Wharton MBA for Executives

About a month or so ago I got a flat tire.  I was leaving work when I noticed that my tire was flat.  I have a AAA card so I did the easiest thing…called AAA and had them come out to put on the spare tire.  It turns out that on my car, there’s a full size spare in the trunk along with the real alloy rim, etc.  So when the spare tire was installed, the car didn’t look like it got a flat tire because there was no donut tire or mismatched rim, etc.

So I got lazy and put off repairing the spare and just hoped that I wouldn’t get another flat tire for awhile.

A few weeks ago I went to Costco on a Saturday (non Wharton class weekend) to get the tire replaced.  They told me that they don’t stock tires that big (19 inches) so it would have to be a special order.  The cost?  $500 (actual cost was $493 and change).  I figured that I didn’t have much of a choice so I got it ordered.

Well, finally the tire came in and I went to get it installed yesterday.  The lady told me that a few days ago another guy came in who needed the same exact tire.  He had the same make/model car as mine.  But she told him that it was a special order only and told him the price.  She said that when she told him the price, the guy went ballistic!  He was yelling and screaming that it’s too expensive for a freaking tire, etc.  That guy probably had a lower reservation price than me.

In econ, we studied price discrimination.  Price discrimination is a way for businesses to extract more consumer surplus from the consumer.   In 1st degree price discrimination, they charge a different price to each consumer to maximize their profits.  However, 1st degree is very difficult to do legally.  Sometimes technology companies do this when they don’t publish their prices for large software products and force the consumers to talk to their sales reps to determine the price.  They generally do this by adding custom support options and things like that to justify their prices.  When I some work at HP and we used Oracle, the price was much different than when I did startup work and used Oracle.  2nd degree price discrimination is easier and is done by discriminating based on quantity.  For example, the 64 oz ketchup bottle is cheaper per oz than the 24 oz bottle.  The person buying the smaller bottle usually is willing to pay more for the product than deal with bigger quantities.  And finally, we have 3rd degree price discrimination where consumers are discriminated based on certainly qualities to segment their consumers.  For example, airlines charge a different price to leisure travelers vs. business travelers by having lower prices if you book 2+ weeks in advance with a Saturday night stay because leisure travelers have a lower reservation price than business travelers.

I think my tire example is a form of 3rd degree price discrimination.  It doesn’t take that much more rubber to build a 19 inch tire than a 15 inch tire.  Likewise, it doesn’t take that much more aluminum alloy to build a 19 inch rim than a 15 inch rim.  However, the consumer who buys a 19 inch rim and tire generally have larger and nicer cars so they are charged more money.  The tire companies are extracting that additional consumer surplus because this consumer segment has a higher reservation price for these tires.

Perhaps in some ways it’s a collusion based oligopoly as well because when I did check on the tire, there were only 2 brands that made that size and the price was only a few dollars off.

And finally, you don’t actually need an MBA to understand this.  When I was talking to the lady at Costco about the irate customer, I said “Well, you don’t set the prices right?  All you do is read them out of the book.” and she said “yup.  So I don’t know why he was getting mad at me.”  In addition, she said “Well, you have a nice car and I guess they figure that if you have a nice car, you can afford more expensive tires”…so there you have it, 3rd degree price discrimination as explained by the tire sales lady at Costco.