Profitable Pricing When Market Segments Overlap

Eitan Gerstner and Duncan Holthausen

In this paper, we analyze profitable pricing strategies when market segments overlap. Overlapping markets are segments that are not perfectly sealed, and leakage between them can occur. Different consumers are assumed to incur possibly different transaction costs if they choose to purchase in the low-price market. A monopolist seller knows the distribution of transaction cost across consumers and must choose an optimal pricing strategy. When price differentiation is optimal, the equilibrium amount of leakage is determined endogenously. Unlike the standard economics text-book model of price discrimination in which zero leakage is determined exogenously and is usually given as a necessary condition for price discrimination, we show that zero leakage is not necessary for differential pricing to be optimal, and that price differentiation can be optimal even when leakage between markets is substantial. We also show that by imposing restrictions on the low-price market buyer, the seller a control leakage and increase profits. Market-specific managerial applications are illustrated.

(Market Segmentation; Pricing; Differential Pricing; Price Discrimination)