So in this video, we're going to explore second degree, or indirect price discrimination. Therefore, we'll also consider three different types of second degree price discrimination, nonlinear tariffs, versioning, and bundling. Second degree price discrimination. What is it? How does it work? And what does it mean? Well, second degree price discrimination implies that firms offer different deals, and by deals I mean combinations of price and quality, or price and quantity, to consumers. And consumers basically self-select into one of those deals according to their willingness to pay, and into into their preferences. So firms do not need to know the consumer's characteristics and preferences precisely. So I don't need to be able to identify an individual consumer's preferences, if I engage in second degree price discrimination. So firms, therefore, construct prices so that consumers self-select. And there are different types of second degree price discrimination. First, there could be nonlinear pricing, which means that every unit of the product does not cost the same. Second, there could be versioning, which means that different consumers get offered or all consumers get offered slightly different versions of the same product. Thirdly, there may be bundling, which means that I offer bundles of different products to consumers. Now let's start with non-linear pricing, which often basically amounts to a quantity discount. So here consumers' willingness to pay is typically highest for the first unit and it decreases subsequently, which means that first we'll charge the highest price for the first unit, and then subsequently lower prices for the following units. In its simplest form, you might have a two-part tariff, which includes a fixed part thateach consumer has to pay regardless of the quantity that he uses the product later on. And there's a variable part that's proportional to the quantity that's being purchased. So, telephone tariffs are a prime example of this. So, you typically will pay a fixed cost, and you pay a cost per minute Right? If you take tariff A here, you have a fixed cost of 24 Euros and 80 cent per month, and you have 12 cent price per unit. So, Tariff B would be a zero fixed fee and then prices become 30% cheaper after you call ten minute and more. Be careful though nonlinear pricing is used regularly and it can improve profits. But offering sev, several nonlinear tariffs can be even more attractive. So there's a temptation to actually start offering lots and lots of different tariffs, lots and lots of different prices. However there's also a cost of offering different prices. So there's costs that need to be taken into account. So you develop a different price, you have to build different options. You have to educate your sales force to charge or to explain these different prices and consumers eventually might just be confused, and might go to a competitor that chargers a simpler pricing scheme. So, an empirical study on mobile calling plans in the US by Eugenio Miravete published in 2004, shows that the benefits of additional tariffs actually decreases, decrease very quickly. So if there is a high cost of offering different tariffs, then firms should actually only end up offering fairly few tariffs. Right, so that's the idea that we have to take into account here. The second form of second degree price discrimination is versioning. So here firms offer several versions of a product at different price levels. And these versions will differ in their quality, their functionality or their flexibility and so on. So take one example of flight, flight tickets. We discussed this in the in the previous videos, but let's take a closer look at that. So business travelers require flexibility to rebook and to cancel flights. Again, let me stress that there is no clear boundary to product differentiation. In an extreme form, you can even have damaged goods, where firms actually end up reducing the end quality of the initial product to exploit price discrimination. So the version with a reduced quality is sold to consumers that have a lower willingness to pay. So, you have additional costs of reducing the quality of the initial product, and you're selling that at a lower price. So take the student version of software that we initially discussed. So here, we have the cost of actually degrading the quality of the student version. And that degraded version of the product is sold at a lower price. Another example would be Intel's processor 486. The DX version came at a price of 588. The SX version, which was exactly the same as the DX version, but it had a disabled math coprocessor. So, in other words there was an additional version, an additional step of production that came into this, was selling at a price of $333. So just a bit more, a bit more than half the price. Another example is the Mathematica program, so that's basically a mathematical program for operations of calculations and so on. The standard version came at a price of $1,000. The student version, that basically just uses a flag that prevents the use of a math coprocessor, is priced at $180. So one fifth of the price for a version that's actually more expensive to produce than the full version. So another version of second degree price discrimination is bundling, and of course we always have the problem of consumer heterogeneity for firms. Some consumers value product A more then product B and other products. Other consumers have exactly the other way around in terms of their preferences. So if you sell product separately, then firms have to decide on a single price for each product. So the better strategy might actually be if we sell products A and B in one bundle. Both consumer groups will value a bundle, a bundle of product A and product B roughly the same, and therefore, we can charge one price, and that price is attractive both for people who like A but don't like B so much, and if we have people who like B, but they don't like A so much. So bundling, therefore can decrease consumer heterogeneity for these different firms. As an example let's take audio CDs. Some con, consumers will want tracks from Erol Alkan, which is actually my favorite DJ. Others want tracks from Mylo. What price, therefore, to set for individual tracks? Well, in fact we can do better than selling the individual product, we can sell a CD that has Erol Alkan and Mylo songs on one sampler, as a bundle. We can increase revenues by bundling software with slightly different software as one bundle. Right, so let's take word processor and spreadsheets. You have people who are writers. And in this example we have 40 people that are writers, they have a high value for the word processor. No value, no use for the spreadsheet. We have number-crunchers, exactly the same number, again 40. And they only value the spreadsheet but not the word processor. And we have the generalists that have a high value for basically both the word processor and the spreadsheet. Strategy one would be to try the high price. So we sell both apps, both programs for 50, means that we sell to writers the word processor, we sell the spreadsheet to number-crunchers, and we make a revenue of 4,000. Strategy two would be to go for the low price. In that case, we sell both apps for a price of 30. Everybody will buy at 30, so sales of 60 units per application and the revenue is going to be 3,600. Finally, strategy three would be bundling. So, we can sell the bundle at 60 and we can sell individual applications at a price of 50. So, writers and number-crunchers will buy their preferred version at a price of 50, and the generalist will by the bundle at 60. And this actually gives us the higher revenue of 5,200. So, firms often actually fiercely compete for valuable consumers. So, when you look at video consoles, there's hardcore gamers that are, of course, the most attractive buyers of a video console. In mobile telephony, you're competing for the businesswomen or businessmen that will use your telephones intensively. Airlines compete for business travelers, again these will be the ones that have the highest willingness to pay for the product. The problem is that if you simply lower prices, you will attract both valuable and invaluable consumers, which may actually end up giving you a very low profit margins. The solution would be to offer additional services that are bundled with the basic product, hat will increase only the utility of high-value consumers. And as an example, let's take the video console market, which is actually based on a working paper that Diana Zegners, a colleague of mine, and myself have written. So, video console manufacturers actually often do not decrease their prices, which is weird because there's lots of demand, especially by low-value consumers for these consoles. And these low-value consumers will actually enter the market in peak seasons such as Christmas. And what they do there is they try to attract valuable consumers by adding bundled games onto those consoles. And this is actually one way of engaging in secondary price discrimination without having to lower prices, and therefore watering down you market. There's only one more to go before this modules wrap-up. Third degree price discrimination is waiting for you in the next video. [BLANK]