Nonlinear Pricing

How to use price innovation to increase profits?

Linear Prices
Suppose you operate a service or sell a good. A customer may purchase a quantity, q. You can charge a price based on that quantity: i.e., a function, P =f (q). A linear price has P =f (q)

Examples of Nonlinear Pricing

Regulated Industries
Per unit price depends on quantity Taxes depend on income

Unregulated Industries
Quantity discounts Rebates Credits towards subsequent purchases

Railroads and Transport

Railroad tariffs specify charges based on the weight, volume, and distance of each shipment.
For instance, discounts on the charge per mile per

hundredweight are offered for full-car shipments and for long-distance shipments.

In other transport industries such as trucking, airlines, and parcel delivery the rates depend also on the speed of delivery or the time of the day, week, or season.

Electricity
Electricity tariffs specify energy charges based on the total kilo-Watt hours used in the billing period, as well as demand charges based on the peak power load during the year. Lower rates apply to successive blocks of kiloWatt hours and in some cases the demand charges are also divided into blocks. Energy rates for most industrial customers are further differentiated by the time of use, as between peak and offpeak periods.

Telecommunications
Telephone companies offer a variety of tariffs for measured toll service and WATS (wide area telephone service) lines [a telephone line; long distance service at fixed rates for fixed zones]. Each tariff provides the least-cost service for a particular range of traffic volumes. Rates are also differentiated by distance and time of use. Mobile phone contracts have a take-or-pay quality.

Airlines
Airline fares allow frequent flier credits toward free tickets based on accumulated mileage. The retail value of a free ticket increases sharply with the number of miles used to acquire it. Further discounts are offered for advance purchase, noncancellation, round trip, weekend stays, and duration.

Rental Agreements
Rental rates for durable equipment and space, such as vehicles and parking lots, are lower if the duration is longer. Rates for rental cars are also differentiated by the size of the vehicle and the time of use.

Advertising
Newspaper and magazine advertising rates are based on the size and placement of the insertion, the total number of lines of advertising space purchased by the customer during the year and in some cases on the annual billings.

Classifying Nonlinear Prices

Block-declining or tapered (narrowed) tariffs: marginal prices decline in successive increments as purchases increase. Two-part tariff: comprises an initial fixed fee and a per-unit price for units purchased.

Graphical Representation
Three-Part Linear Two-Part P(q)q Fixed-Fee Block Nonlinear

What prices should be set?

Price discrimination.

Multiple and joint product pricing.

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Price discrimination.

Where a firm exercises market power, the opportunity may exist to further increase profits by charging different prices to different consumers, or to different groups of consumers for reasons other than costs In doing so, the firm will appropriate all or part of the consumer surplus.

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Price discrimination.

Types of price discrimination

First-degree: the firm is aware of each buyers demand curve Second-degree: the firm charges a different price, depending on the quantity each buyer purchases Third-degree: the firm breaks buyers into groups based upon their price elasticity of demand

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Price discrimination.

First Degree Price Discrimination (Perfect Price Discrimination) Each consumer is charged the price he/she is willing to pay. Selling each unit of the product separately and charging the highest price possible for each unit sold. Producer takes all the consumer surplus
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Price discrimination.

1st. degree price discrimination

Price

P1

PL

Demand

Q1

Quantity
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Price discrimination.

1st. degree price discrimination

Price

P1 P2
PL Demand

Q1 Q2

Quantity
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Price discrimination.

1st. degree price discrimination

Price

P1 P2 P3

PL

Demand

Q1 Q2 Q3

Quantity
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Price discrimination.

1st. degree price discrimination

Price
P1 P2 P3 P4 . .

For each consumer price charged=price willing to pay Example: selling of govt bonds by asking buyers to submit tenders
Demand

PL

Quantity
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Price discrimination.

2nd Degree Price Discrimination

(non-linear pricing)
Different price is charged for a different quantity bought (but not across consumers). set one price for a 1st bundle, a lower price for a 2nd bundle, .... extract some, but not all of consumer surplus Note: In 1st deg case=>different prices charged for different consumers In 2nd deg case=>different prices charged for different quantities (for same consumer)
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Price discrimination.

2nd Degree Price Discrimination (non-linear pricing)

Examples: Telephone companies charging different prices for different quantities

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Price discrimination.
3rd Degree Price Discrimination: Separates consumers or markets on the basis of their price elasticity of dd. This segmentation based on geographic separation of markets, nature of use (business, residential)

MC D2 MR2
DT
MRT

MR1

D1 Q

Market1 steeper D less elastic

Market 2 flatter D more elastic

QT Q Mkt1&Mkt2 QT=Q1+Q2

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Price discrimination.
3rd Degree Price Discrimination

MC D2 MR2
DT
MRT

MR1

D1 Q

Market1

Market 2

QT Q Mkt1&Mkt2 QT=Q1+Q2

How much to sell in each Mkt (Q1? Q)2? what prices (P1? P2)?
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Price discrimination.

3rd Degree Price Discrimination

MC D2 MR2
DT
MRT

MR1

D1 Q Q2

Q1
Market1 MR1=MC Less elastic demand

Market 2 MR2=MC More elastic demand

QT
Mkt1&Mkt2 QT=Q1+Q2 MR1=MR2=MC

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Price discrimination.

3rd Degree Price Discrimination

P P1 D1 Q

MC D2 MR2 Q2 Q QT
Mkt1&Mkt2 QT=Q1+Q2 MR1=MR2=MC
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P2
MR1

DT
MRT

Q1
Market1 MR1=MC Less elastic Demand Higher price

Market 2 MR2=MC More elastic Demand - Lower Price