price-discrimination

What is price discrimination?

Price discrimination is a pricing strategy where one business charges consumers different prices for identical goods and services in different markets. In essence, businesses use price discrimination to ensure they maximize the revenue that is made from each customer. Price discrimination is a pricing strategy where identical or near-identical products and services are sold at different prices in different markets by the same supplier.

Understanding price discrimination

The price of movie tickets is one example of price discrimination at work, with separate prices for children, adults, families, and seniors.

Movie ticket prices also vary according to the time of day and whether the movie is a blockbuster new release or a timeless old classic.

Three types of price discrimination

There are three general types of price discrimination, with each consisting of various pricing strategies businesses use.

An explanation of each of these is provided below.

First degree

First degree price discrimination is also known as perfect price discrimination and this perfection makes it difficult to implement in practice.

Nevertheless, it involves the business charging the maximum price consumers are willing to pay for each unit of product or service sold.

This allows the business to capture all the consumer surplus in the market, which can be defined as the difference in price between what the consumer actually pays and what they are prepared to pay.

Second degree

Second degree price discrimination is perhaps the most recognizable and involves the business charging a different amount according to the amount or quantity consumed.

Frequent flyer programs, for example, reward customers with cheaper tickets the more they fly with an airline. Phone and internet data also tends to be cheaper the more data that is consumed.

Second-degree price discrimination is sometimes referred to as indirect price discrimination since companies allow consumers to choose what price they will ultimately pay.

Some choices which appear more cost-effective on the surface are only affordable because the business imposes an extra cost on the consumer.

This includes pricing that is influenced by coupon collecting and bulk purchases, among other factors.

Third degree

Third degree price discrimination is the strategy that movie theatres employ where different prices are charged to different groups of people such as:

  • Students.
  • Seniors.
  • Emergency services personnel.
  • Veterans.
  • Men or women.

This form of price discrimination is also often used by utility, parking lot, and gym businesses to charge one price for peak usage and another for off-peak usage. 

What are the necessary conditions for effective price discrimination?

For price discrimination to be effective, a few conditions must be met:

The company must be a price maker

That is, it must operate in an imperfect market with a demand curve that slopes downwards.

The company should also possess some degree of monopoly power.

The ability to separate markets

The company must also be able to prevent the resale of its products and services to consumers who would otherwise have to pay a higher price.

A children’s movie ticket, for instance, would need to be distinguishable from an adult’s ticket.

Microsoft Office for university students must also be kept separate from home or workplace users.

Online, eCommerce companies use dynamic pricing where prices vary from second to second according to real-time demand and other metrics.

Elasticity of demand

There must also be different elasticities of demand within the same market for price discrimination to be effective.

Lower-income individuals tend to be more elastic to the cost of an airline ticket than business travelers.

This means the airline can sell cheaper “red-eye” flights or those without meals to target this segment.

Key takeaways

  • Price discrimination is a pricing strategy where identical or near-identical products and services are sold at different prices in different markets by the same supplier.
  • There are three types of price discrimination: first degree, second degree, and third degree. Each type has a selection of unique price discrimination strategies.
  • To be effective, price discrimination must be carried out by a company operating in an imperfect market with the ability to segment its products. There must also be varying elasticity of demand within the market itself.

Read Next: Pricing Strategies, Dynamic Pricing.

Connected Business Concepts

Revenue Modeling

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Revenue model patterns are a way for companies to monetize their business models. A revenue model pattern is a crucial building block of a business model because it informs how the company will generate short-term financial resources to invest back into the business. Thus, the way a company makes money will also influence its overall business model.

Pricing Strategies

pricing-strategies
A pricing strategy or model helps companies find the pricing formula in fit with their business models. Thus aligning the customer needs with the product type while trying to enable profitability for the company. A good pricing strategy aligns the customer with the company’s long term financial sustainability to build a solid business model.

Dynamic Pricing

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Price Sensitivity

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Price sensitivity can be explained using the price elasticity of demand, a concept in economics that measures the variation in product demand as the price of the product itself varies. In consumer behavior, price sensitivity describes and measures fluctuations in product demand as the price of that product changes.

Price Elasticity

price-elasticity
Price elasticity measures the responsiveness of the quantity demanded or supplied of a good to a change in its price. It can be described as elastic, where consumers are responsive to price changes, or inelastic, where consumers are less responsive to price changes. Price elasticity, therefore, is a measure of how consumers react to the price of products and services.

Premium Pricing

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The premium pricing strategy involves a company setting a price for its products that exceeds similar products offered by competitors.

Price Skimming

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Price skimming is primarily used to maximize profits when a new product or service is released. Price skimming is a product pricing strategy where a company charges the highest initial price a customer is willing to pay and then lowers the price over time.

Productized Services

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Productized services are services that are sold with clearly defined parameters and pricing. In short, that is about taking any product and transforming it into a service. This trend has been strong as the subscription-based economy developed.

Menu Costs

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Menu costs describe any cost that a business must absorb when it decides to change its prices. The term itself references restaurants that must incur the cost of reprinting their menus every time they want to increase the price of an item. In an economic context, menu costs are expenses that are incurred whenever a business decides to change its prices.

Price Floor

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A price floor is a control placed on a good, service, or commodity to stop its price from falling below a certain limit. Therefore, a price floor is the lowest legal price a good, service, or commodity can sell for in the market. One of the best-known examples of a price floor is the minimum wage, a control set by the government to ensure employees receive an income that affords them a basic standard of living.

Predatory Pricing

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Predatory pricing is the act of setting prices low to eliminate competition. Industry dominant firms use predatory pricing to undercut the prices of their competitors to the point where they are making a loss in the short term. Predatory prices help incumbents keep a monopolistic position, by forcing new entrants out of the market.

Price Ceiling

price-ceiling
A price ceiling is a price control or limit on how high a price can be charged for a product, service, or commodity. Price ceilings are limits imposed on the price of a product, service, or commodity to protect consumers from prohibitively expensive items. These limits are usually imposed by the government but can also be set in the resale price maintenance (RPM) agreement between a product manufacturer and its distributors. 

Bye-Now Effect

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The bye-now effect describes the tendency for consumers to think of the word “buy” when they read the word “bye”. In a study that tracked diners at a name-your-own-price restaurant, each diner was asked to read one of two phrases before ordering their meal. The first phrase, “so long”, resulted in diners paying an average of $32 per meal. But when diners recited the phrase “bye bye” before ordering, the average price per meal rose to $45.

Anchoring Effect

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The anchoring effect describes the human tendency to rely on an initial piece of information (the “anchor”) to make subsequent judgments or decisions. Price anchoring, then, is the process of establishing a price point that customers can reference when making a buying decision.

Pricing Setter

price-setter
A price maker is a player who sets the price, independently from what the market does. The price setter is the firm with the influence, market power, and differentiation to be able to set the price for the whole market, thus charging more and yet still driving substantial sales without losing market shares.

Economies of Scale

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In Economics, Economies of Scale is a theory for which, as companies grow, they gain cost advantages. More precisely, companies manage to benefit from these cost advantages as they grow, due to increased efficiency in production. Thus, as companies scale and increase production, a subsequent decrease in the costs associated with it will help the organization scale further.

Diseconomies of Scale

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In Economics, a Diseconomy of Scale happens when a company has grown so large that its costs per unit will start to increase. Thus, losing the benefits of scale. That can happen due to several factors arising as a company scales. From coordination issues to management inefficiencies and lack of proper communication flows.

Network Effects

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network effect is a phenomenon in which as more people or users join a platform, the more the value of the service offered by the platform improves for those joining afterward.

Negative Network Effects

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In a negative network effect as the network grows in usage or scale, the value of the platform might shrink. In platform business models network effects help the platform become more valuable for the next user joining. In negative network effects (congestion or pollution) reduce the value of the platform for the next user joining. 

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