Price Discrimination – Pricing Based on Your Customers
Charging every customer of yours a different price for the same product – sounds like a crazy idea, right? Perhaps unnecessary? Overboard? Don’t worry if those adjectives are the first ones that came to your mind when you read the first sentence. You’re not completely wrong. Let us explain what price discrimination is all about.
Having a different price for the same product for every individual customer is an ideal case, possible only in perfect market conditions. This theoretical setting is important, though, because it is the basis for price discrimination – a pricing strategy we’ll cover in this article. However, as we’ll see later on, perfect market conditions aren’t necessary in order to implement this pricing strategy to a certain extent.
In this article, we’ll mostly focus on the real-world application of price discrimination. We’ll talk about what it is (with only a slight look at the theoretical side of things), how does it vary, provide examples and its ups and downs.
What is Price Discrimination?
We can define price discrimination as a pricing strategy that is based on the seller’s expectations of what is the maximum amount the customers are willing to pay. With this expectation in mind, the seller tries to price the products in such a way as to get the most out of every individual customer. This means different prices for the same product or service.
It’s important to have in mind that price discrimination isn’t applicable in every case. We’ll come to the downsides of this pricing strategy later, but here you should have in mind that segmenting customers into different groups does have its costs. Therefore, thinking about implementing price discrimination is sensible if:
- These costs are lower than the expected income
- The profit earned from segmenting your customers is higher than charging every customer the same price
Three Different Types of Price Discrimination
Price discrimination comes in three different forms. According to Investopedia, those are 1st Degree Price Discrimination (also known as “personalized pricing”) 2nd Degree Price Discrimination (“product versioning”), and 3rd Degree Price Discrimination (“group pricing”). Let us go over each of those types and find out what they’re all about.
First-Degree Price Discrimination
This form of Price Discrimination means that a company captures all of the available consumer surplus for itself by charging the highest possible price for every unit.
One thing that a seller needs to know before proceeding with this form of price discrimination is the reservation price – which, according to Wikipedia, is the highest amount that a customer is willing to pay.
Second-Degree Price Discrimination
Second-Degree Price Discrimination refers to pricing different quantities of the same product in a different way. This means that the price per unit will be different depending on the quantity purchased.
You could say that the customer segmentation in this approach is done by the customers themselves. They decide what amount of a certain product they need and based on that fall into a certain category.
Third-Degree Price Discrimination
When a company is charging different segments of its customers different prices there’s third-degree price discrimination at work. Customers can be segmented in different ways (eg. by age, student status, etc.). We’ll come back to this, but here it’s important to note that the way a seller segments their customers is dependent on the type of business itself. There’s no one approach that fits all.
Examples of Price Discrimination Implementation
In order to make everything more understandable, let’s go over some examples of price discrimination implementation.
In the travel industry, and especially with airline companies, price discrimination is encountered frequently. One of the ways airlines try to segment their customers is by distinguishing between leisure and business passengers.
Over time it has been shown that business travelers are less price-sensitive than leisure travelers. This means that they are less likely to give up on purchasing a seat on a flight that suits their needs, despite a potential price increase.
This is why airlines frequently come up with ways to make certain options very unappealing to business passengers. For example, the requirement for a Saturday-night stay, different prices for different departure times, or cheaper prices for purchasing in advance (which business travelers aren’t prone to doing).
Providing your customers with coupons enables you to incentivize price-sensitive customers to purchase your product.
In this case price discrimination means that you are segmenting your price-sensitive and insensitive customers and charging them different prices.
What you’ll have to decide is whether you want to set certain conditions for getting coupons or not.
Premium pricing can be a form of price discrimination. First of all, premium pricing means charging prices that are significantly above the costs of production.
If you’re selling a regular and a premium version of a product, this for example means a 100% markup for the regular and 350% markup for the premium product. It’s important that these products have similar production costs.
The airline industry is one case of this type of price discrimination being implemented. Another industry where sellers earn more profit by selling significantly marked-up versions of a product is the alcohol industry.
Various ways to segment your customers
Let’s quickly go over a couple of the most frequent ways sellers segment their customers.
Segmenting by age has to be one of the most frequently encountered segmentation methods when it comes to price discrimination. As the name suggests, it means charging prices based on your customers’ age. In practice, this can mean free entrances for children or special offers for the elderly.
Another way to segment your customers is by citizenship. This is mostly applicable in tourist areas, where it is expected that foreigners (especially the ones who are on a vacation) have more disposable income compared to the locals. It’s a relatively controversial approach and is encountered, among others, in the taxi industry.
Students are a customer segment that is frequently targeted by sellers who use price discrimination. They are often provided with various discounts. The most common explanation for this is that sellers are “playing the long term game”. This means that they expect that at least some part of those students, later on, become their regular customers.
Other criteria based on which sellers segment their customers can be gender, ethnicity, motherhood, location, etc.
Benefits and Downsides of Price Discrimination
- Increased profit – if applied properly, price discrimination means collecting as much profit as possible from every individual customer. It’s not applicable in every situation, because sometimes one price across all boards may be more profitable. However, in situations where price discrimination is applicable, it can be very fruitful.
- Get more data on various market segments – by doing research, implementing price discrimination, and then analyzing the results you get much more information on your customers than you had before you implemented this strategy. This then becomes a cycle of making better and better decisions, based on an increasing amount of data.
- Implementation costs – doing research on different customer segments, administrative costs, tracking the results of your efforts – all of these take time and money.
- “Scale” requirement – Small businesses are not able to implement this strategy as easily as some larger ones are. This is due to the fact that this strategy carries risks with itself, but also due to the fact that sometimes it’s impossible to cover its costs.
- Customers can become competitors – If your customers who are being charged the lower price for the product are aware of your higher prices, they may become interested in reselling your products. They would purchase your product at the low and then sell it to other customers for a price slightly below yours. This can further lead into customer alienation and negative brand image.
In this article, we’ve covered what price discrimination is, what different forms does it come in, who is it used by and what are the benefits and drawbacks it carries.
As we’ve already mentioned implementing price discrimination requires serious market research efforts, both of your competitors and your customers.
This is where Price2Spy comes into play. Price2Spy is a price monitoring tool that will provide you with all the necessary information regarding your competitors and their pricing approaches.
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