4.4 Pricing Strategies
[4.2 Market Power] [4.3 Pricing with Market Power]
[4.5 Pricing in Competitive Markets] [4.6 Entry and Exit]
Topic 4.3 examined how firms with market power set the price of their product in a mass market. This analysis, however, presumed that firms were constrained to set a single price per unit of their product. Many firms, however, set more imaginative pricing strategies. Those strategies include different prices to different customer types, tailored products each with different prices, bundled products and 'non-linear' prices that take more complex forms than the simple per unit form.
Click the link here to find out about pricing strategies in airlines.
Economists use the term price discrimination to refer to situations where firms charge more complicated prices than simple linear prices. In this topic, you will be introduced to the group-pricing, two-part and bundling pricing strategies that involve price discrimination. In so doing, you will learn how firms can use imagination and innovative pricing policies to earn more profit.
Types of Price Discrimination
When businesses practice price discrimination, they sell the same product or service to different customers at different prices. Economists recognise three major types of price discrimination.
Personalised pricing (first-degree price discrimination)
First-degree price discrimination refers to the practice of charging prices to each customer based on their maximum willingness to pay. The most common form of first-degree price discrimination is the personalised pricing strategy where companies set different prices for customers based on the personal information they have about the customers. Businesses recognise that buyers value any given product or service differently. In other words, consumers are willing to pay different prices for the same product. If companies were to sell their products to all customers at one price, they would lose the extra revenue from consumers who are willing to pay more. By establishing highly personalised prices, companies reap the maximum amount of revenue.
Click on the link here to read about industries that are suitable for personalised pricing.
Wealthier consumers often pay higher prices for services than less-affluent people do. The most common examples of such pricing practices occur in medical and legal services. Colleges and universities also practice income-based pricing by tailoring financial aid packages to each student's ability to pay.
Click on the here to read about how many companies are using personalised pricing.
Versioning (second-degree price discrimination)
In second-degree price discrimination, firms typically offer a list of different prices to consumers, allowing the consumers to self-select. In versioning pricing strategies, companies sell variations of a product or service at different prices to different groups of customers. Ideally, companies want to charge what consumers are willing to pay thereby maximising company revenues. But it is difficult to know precisely how much each person is willing to pay. Companies therefore create versions of a product to appeal to different types of buyers. Customers then choose the version that best meets their needs.
Businesses often distribute a physically identical product under different brand names, charging lower prices for the less known brand name. For example, the Gap Company sells its products with the Gap label at its own stores as well as under other labels at other retail stores.
Click the here for more cases of how companies use versioning.
Group pricing (third-degree price discrimination)
Third-degree price discrimination refers to the practice of charging different prices to different classes, or groups, of customers. In many cases companies do not have enough information about the maximum price that an individual will pay for a product or service. However, companies do know that different groups of people value the same commodity in different ways. If a firm is able to identify particular groups of consumers, it can adjust its prices to reflect the groups' willingness to pay. Although this strategy does not increase profits as much as personalised pricing, it does allow the firm to extract more consumer surplus (and profits) than it would by charging a single price.
For example, newspapers often quote lower prices to new subscribers and higher prices to established subscribers. Academic journals often quote higher prices to libraries and universities than they do to individual subscribers.
Click the link here to read about whether coupons and sales are a form of price discrimination.
Why Do Companies Price Discriminate?
Suppose that a pastry shop makes chocolate chip cookies that its customers prefer to those of any other bakery and also that the MC of baking and selling a cookie is $0.30. The loyalty of the customers allows the company to decide the price. The owner of the pastry shop has determined that the profit-maximising price for each cookie is $1.10.
In selling its cookie at a single price, however, the shop loses in two ways. Firstly some customers would be willing to pay more than $1.10 for a cookie. Secondly the company does not sell to customers who are willing to pay more than $0.30 but less than $1.10. This is illustrated in the graphic below, where P=price and Q=quantity.
By charging such customers a different price, the company could profitably sell to a much larger customer base.
For a company to price discriminate successfully, three factors are critical.
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A company must have some degree of market power. For example, if the pastry shop cannot set the price of cookies, it cannot establish multiple prices.
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A company must be able to prevent arbitrage. Arbitrage is the practice of buying a good at one price and reselling it at a higher price. The pastry shop cannot use price discrimination successfully if customers buy cookies at the lowest available price, then resell them at a higher price.
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A company must obtain information about its customers tastes and preferences. By monitoring its sales, the pastry shop might learn that some of its customers value cookies with extra chocolate. The shop can then sell a cookie with double the chocolate chips, at a considerably higher price, to some regular customers.
We now turn to explore three pricing strategies: group pricing, two-part tariffs and bundling in more detail.
Group Pricing Examples
Group pricing is based on the premise that businesses sometimes do not have enough information about the maximum amount a person will pay for a specific commodity, ie, they do not know the reservation price of buyers. Therefore, they are not able to use personal pricing to get the maximum revenue from buyers. By using group-pricing strategies, firms are able to extract additional surplus from groups of consumers, even though the individual reservation prices are unknown.
Click on the link here for an example of group pricing.
To implement third-degree price discrimination, a business must first identify the most appropriate characteristic(s) of the consumer groups, such as age, time and information so that the different groups can be distinguished. The next step for the business is to choose a price for each group of consumer that will maximise the profits of the business. With third-degree price discrimination, one assumes that the business is able to sort its customers into groups so that those who can pay a higher price for the product cannot purchase the product at a lower price.
Some common examples of group pricing are
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Pricing across countries Businesses often charge different prices to consumers in different countries. For instance, automobile manufacturers generally charge higher prices in Japan than they do in the United States.
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Airline pricing Airlines routinely charge higher prices for those travellers who want to make a return trip without staying a Saturday night than they do for travellers who will stay a Saturday.
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Pricing of services by lawyers, doctors and accountants Service providers such as doctors, lawyers and accountants often charge different prices for different groups of customers.
Distinguishing Among Groups
The characteristics that businesses use to distinguish among groups of consumers include
Geographic location
Segmenting markets by geographic location is generally easy. Businesses routinely charge higher prices to residents in some areas, while charging lower prices to residents in other areas. Indeed, businesses have now become so adept at making these distinctions that it is not uncommon to observe retailers charging higher prices in some suburbs while maintaining lower prices in adjacent suburbs.
Time
Airlines, hotels and department stores regularly segment consumers by time of use or purchase. The lowest prices are generally offered to those who are willing to stay a Saturday and those who are willing to wait till the end of the fashion season.
Age
Segmenting markets by the age of customers is relatively easy to implement. All that is required to distinguish between customer groups is an identification (ID) card such as a student ID card or a senior citizens ID card. Those who can demonstrate that they belong to a specific age group are quoted the lower price; those do not belong to the specific age group are quoted a higher price.
Income
Businesses have become adept at distinguishing among consumer groups on the basis of income. For instance, retailers like the Gap and Old Navy may carry similar products, but the two chains have very different price structures because their customers are typically from different income demographics.
Click the link here for some examples of group pricing.
To see the economic logic behind group pricing, click here.
The two-part tariff is a pricing strategy that is used by firms with market power to increase their revenues and profits. The term "two-part tariff" refers to the two fees that are charged to consumers under this strategy. The first tariff is a fixed fee that gives them the right to purchase units of a product or a service. The second tariff is a per-unit charge based on the actual rate of usage or purchase of the good.
To see the economic logic behind two-part tariffs, view the animation here.
Bundling products is not a new strategy. Industries have long bundled their products to increase revenues.
The next time you walk into your favourite electronics store and inquire about the price of a personal computer, you will notice that you can buy a computer (CPU), a monitor and a printer in one package. In addition, these packages also commonly include certain software programs and perhaps a DVD player, a compact disc (CD) writer and free access to the Internet for a limited time.
Many homeowners in the
These are examples of a common pricing strategy called bundling.
Click the link here for other examples of bundling.
Goal of bundling
The objective of bundling, as with all other pricing strategies, is for the seller to capture as much of the buyer's value as possible. Successful bundling often results in greater revenue for the seller.
Bundling occurs when sellers combine different products and charge one price for them. Generally, the price of the bundle is less than the sum of the individual components. Buyers who purchase bundles may not always want or value all components of the bundle; however, they value some of them enough to purchase the bundle which they perceive as a good deal.
Click on the link here for an example of how bundling works.
Although consumers have different valuations of individual items, their valuations of the bundle may not differ much. Buyers who like particular features of a bundle will ask themselves if the additional items are worth the extra cost of the bundle. If a bundle is priced properly, buyers will often choose the bundle because they believe that the bundle is a good deal compared with buying the individual items separately.
What options should be bundled together? To see how to pick the best options to package together in a bundle, view the animation here.
You've just seen how bundling can be successfully used to maximise profits. To
see an example where bundling will not be a success, view the
animation here.
Finally, click on the link here to read about other considerations when bundling.
Click on the link here for details of your discussion activity.
Topic Summary
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There are many more ways of pricing than charging a simple amount per unit sold. Economists call these pricing forms 'price discrimination'.
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There are three broad types of price discrimination: personalised pricing, versioning and group pricing.
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Group pricing involves charging different customer types different prices. It can only be achieved, however, when those customers cannot re-sell goods to one another.
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Two-part tariffs are a commonly used type of non-linear price. In addition to a per unit price, customers also pay a fixed fee that does not vary with usage.
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Bundling is a practice of putting more than one product together and charging a price for the total package that is less than the price of products sold individually.
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All these types of pricing strategies can assist firms in improving their profits.
You may now proceed to topic 4.5, "Pricing in Competitive Markets".