Friday, January 11, 2013

3 ingredients necessary for price discrimination

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As discussed in a previous post, despite its negative-sounding name, price discrimination can be a powerful tool for creating value for your business.  In this post, we'll go over the three conditions necessary to enable price discrimination...

If you recall from my earlier post, price discrimination requires charging different customers different prices based on their willingness to pay.  In order to make price discrimination work, three conditions must be met.  The first is almost always present in any industry for any product.  The second is usually possible, but the third can be challenging.

1.  Customers with different willingness to pay (WTP)

The technical description would be customers different price elasticities of demand.  But, the mission of this blog is to simplify business concepts, so I'm going to rephrase it as willingness to pay.  For price discrimination to work, you have to have two or more groups of customers, with each group willing to pay a different price than the other groups.

Fortunately, this is a ubiquitous situation.  In fact, if you had a perfect means for quantifying the willingness of each, individual customer to pay for an item, you'd probably have as many prices as customers.  But, in most instances, you'll have groups of customers - customer segments - that behave similarly.  In this case, members of each customer segment will view the price of your product similarly to each other, but very differently from members of other customer segments.

An everyday example of segments that differ by WTP are students and retirees vs. full-time workers.  Students and retirees often have less disposable income than people who are fully employed, and therefore might have lower willingness (or ability) to pay for things like movie tickets.


2.  Ability to distinguish one group from another

For price discrimination to work, you have to be able to identify to which customer segment a given customer belongs.  Therefore, it's helpful if you can identify demographic or behavioral traits that are more common in one group than another.  This one is often overlooked in academic explanations of price discrimination, but is absolutely critical for the entrepreneur who wants to implement it.

In the movie theater example, there's a correlation between age and student/employment status belonging to the lower or higher willingness to pay segments.  Younger students and older retirees are in the lower willingnessto pay group, while other adults might be assumed to be in the higher WTP group.  However, it might not be that easy for a ticket seller to look at a potential customer and distinguish which group they're in.  For example, it might be hard to tell if someone in their mid-20s is a college student or employed full-time.  In this case, businesses use age, along with various forms of ID, enable us to distinguish one customer segment from another.  Often, anyone under 18, with a student ID, or seniors above a certain age are given student discounts by various businesses.


3.  The means to prevent high WTP customers from paying lower prices

Just because some customers are WILLING to pay more, it doesn't mean they WANT to pay more.  If given the option, even high-WTP customers would much rather pay the lower price - that would be an example of price ARBITRAGE.  So, for price discrimination to work, you have to be able to create pricing "walls" or "fences" to keep high-WTP customers from paying low-WTP prices.  This is often the most challenging aspect of designing an effective price discrimination scheme.

Let's consider airline ticket pricing.  Business travelers are typically willing to pay more for flights than vacation travelers, usually because their companies are footing the bill.  So, airlines try charge business travelers more than vacation travelers.  Airlines combine items #2 and #3 on this list by distinguishing business and vacation travelers by travel and purchasing habits that are difficult for high-WTP customers to change.

Vacation travelers usually plan their trips in advance and their plans are not easily changed - they need to do things like schedule time off from work or board their pets.  Vacation travelers often travel over weekends, allowing them to extend their trips without using up extra vacation days.  So, flights are often less expensive if you book in advance, buy non-refundable tickets that cannot be changed, and you travel over a weekend.  These are also things difficult for business travelers to do.  Many business trips arise at the last-minute, need to be adjusted, and take place during the work week.  This makes it difficult for business travelers to pay vacation traveler fares.

What does this mean for your business?

Think about aspects of your business that you can apply to satisfy each of these price discrimination requirements.

Ask your self the following questions:

What WTP customer segments do you serve?

Think about your customers.  Even though each one is unique, they are more similar than some and more different than others.  Your customers will naturally belong to WTP customer segments but you have to identify those segments.  There are more quantitative, scientific ways to do this, but successful entrepreneurs often know their customers well enough to do this intuitively.
  • Which customers are willing to pay the most?  What do they have in common?
  • Which customers are willing to pay the least?  What do they have in common?
  • Do you have any other WTP customer segments?  What do they have in common?


How can you tell your WTP customer segments apart?

Suppose a new customer comes to your business.  What identifying traits or behaviors can you look for to help you determine their WTP segment?  The more tightly these identifiers are linked to their WTP, the better.  Some common examples include:
  • Age (e.g., senior discounts)
  • Gender (e.g., ladies night, dry cleaners, haircuts)
  • Volume (e.g., unit price breaks for higher volumes)
  • Time (e.g., matinees, peak/off-peak pricing)


How can you prevent arbitrage?

Consider what pricing "walls" or "fences" you can construct to prevent arbitrage.  Think about it as protecting your low prices from high-WTP customers.  Sometimes this can require making changes to your product.  There are some interesting examples of how this is done, which I'll cover in a future post.

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