.

McAfee presents a mathematical formula for monopoly pricing, which no AP or IB text that I’ve seen has included:

Monopoly Price = [PED/(1-PED)] x MC where PED is the price elasticity of demand of the customer and MC is the firm’s marginal cost of production.

The basic idea is that the more inelastic the customer’s demand, the higher price the monopolist should charge over its marginal cost. The implication, therefore, is that a monopolist prefers to charge higher prices to customer’s whose demand is inelastic and lower prices to customers who are “price sensitive” or whose demand is elastic. The charging of different prices to different consumers for the exact same product is what economists call price discrimination.

McAfee begins talking about price discrimination at minute 8:44 in the video. His examples include:

• Movie theaters: Charge different prices based on age. Seniors and youth pay less since they tend to be more price sensitive.
• Gas stations: Gas stations will charge different prices in different neighborhoods based on relative demand and location.
• Grocery stores: Offer coupons to price sensitive consumers (people whose demand is inelastic won’t bother to cut coupons, thus will pay more for the same products as price sensitive consumers who take the time to collect coupons).
• Quantity discounts: Grocery stores give discounts for bulk purchases by customers who are price sensitive (think “buy one gallon of milk, get a second gallon free”… the family of six is price sensitive and is likely to pay less per gallon than the dual income couple with no kids who would never buy two gallons of milk).
• Dell Computers: Dell price discriminates based on customer answers to questions during the online shopping process. Dell charges higher prices to large business and government agencies than to households and small businesses for the exact same product!
• Hotel room rates: Some hotels will charge less for customers who bother to ask about special room rates than to those who don’t even bother to ask.
• Telephone plans: Some customers who ask their provider for special rates will find it incredibly easy to get better calling rates than if they don’t bother to ask.
• Damaged goods discounts: When a company creates  and sells two products that are essentially identical except one has fewer features and costs significantly less to capture more price-sensitive consumers.
• Book publishers: Some paperbacks cost more to manufacture but sell to consumers for significantly less than hard covers. Price sensitive consumers will buy the paperback while those with inelastic demand will pay more for the hard cover.
• Airline ticket prices: Weekend stayover discounts for leisure travelers mean business people, whose demand for flights is highly inelastic, but who will rarely stay over a weekend, pay far more for a roundtrip ticket that departs and returns during the week.

McAfee also goes into a fascinating discussion of price dispersion which is essentially a theory of oligopoly pricing. All Econ teachers should watch this video and find examples of price discrimination and oligopoly pricing that they can incorporate into their own class.

If you’re up for a challenge, try deciphering some of the mathematics in McAfee’s free, downloadable intro to economics text, available here.

YOUmoz | Price Discrimination in Pay Per Click Advertising

The article above gives a great introduction to and several examples of price discrimination among firms with market power. Read the excerpt below then discuss the questions that follow in your comments:

For any product or service, different people have different prices they are willing to pay. If you ever took an Economics course you surely remember the downward sloping demand curve, which is a graphical way of saying that you’ll get more buyers at a low price and fewer buyers at a high price. For a business that cannot price discriminate, this poses a problem. What price to offer?

There might be some consumers willing to pay 80, but twice as many consumers willing to pay 50. If you set the price at 50, you get more revenue, but the people who are willing to pay 80 are happy that your offering was 30 less than they were willing to pay. (Economists call this consumer surplus.) The ideal situation for the business would be to sell to some consumers at 80 and others (the price sensitive ones) at 50. Price discrimination – charging each consumer close to what he or she is willing to pay – increases revenue for the business.

Business strategists are forever trying to figure out ways to price discriminate. For commodities it can be difficult, but some markets are conducive to price discrimination. The classic example is the airline industry. Travelers have different itineraries and routes, and the airlines purposely impose complex pricing rules (e.g. cheaper if you stay over a Saturday) in order to price discriminate. Business travelers typically end up paying more than leisure travelers, and if you fly into or out of a small city you pay more than between large cities. On a flight with 100 passengers, it is possible that everyone paid a different price for the seat – 100 different prices for the same product. Consumers often resent these schemes, but economists love them.

Movie theaters price discriminate by charging lower admission for kids and seniors. Everyone gets the same product – a seat in the theater – but consumers that are more price sensitive pay less. Car dealers discriminate based on how much the customer haggles. Sellers of new products, especially consumer electronics, often price discriminate over time. When the iPhone was first released, consumers willing to pay $600 got to buy it. A couple months later, Apple lowered the price and a larger segment of the public was willing to buy. Apple could have charged $400 from the beginning, but then they would have lost all that revenue from the people willing to pay $600.

Buyers often feel like they are being played for chumps when they learn about price discrimination, but many economists absolutely are crazy about it and wish we had more price discrimination. Businesses are encouraged to make prices secret – create a fog of uncertainty – to get customers to accept prices offered to them. Preston McAfee, an economics professor at the California Institute of Technology, gave a talk about prices. He raves about Dell selling the same computer at different prices based on how the consumer identifies themselves at the website (small business, large business, home users).

Discussion Questions:

1. Who suffers as a result of price discrimination?
2. Who benefits from price discrimination and how do they gain?
3. Is society as a whole better or worse off when a monopolist is able to price discriminate? Explain…

BBC NEWS | Technology | Nintendo warns of Wii shortages

Looks like Brits dreaming of the Wii from Nintendo may have to wait a while longer this holiday season, as British retailers are finding it nearly impossible to fill customers’ orders. It turns out there is quite a shortage for the hot new gaming system from Nintendo!

“Although we’re receiving regular deliveries from Nintendo, Sony and Microsoft and getting the products onto the shelves as fast as we can – it’s possible that demand will outstrip supplies on some products, for example the Nintendo Wii, which has been hugely popular all through the year,” read a statement from high street gaming specialist Game…

“The Nintendo Wii consoles have proved extremely popular with our customers and have been flying off the shelves whenever we get new stock in,” said a spokeswoman.

It seems like the shortage of Wii’s in the UK should send a message to Nintendo and its retailers: RAISE THE PRICE!! One way retailers have tried to do this is by bundling the consoles with up to three or four games, meaning to take home a console shoppers would have to fork over 300 GBP. This seems like a great strategy for retailers faced with strong demand from customers, given that they are probably not allowed to charge above Nintendos suggested retail price for the console itself. Continue Reading »