Why Do Companies Price Discriminate?

By Moira McCormick on July 4, 2016

Why Do Companies Price Discriminate?

Price discrimination is a pricing strategy that charges customers different prices for identical goods or services according to certain criteria. In pure price discrimination, the seller/provider will charge each customer the maximum price they are willing to pay. In more common forms of price discrimination, the seller places customers in groups based on certain attributes and charges each group a different price.

Industries that commonly use price discrimination include the travel industry, pharmaceuticals, leisure and telecom industries. Examples of forms of price discrimination include coupons, age discounts, occupational discounts, retail incentives and gender based pricing.

There are three types of price discrimination:

  1. First degree - the seller must know the absolute maximum price that every consumer is willing to pay.
  2. Second degree - the price of the product or service varies according to the quantity demanded.
  3. Third degree - the price of the product or service varies by attributes such as location, age, sex, and economic status.

The purpose of price discrimination is to capture the market's consumer surplus. Price discrimination allows the seller to generate the most revenue possible for a product or service.

 

First-Degree Price Discrimination

First-degree price discrimination means exploring/judging what your customers are willing to pay for an item and selling it at that price. Car dealers may exercise first degree price discrimination by looking at how a potential car buyer is dressed.

A potential customer who has the latest version of a phone and wears expensive clothes is more likely to be able to pay a premium for a new car – or that's what the dealer will surmise! This strategy can also require a business to profile its customers and offer personalised prices based on previous purchases, particularly online.

Merchants who use a customer's purchase history and data on comparison shopping behaviour to determine prices could however be vulnerable to possible consumer alienation.

 

Second-Degree Price Discrimination

Second-degree price discrimination refers to special deals and prices offered to customers who meet certain conditions or who are seeking certain special qualities. Buy-two-get-one-free offers, special prices for bulk purchases and premium packages are examples of second-degree promotions. Customers typically appreciate these opportunities as long as the rewards are obtainable and they are not accompanied with price increases to compensate.

This form of price discrimination allows your business to provide savings to customers who value "deals," to reward loyal customers with frequent purchase cards and to increase your margin on rare or premium items. Communications companies usually offer a packaged deal for Internet, phone and TV services at a discount to what consumers would pay for all three services separately.

 

Third-Degree Price Discrimination

Third-degree pricing offers special discounts to members of certain groups, such as students, OAPs, or children. These discounts are frequently reflected in restaurant offers, bus/rail fares and admission prices, but can also apply to retail prices on production of ID. Students and pensioners are given discounts because they exhibit high price sensitivity.

Third-degree price discrimination gives you the opportunity to expand your market by selling to a group that might not buy otherwise. It is rare to encounter resentment among customers who do not fall into the discounted group as long as you have not raised prices in general to compensate for the discounts.

 

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Methods of Price Discrimination

Methods of Price Discrimination include:

  • Coupons: coupons are used to distinguish consumers by their reserve price. Companies increase the price of a product and individuals who are not price sensitive will pay the higher price. Coupons allow price sensitive consumers to receive a discount. The seller is still making a profit.

  • Age discounts: the price of a good or admission to an event is based on age. Age discounts are usually broken down by child, student, adult, and OAP. In some cases, children under a certain age are given free admission or eat for free. Examples of places where age discounts are given include restaurants, cinemas, and other forms of entertainment.

  • Occupational discounts: price discrimination is present when individuals receive certain discounts based on their occupation. One example would be for members of the armed services.

  • Retail incentives: this includes rebates, discount coupons, bulk and quantity pricing, seasonal discounts, and frequent buyer discounts.

  • Gender based prices: in certain markets prices are set based on gender. A Ladies Night at a bar or club is a form of price discrimination.

 

Examples of Price Discrimination

Price Discrimination in the Travel Industry

The travel industry conducts a substantial portion of their business using price discrimination. Travel products and services are marketed to specific social segments. Airlines usually assign specific capacity to various booking classes. Also, prices fluctuate based on time of travel (time of day, day of the week, time of year).

If you are looking for a bargain flight with a low-cost airline, booking early with carriers such as easyJet or Ryanair will normally mean lower prices. This gives the airline the advantage of knowing how full their flights are likely to be and is a source of cash flow prior to the flight time.

Closer to the time of a flight with most airlines the fare rises, on the justification that a consumer’s demand for a flight becomes inelastic. People who book late often regard travel to their intended destination as a necessity and they are likely to be willing and able to pay a much higher price.

 

Peak and Off-Peak Pricing

Peak and off-peak pricing is common in the telecommunications industry, leisure retailing and with utility companies. For example, telephone and electricity companies separate markets by time - there are usually three rates for telephone calls: a daytime peak rate, an off peak evening rate and a cheaper weekend rate. Electricity suppliers also offer cheaper off-peak electricity during the night.

The reason for this price discrimination is that at off-peak times there is plenty of spare capacity whereas at peak times when demand is high the supplier may experience capacity constraints. Leisure Centres on the other hand will often charge more for evening and weekend attendances because this is when the majority of the public want to use the facilities. They want to encourage more users to attend during weekdays by charging less for admission during off-peak times.

 

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Is it Legal?

Charging different amounts for the same item to different people or to different groups of people is price discrimination - and as long as you can justify why you are charging different prices, such as implementing "children's meals" to attract families, it is perfectly legal. Similarly, wholesalers can offer price breaks for quantity purchases and they can offer customised merchandise but they cannot influence competition by limiting these offers to a few select retailers because doing so would harm excluded retailers.

 

Is Price Discrimination Good for the Buyer or Seller?

Customers want to be treated fairly. If they find out they are being charged more online than Joe Bloggs down the road then they rightly get upset. Often, customers don’t know that they are being offered different prices.

Privacy is another issue. There’s something a little unsettling about the amount and type of information that can be captured about you online. Consumers already have their doubts and it is essential for retailers to try to maintain trust.

On the flip side, there are plenty of tech-savvy consumers out there and it’s quite easy for them to log in from a different IP address. These consumers may be able to take advantage of companies with geographic price differentials. Consumers also constantly utilise data themselves through price checking.

Retailers also need real-time data and analytics to stay ahead of the curve. They are increasingly investing in dynamic pricing technologies that allow them to optimise prices based on changes in the marketplace. Dynamic pricing can also be buyer-friendly and result in a win-win situation for retailers and consumers (i.e. lower prices for consumers, higher volume for retailers).

 

Conclusion

Price discrimination may enable a business to turn a loss into a small profit - or a business activity can keep going, rather than close down. This is obviously beneficial for consumers because it increases their choice of goods and services. One example of this might be rail travel. Without off peak and peak prices train companies would make a bigger loss and may have to discontinue their service.

Price discrimination means that firms have an incentive to cut prices for groups of consumers who are sensitive to prices (elastic demand). These groups often have less disposable income than the average consumer. The downside is that some consumers will face higher prices.

Price discrimination is one way to manage demand. For instance, if there was no price discrimination morning rush hour trains would be even more overcrowded and it can be used to give an incentive for some people to go later in the day. This should mean that those who have to travel at rush hour benefit from less congestion.

 

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