Calculating the expected value Changing the Odds by Using New Information to

Chapter 14: Increasing Revenue with Advanced Pricing Strategies

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Perfecting price discrimination

A pharmacy I go to has a nifty little card that gives me discounts when I use it to make purchases. The store scans the card with every purchase, collecting information on what products I buy. This information is used to determine my price elasticity of demand for products I purchase. It’s also used to determine what products are complements or substitutes for the things I buy. Perhaps the most important use is to move toward perfect price discrimination. When my receipt prints out, it usually includes one or more coupons giving me price discounts on various items. Because the coupons appear on my receipt, coupons are tailored to individual customers for both the items and coupon amount, moving closer to perfect price discrimination.

Making a Bundle through Bundling

Bundling refers to a situation where you package two or more goods together and sell them as a single unit. Firms use bundling to increase profit — make a bundle. A fast food restaurant may bundle a sandwich, French fries, and soft drink, selling all three bundled together for a single price.

You’re most likely to increase profit by bundling goods that have large differences in the prices customers are willing to pay. Economists use the term reservation price to indicate the price where the consumer is indifferent between purchasing the good or continuing to search for a lower price. In essence, the reservation price is the maximum price the consumer is willing to pay.

Effective bundling requires you to package goods that are negatively correlated across consumers. Therefore, for some consumers, good A has a high reservation price, and good B has a low reservation price. For other consumers, good A has a low reservation price, and good B has a high reservation price. This reverse relationship or negative correlation across consumers enables you to bundle goods A and B and have both sets of consumers purchase the bundle consisting of goods A and B. The result is all customers buy both goods instead of having only the consumers with high reservation prices buying the good.

Using pure bundling

Pure bundling exists when consumers can only purchase the goods together. It isn’t possible to purchase the goods separately. This pricing strategy is found in many restaurants where the entrée comes automatically with a side dish — the entrée and side dish can’t be purchased separately. Satellite and

252 Part III: Market Structures and the Decision-Making Environment

cable television also use pure bundling — you can’t pick and choose the channels you want; you must choose among the packages offered by the service.

Figure 14-4 illustrates pure bundling for two computer software programs — a word-processing program, Software W, and a spreadsheet program, Software X. In order to simplify the analysis, 1,200 customers are uniformly distributed over the range of possible reservation prices for both software programs. The reservation prices for Software W appear on the vertical axis and range from $0 to $40.00. The reservation prices for Software X appear on the horizontal axis and range from $0 to $30.00.

Figure 14-4:

Pure bundling.