Price discrimination is a pricingstrategy 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.
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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.
Case Studies
Airlines
Airlines commonly use price discrimination strategies. They offer different prices for the same flight based on factors like booking time, day of the week, and flexibility of the ticket. Business travelers who need to book flights at the last minute might pay higher prices, while leisure travelers who book in advance may find lower fares.
Software Licensing
Software companies often implement price discrimination by offering different licensing options based on usage. They might offer lower prices for individual users, higher prices for businesses with multiple users, and even higher prices for enterprise-level features and support.
Streaming Services
Streaming platforms like Netflix and Spotify use price discrimination by offering tiered subscription plans. Customers can choose between basic, standard, and premium plans, each with varying features and pricing. This allows the service to cater to different segments of users with different needs and budgets.
Hotels
Hotels employ price discrimination by offering different rates for rooms based on factors such as room size, amenities, and booking timing. Guests booking a standard room in advance might pay a lower rate, while those who opt for suites or book closer to the check-in date might pay higher prices.
Education
Educational institutions often use price discrimination with tuition fees. They might charge different rates for in-state and out-of-state students, as well as different rates for undergraduate and graduate programs. Scholarships and financial aid can also be considered a form of price discrimination to attract students of varying financial backgrounds.
Cell Phone Plans
Cell phone companies apply price discrimination through their various plan offerings. They offer different plans with varying data limits, talk minutes, and text messages. Customers can choose plans that align with their usage needs, allowing the company to cater to different customer segments.
Concert Tickets
Concert promoters use price discrimination by offering different ticket prices based on seating locations. Front-row seats or VIP sections are often priced higher, while seats farther from the stage are offered at lower prices. This allows fans to choose the experience and price point that suits them.
Fast Food Combos
Fast food chains often create combo meals that bundle a burger, fries, and a drink at a slightly discounted price compared to purchasing each item separately. This encourages customers to spend more by providing perceived value while boosting overall sales for the restaurant.
E-Commerce Discounts
Online retailers frequently use price discrimination by offering discounts and promotions to specific customer segments. They might provide exclusive discounts to newsletter subscribers, first-time customers, or those who have abandoned their shopping carts, encouraging them to complete their purchases.
Fitness Memberships
Gyms and fitness centers use price discrimination by offering different membership packages. They may have basic memberships with access to standard equipment and premium memberships with additional perks like personal training sessions or exclusive classes. This allows them to target customers with varying fitness goals and budgets.
Key takeaways
Price discrimination is a pricingstrategy 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.
Key Highlights:
Definition of Price Discrimination:
Price discrimination is a pricingstrategy where identical or similar products are sold at different prices in different markets by the same supplier.
The goal is to maximize revenue by charging customers the highest price they are willing to pay.
Examples of Price Discrimination:
Movie tickets: Different prices for children, adults, families, and seniors.
Time-based pricing: Varying movie ticket prices based on time of day and movie popularity.
Types of Price Discrimination:
First Degree Price Discrimination:
Also known as perfect price discrimination.
Charging each customer the maximum price they’re willing to pay.
Capturing all consumer surplus in the market.
Difficult to implement due to the need to know individual willingness to pay.
Second Degree Price Discrimination:
Charging different prices based on the quantity consumed.
Examples include bulk discounts, frequent flyer programs, data plans.
Consumers choose the price by selecting a consumption level.
Often referred to as indirect price discrimination.
Third Degree Price Discrimination:
Charging different prices to different customer groups.
Examples include student discounts, senior discounts, off-peak pricing.
Utilizes characteristics like age, profession, gender to differentiate pricing.
Conditions for Effective Price Discrimination:
Price Maker: Operates in an imperfect market with demand curve sloping downwards.
Ability to Segment Markets: Prevents resale of products between segments.
Elasticity of Demand: Different elasticities within the market; some customers more sensitive to price changes than others.
Benefits and Takeaways:
Price discrimination allows businesses to capture different consumer segments and maximize revenue.
It requires understanding market conditions, customer behaviors, and demand elasticity.
Implementing price discrimination strategies can enhance profitability in competitive markets.
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 businessmodel.
A pricingstrategy 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 pricingstrategy aligns the customer with the company’s long term financial sustainability to build a solid businessmodel.
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 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.
Price skimming is primarily used to maximize profits when a new product or service is released. Price skimming is a product pricingstrategy where a company charges the highest initial price a customer is willing to pay and then lowers the price over time.
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 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.
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 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.
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.
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.
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.
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.
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 organizationscale further.
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.
A 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.
Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
