3. Screening

Amine OuazadMicroeconomics C

Career Choices• A real estate broker wishes to hire an agent.

He posts a job offer.• Initially, the dealer was offering 50,000 euros a

year, fixed. What was/were the problem?• The compensation is as follows:

– The salesman gets 1% of all sales, and an additional fixed wage of 30,000 euros.

– The average price of a house in the area is 150,000 euros.

• Who accepts the offer?

Push a little further

• What is the optimal contract?• The real estate broker is greedy:

max Revenue – Wage.• The productive candidate has options:

Wage >= productive broker’s outside option.• The unproductive candidate has (worse) options:

Wage >= unproductive broker’s outside option.• What is the optimal wage contract, assuming it is

a fixed percentage + a flat wage?

Outline

1. Asymmetric information on the labor market (done)

2. Screening car rental customers:Explicit price discrimination

3. Screening airline customers:Implicit price discrimination

4. Screening eclectic and obsessive customers:Bundling

Q

P

MC

Demand

Variable profit“No money is left on the table”

High valuation customers

Lower valuation customers

Perfect Price Discrimination

Q

P

MC

DemandMR

Variable profit

Uniform Pricing

Optimal price

“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.

Sp

ot

the

Dif

fere

nce

2. Explicit Price Discrimination

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.

Segment the market by observable characteristics.Charge customers in different segments different prices, according to their elasticity.

Explicit Price Discrimination- Condition #2: Observability

• Tourists pay more for kilims in Istanbul than locals.• Students get discounts on air/rail tickets.• Californians pay $97; non-Californians pay $151 for a 2-day park

hopper• Dell Inspiron 580, Base Configuration: Home:$749 Small Business:

$899• Victoria’s secret?

Condition #3: No Arbitrage

MC

MRC

PC

MRC = 90-20QC = 10 = MCQC = 4 PC = $50

MRG

PG

MRG = 60-10QG = 10 = MCQG=5; PG = $35

CoalPC = 90 - 10 QC

GrainPG= 60 - 5 QG

90

60

Railroad freight pricing

U.S. railroads charge 1.5-2 times as much to move coal as they do to move grain MC = $10 per ton;

10

Higher choke price → Less Elastic → Higher price

Outline

1. Asymmetric information on the labor market2. Screening car rental customers:

Explicit price discrimination3. Screening airline customers:

Implicit price discrimination4. Screening eclectic and obsessive customers:

Bundling

The Mother of All Discriminatory Pricing: Airline PricingAirlines like to segment the market based on valuations, but valuations are not observed

On the other hand, valuations are correlated with time sensitivity

In general consumers with higher valuation are less likely to accept:

• Saturday night stay

• A 14-day advance ticketing ,..etc.

Solution: Create a product line based on artificial restrictions.

These simply annoy the customers, and have little or no bearing on their cost of operation

2. Implicit Price Discrimination

Screening with Differentiated Products

Scenario: Airline has B business customers and L leisure customers.

Type of Customer

Valuation

Unrestricted Restricted

Business $1000 $600

Leisure $600 $500

Cost per ticket = $ 300(Same for restricted and unrestricted tickets)

– Explicit Market Segmentation –

Pricing of Only Unrestricted Tickets

Option 1: Charge $1000 and sell only to Business travelers

Profit = (1000-300)*B = 700B

Option 2: Charge $600 and sell to both Business and Leisure

Profit = (600-300)*(B + L) = 300 (B + L)

Screening with Restricted & Unrestricted Tickets

Option 3: Charge $900 and sell unrestricted tickets to Business travelers Charge $500 and sell restricted tickets to Leisure travelers

Profit = (900-300)*B + (500-300)L = 600B + 200L

This is Screening or Implicit Market Segmentation

Comparison of 3 Options

(A) sell only unrestricted tickets at a price of ___________ to business

travelers only;

Profit:

(B) sell only unrestricted tickets at a price of ____________ to all travelers;

Profit:

(C) sell unrestricted tickets to business travelers for ____________ and

restricted tickets to leisure travelers for __________.

Profit:

0

10000

20000

30000

40000

50000

60000

0 10 20 30 40 50 60 70 80 90 100

% Bus. Travelers (B )

Profit

B

C

A

B Best C Best A Best

• Even if you cannot explicitly segment the market don’t lose heart – implicitly segment the market!

• Offer a menu of options and try to come up with a creative screening mechanism

• Try product differentiation, versioning, inter-temporal pricing, damaging, bundling (see this next time) – these achieve price discrimination

Wrap Up

Outline

1. Asymmetric information on the labor market2. Screening car rental customers:

Explicit price discrimination3. Screening airline customers:

Implicit price discrimination4. Screening eclectic and obsessive customers:

Bundling

• Selling several goods in one bundle

Hardware and software

Software suites

Sports/Concert tickets

Auto accessories

Bundling

Exercise 6.6: Screening via Bundling

Pricing of a two-concert mini season (Wagner and Harbison) at a theater.

Highly segmented, with only three types of customers:

Type of Customer

Valuation

Wagner Verdi

A $50 $5

B $40 $40

C $5 $50

A customer may go to one or both of the concerts.

– Benchmark: Explicit Market Segmentation –

– No Bundling –

– Pure Bundling –

– Mixed Bundling –

The Genius of Dell??