# 16 Pricing Strategies

## The Policy QuestionShould Public Universities Charge Everyone the Same Price?

Modern public universities, like their private counterparts, publish a tuition price each year that few students actually pay. Most students receive internal grants and awards that reduce their costs well below the list price. The amount of this reduction in price varies dramatically and is closely related to the income of the student’s family.

Unlike their private counterparts, public universities in the United States receive public funding and are expected, in return, to provide an affordable college education for residents of the states they serve. Are their pricing policies antithetical to their mission? Are they fair? Do they support the mission of the institution? These are questions we will seek to answer by studying the practice of price discrimination.

## Exploring the Policy Question

1. Does charging tuition based on family income support or undermine the mission of public universities?
2. Is charging tuition based on family income fair?

## Learning Objectives

### 16.1 Market Power and Price Discrimination

Learning Objective 16.1: Explain differentiated pricing and describe the three types of price discrimination.

### 16.2 Perfect or First-Degree Price Discrimination

Learning Objective 16.2: Describe first-degree price discrimination and the challenges that make it hard.

### 16.3 Group Price or Third-Degree Price Discrimination

Learning Objective 16.3: Describe third-degree price discrimination and its effect on profits.

### 16.4 Quantity Discounts, or Second-Degree Price Discrimination

Learning Objective 16.4: Describe second-degree price discrimination and how it overcomes the identification problem.

### 16.5 Two-Part Tariffs and Tie-In Sales

Learning Objective 16.5: Define two-part tariffs and tie-in sales and how they work as price discrimination mechanisms.

### 16.6 Bundling, Versioning, and Hurdles

Learning Objective 16.6: Define bundling, versioning, and hurdles and how each works to increase firm profits.

### 16.7 Policy ExampleShould Public Universities Charge Everyone the Same Price?

Learning Objective 16.7: Explain how the use of price discrimination can be seen as a way for public universities to accomplish their mission.

## 16.1 Market Power and Price Discrimination

Learning Objective 16.1: Explain differentiated pricing and describe the three types of price discrimination.

Firms that have market power face demand curves that are downward sloping. We call such firms price makers, since the shape of the demand curve gives them choices about the prices they charge. Monopolists of the type examined in chapter 15 are simple monopolists: monopolists that are limited to a single price at which all the output they produce is sold. This limitation leads simple monopolists to limit output so that they can maintain a higher price for all their goods or services. This limitation in output creates deadweight loss, the lost surplus from transactions that don’t happen but that for which positive total surplus is possible. What we will see in this chapter is that firms with market power that are able to differentiate their consumers based on their demands or willingness to pay for the goods and services may be able to charge different prices for their goods and services. This practice is called differentiated pricing: selling the same good or service for different prices to different consumers. Differentiated pricing can come in many forms, from a car dealership that negotiates prices with consumers, selling the same model car for different prices to different customers; to a movie theater that offers a student price and an adult price; to volume discounts where consumers who buy multiple units qualify for lower per-unit prices, such as a sale on socks that are either $4 a pair or$10 for three pairs. Differentiated pricing can also come in the form of bundling, selling a set of goods for a single price, and product differentiation, selling different versions of a product for different prices that do not reflect production cost differences.

These more sophisticated pricing strategies are the topic of this chapter, and economists call the practice of charging different prices for the same good to different consumers price discrimination. Price discrimination often leads to higher profits for firms and to higher output, as the incentive to constrain output to maintain a higher price for all units is no longer there. Price discrimination allows discriminating firms to capture more or all of the consumer surplus and the deadweight loss that results from a single price and is therefore a strategy that increases profits. As we will see in this chapter, price discrimination can be hard because it requires firms to know information about consumers’ demands and to be able to prevent the resale of goods by a consumer who was charged a low price to a consumer who is being charged a high price.

Price discrimination is characterized by three main categories in economics: perfect price discrimination, group price discrimination, and quantity discounts. Perfect price discrimination, or first-degree price discrimination, is a type of pricing strategy that charges every consumer a price equal to their willingness to pay. Firms that can do this can extract the entire consumer surplus and all the deadweight loss for themselves and can extract all potential profit from a market. This type of price discrimination is rare because it requires that firms deduce each consumer’s willingness to pay and change the price to equal it. Though it might be a hypothetical extreme, many firms try to charge customers a price that is based on their willingness to pay, even if they can’t reach their exact willingness to pay. Car dealers that set final prices through negotiations or haggling are an example of this.

When firms are unable to ascertain individual willingness to pay but know something about the average demands among different distinguishable groups, they can practice group price discrimination, or third-degree price discrimination: charging different prices for the same good or service to different groups or different types of people. Movie theater pricing is a good example of this type of price discrimination: they often have different prices for kids, students, adults, and seniors. This type of price discrimination requires only that firms are able to ascertain group membership and prevent resale from one group to the other.

When firms are unable to determine individuals’ willingness to pay or categorize individuals into groups based on average demand, they can often employ pricing strategies that get consumers to self-select different prices based on their demands through the use of quantity discounts. Quantity discounts, or second-degree price discrimination, are when firms charge a lower price per unit to consumers who purchase larger amounts of the good.

It is important to understand that any firm with pricing power can potentially price discriminate, but in this chapter, we are focusing on monopolists and how these pricing strategies are potentially profit enhancing. It is also important to note that not all price differentials are evidence of price discrimination, such as when price differentials simply reflect the actual cost differential. For example, a store might offer a single pair of socks for $4 or three pairs for$10, which could be clever price discrimination; however, a mail-order retailer might make the same offer knowing that it costs $1 to prepare the shipment regardless of how many pairs of socks are ordered. So the socks are being sold for$3 plus the preparation charge, and the price difference is simply a reflection of this fixed cost divided by the number of pairs of socks.

## 16.2 Perfect or First-Degree Price Discrimination

Learning Objective 16.2: Describe first-degree price discrimination and the challenges that make it hard.

Imagine a firm with market power that can prevent the resale of its goods and is able to ascertain each of its customers’ reservation price or maximum willingness to pay. If they are able to sell their goods at individual prices, the very best they can do in each transaction is to charge each customer exactly their reservation price. This ensures maximum revenue from each transaction as well as that the entire available surplus is captured by the firm as producer surplus.

Consider the example of a firm that makes gold-plated designer smartphones that has only five potential customers, each of whom would purchase exactly one unit if the price is at or below their reservation price.

Table 16.2.1 Customers and their reservation prices
Consumer ID Reservation price ($) #001$10,000
#002 $8,000 #003$6,000
#004 $4,000 #005$2,000