Price Discrimination (Differentiation)

Price Discrimination (Differentiation) It is often possible to sell the same product to different customers at different prices. In order to do this, the market must be divisible into segments, each quite separate from the others, and each with its own degree of price sensitivity. The principle of market segmentation is not new - variations of standard product types have been designed for particular social classes or regional markets for several thousand years. Although mass production techniques lead naturally to homogeneity of products (the Henry Ford maxim), the trend in the last 40 years has been to recognize the profit potential of discrete market segments, with their different demand functions. If natural demarcation lines already exist, so much the better; if not, they can be created by marketing techniques. There are five possible bases for segmentation. 1. Time : One example of differentiation by time has already been mentioned: market skimming. The customers who buy a product relatively early in its life cycle will pay more than those who buy later. More obvious (and personal) everyday examples include rail travel and telecommunications. A huge inelastic demand curve is presented to the suppliers of these services in the form of customers having little or no control over the time of day they use them. Other examples, exploiting a different section of the market, are seen in the reverse of the above situation. The concept of off-peak or low-tariff services is an attempt to maximize profits by attracting marginal income which will make an additional contribution to fixed costs. Hotel groups were one of the first successfully to discriminate in this particular way - low weekend tariffs for accommodation and food reflect the fact that any income in excess of the marginal cost of supply goes to reduce overheads that are incurred regardless of volume. Moreover, the weekend leisure customer represents a totally different market segment that poses no threat to the highly profitable weekday business trade. 2. Quantity : Discounts for bulk purchases are a long-established and well-known form of price discrimination, which reflect cost savings for the supplier in terms of lower handling and distribution costs. Customers can also be persuaded that the principle should be applied in reverse, namely, that small orders should carry a price premium not always represented by concomitant additional supply or distribution costs). 3. Function : A common form of segmentation is based on differences in the functions performed by various groups of customers within the market. Different prices will usually be paid by wholesaler, retailer and the ultimate consumer. Like bulk discounts, functional discounts reflect the degree of cost savings to each supplier along the chain. However, if the difference in price departs significantly from the costs of performing the marginal functional service, the chain is likely to break, and prices obtainable from the ultimate consumer will be eroded. For example, too wide a band between wholesaler and retailer may prompt the wholesaler to sell directly to the consumer at a lower price than the retailer is able to quote. 4. Location : Products which are subject to high transportation costs may be successfully differentiated in price in different geographical locations. As long as the differential is less than the cost of moving individual cheaper priced goods to the more expensive market, there should be no risk of their filtering across boundaries and diluting margins. Retail price differentiation is also possible between urban and rural locations, and between wealthy and poor districts within cities: the support for higher prices in these situations is not so much the prohibitive transportation costs from one location to another, but the unlikelihood (for reasons of convenience or snobbery) of higher priced customers seeking out the lower priced outlets. 5. Product content and presentation : Relatively minor (in cost terms) physical variations can be made of the same basic product, which is then sold to different market segments at significantly different prices. Cars are an obvious example: a more sporty look to a small saloon, a different finish to its paintwork and facia, or a more comfortable fabric for the seats. On the other hand, the difference may simply be in the presentation of the goods for sale to the consumer - the same basic products can be set out in more attractive showrooms, with more attentive and knowledgeable sales assistants, and no-quibble exchanges. The only requirement for successful segmentation in these cases is a sufficiently large number of customers who will value the differences highly enough to pay a premium price for them. It is frequently pointed out that price differentiation has both private and public benefits. The private benefits to both supplier and low price consumer are obvious, but the public benefit is less so. It is seen when a 'single-price' policy fails to cover total costs, and would result in the supplier withdrawing the product from the market. Let us take a simple illustration of a retailer who buys a particular product for £125, and has shop overheads of £180 in total. Let us asume that there are only two customers in the market, one willing to pay up to £250 for the product, the other no more than £200. If the retailer is able to differentiate the price between the two customers, he will sell two units and make a profit on the deals: However, if the retailer can only set a single price for the product, he will lose money, no matter what price is quoted. If he says £200, he can sell two units, but will fail to cover his total costs: If he quotes £250, he will only sell one unit, the second customer being unwilling to pay more than £200. A bigger loss ensues: The net result of his inability to exercise price discrimination would be his withdrawal from the market, so that neither customer has the opportunity to buy the product.