Wednesday, January 2, 2013

PRICE DISCRIMINATION - Sounds bad, but can be great for your business and customers

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Price discrimination is the practice of charging different customers different prices, based on their ability or willingness to pay.  In this post we'll go over some examples of price discrimination and how it creates value.


One of my friends encountered this example of price discrimination while on vacation in southeast Asia.  While shopping in a local market, her friend translated and helped her negotiate a purchase with one of the vendors.  They got into a conversation with the seller and learned that the vendors in the market would assess every customer and charge one of three prices for any given item. 

The "local Asian" price was the lowest, the "tourist Asian" price was higher, and the "white tourist" price was the highest.  Vendors were likely assuming that caucasian tourists had the highest willingness or ability to pay, were least familiar with what items should cost, and would be one-time buyers.  On the other end of the spectrum, local customers likely had lower ability to pay, better sense of what things should cost, and could become loyal, repeat buyers.  If they charged only one price, they might be too expensive for local customers and leave money on the table when selling to more affluent tourists.


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Another example that most travelers have encountered is how rental car companies set prices.  Weekday rentals are typically more expensive than rentals that include weekends.  The higher, weekday prices are aimed at business travelers who are not price sensitive because they're expensing the rental cost.

The lower, weekend prices are for vacation travelers who are more price sensitive since they're paying for the car out of their own pockets.  Without price discrimination, vacation travelers might not be able to afford to rent a car or have to pay much more for their car.

But how does the rental car company know which price to charge a traveler?  In this case, they use the rental days can inform their price discrimination.  Their assumption is that business travelers only rent on weekdays - because they head home on the weekends - and vacation travelers often rent during the weekend, when they have off from work.


Other familiar examples are restaurants that have early-bird specials.  In this case, restaurants assume that elderly diners are more price sensitive and willing to - or prefer to - eat earlier in the evening.  In addition  to bringing in customers that might not otherwise dine at the restaurant, it also shift demand to less busy times of the day.


To illustrate how this creates value, let's look at the rental car example.  Let's imagine a greatly simplified rental car market in which there are 100 potential customers - 50 vacation travelers and 50 business travelers.  The vacation travelers only rent on Saturday and Sunday and are willing to pay $20/day for a rental car.  Business travelers are willing to pay $80/day and only rent cars on weekdays.

Let's see how much revenue is generated during one week under some pricing scenarios:

$20/day, every day (no price discrimination)
On the weekend we rent to 50 vacation customers at $20/day for 2 days = $2,000
During the week we rent to 50 business travelers at $20/day for 5 days = $5,000
Total revenue = $7,000

$40/day, every day (no price discrimination)
In this example we'll get more revenue from business travelers, but vacation travelers won't be able to afford to rent...
On the weekend we rent to 0 vacation travelers at $40/day for 2 days = $0
During the week we rent to 50 business travelers at $40/day for 5 days = $10,000
Total revenue = $10,000

But we can still do better by generating revenue from vacation travelers over the weekend.  This is where price discrimination comes in to play:

$20/day on weekends, $40/day during the week (price discrimination)
On the weekend we rent to 50 vacation travelers at $20/day for 2 days = $2,000
During the week we rent to 50 business travelers at $40/day for 5 days = $10,000
Total revenue = $12,000

In this example, price discrimination has increase our revenue by $2,000 or 20%.

Why is this important?

As you can see, price discrimination can generate additional revenue for your business by:
  • Attracting new customers who can't afford your current prices
  • Maximizing value captured from customers willing to pay the more

1 comment:

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