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The Case for Price Discrimination

March 2004 Pricing

It is a simple fact: different customers will place different values on your offering. Some will greatly value your product or service while others will value it less. There is little to profit in driving all customers towards a homogeneous demand level, but there is much to profit in taking advantage of the heterogeneity in demand. Correctly constructed, the pricing mechanism can use heterogeneity in demand to improve revenues and profits, even in highly competitive industries.

The approach to pricing for many companies is that of a price taker in a commodity market. The executives of the business feel that their price is determined by competitive offerings and suspect customers view the offering is viewed as a commodity. While competition may limit the room for price discrimination, it rarely removes all price flexibility.

Price discrimination is often defined as charging different customers different prices for the same or highly similar offering. Left with this definition, it is easy to conclude that price discrimination is an unfair market practice. After all, why should one customer pay more for that same product than the next customer? Based solely on this question, price discrimination would be unfair. However, additional relevant questions can be raised. Furthermore, price discrimination can be not only fair, but by the high prevalence of this mechanism in markets, we can suspect it is a best practice.

The variability in value that customers derive from a product or service leads to a variability in consumer surplus, wherein consumer surplus is defined as the value that a customer receives over the price that they pay for the offering. Price discrimination will recapture some of the excess consumer surplus from customers who value the offering highly and transfer that consumer surplus to the providing business. That business will directly see that recaptured consumer surplus in improved profitability. Viewed in this manner, it is appropriate for the price for a good or service correctly reflect a fair brokerage of profit sharing between the consumer surplus and the business’s profits.

A secondary value of price discrimination is that it awakens a business to the opportunity of serving customers that don’t value the offering as highly but would like to purchase if prices were lower. Price discrimination mechanisms that enable the minimum price charged to be lowered can improve market participation to include new customer sets that would otherwise be priced out of the market. This larger market opening can be used to improve capacity utilization or, in the case of intellectual property, improve the value that the intellectual property provides to society.

There are many examples of price discrimination that perform the effect of improving profits and enlarging the market served. We can see this simply by considering three industries: automobile manufacturers, airlines, and software.

US automobile manufactures are encouraged by the government to price discriminate through the CAFE Standards mechanism. CAFE Standards, or Corporate Average Fuel Efficiency Standards, require that the combined fleet of passenger cars sold in the US by any one manufacturer has an average fuel efficiency of 27.5 mpg, and the CAFE Standard for light trucks (which includes SUVs) is 20.7 mpg. To encourage the right mixture of large, fuel guzzling, luxury and sports cars with small, fuel miserly, cars; automobile manufactures will raise the prices on large cars above an even profit margin ratio and lower the prices on small cars below an even profit ratio. In effect, CAFE Standards encourage automobile manufacturers to use price discrimination to enable large cars sales to subsidize the sale of small cars.

Industries will also use price discrimination without the encouragement of federal regulation. Airlines regularly vary the prices on for identical seats according to their expected sales for a given city-pair at a given departure time. Flights at unpopular times for unpopular city-pairs will have more lowest-fare seats while flights for popular times between popular city-pairs will have fewer lowest-fare seats and more full-fare seats. From the airline’s perspective, it derives the value from providing a wide variety of city-pairs with a wide variety of departure times to attract the flexibility starved business customer. Low fare seats are sold to improve overall flight profitability on an otherwise fixed cost city-pair departure time offering. In effect, price discrimination enables airlines to offer greater value in the form of flexibility to high-value business customers and offer greater value to low-value bargain seekers in the form of low prices.

In the software industry too, success is highly dependent upon price discrimination. In terms of underlying software infrastructure, there may be high similarity between a back office system sold to a billion dollar company and the same sold to a company with a few hundred million in revenue. However, the cost of the same back office system will vary widely between these two companies. Not only does the larger company derive greater value from the back office system, but their ability to pay will also be greater. Smaller companies benefit from the strenuous demands for functionality placed by larger companies in receiving a back office system that provides greater benefits, in effect receiving greater value than that which the market would provide in the absence of large company customers.

From the above three examples, price discrimination plays an important role in brokering a fair deal between production and demand, and expanding the market for the output of production.

Mathematically, it can even be shown that price discrimination can increase revenues and overall consumer surplus. Consider a hypothetical market where overall demand increases at half the rate in which price decreases. For the first unit, a customer is willing to pay $200 thousand while for the 100th unit, a customer is willing to pay only $2 thousand. With only one-price for the entire market, the best price is at $100 thousand wherein half the market will purchase and half the market will avoid the offering. On a one-price basis, the total market revenue is at $5 million and the sum-total consumer surplus reaches $2.5 million. However, in an efficient price discrimination scheme, the business can vary its price according to the value its customers receive from purchasing. If each customer will see a price that is 30% less than the value that they receive from the purchase, every customer will participate in this market and both customers and the business are better off. In this case, the total market revenue will rises above $7 million and the sum-total consumer surplus rises above $3.0 million.

One Price
Total Revenue = $5000
Total Consumer Surplus – $2550

Variable Price at 30% of Customer Value
Total Revenue = $7070
Total Consumer Surplus – $3030

Surely a principle that leads to increases in the number of individuals receiving consumer surplus and in the profits of the company producing an output can’t be all bad. Perhaps it is simply the name of this principle that discourages discussion. Any takers for “Surplus Redistribution”?



About the author

Tim J. Smith, PhD is the Managing Principal of Wiglaf Pricing, and an Adjunct Professor at DePaul University of Marketing and Economics. His most recent book is Pricing Strategy: Setting Price Levels, Managing Price Discounts, & Establishing Price Structures.

Tim J. Smith, PhD
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