Price Differentiation

Week 10

Price differentiation

• One of the most fundamental concepts of PRO• Charging different prices to different customers, either

for exactly the same good or for slightly different versions of the same good

• Terminology: we speak of price differentiation rather than of price discrimination

• Includes phenomena such as group pricing, product versioning, regional pricing and channel pricing

• A powerful way for sellers to improve profitability• Both art–dividing market into segments–and science*

Third degree price discrimination*

• In this case the seller benefits and all customers are at least as well off, too; but as we will later see, this is not always the case

• Why not always?– Segments are hard to find*– A risk of cannibalization– A risk of arbitrage

• E.g. already if more than 10% of high paying customers would find a way of paying the low price, we would be losing money

Impact of market segmentationUnsegmented Segment 1 Segment 2 Total Change %

Cost 5 5 5 5 0.0%Average price 8.75 8.75 6 8.17 -6.6%Demand 3000 3000 800 3800 26.7%Revenue 26250 26250 4800 31050 18.3%Gross contribution 11250 11250 800 12050 7.1%

Group pricing, exactly the same product

• Terminology: different from what passanger airlines, hotels and cruise lines do, while offering lower rates to groups of customers – which is volume discounting that we consider later

• Student discounts• Senior citizen discounts• „Ladies’ Night“ specials• Family specials• Discounts for favored customers• Favorable terms offered by manufacturers to large retailers• Lower prices offered to governement, educational institutions

and nonprofits by suppliers

Group pricing

• There must be an unambigious indicator of group membership; it must be difficult for members of one group to masquerade as members of another*

• Group membership must strongly correlate with price sensitivity

• The product should not be easily traded or exchanged among purchasers

• The segmentation must be both culturally and legally accepted; age – ok; race, gender – not; Robinson-Patman Act (konkurentsiamet) prohibits many forms of group pricing that wholesalers want to use for retailers

Group pricing

• Most common in services (not so much in direct consumer sales): e.g. – Disneyworld checking kids age– Haircuts and health care are non-transferable– Airlines historically began checking passenger ids

in order to prevent arbitrage• In b2b, often combined with later described

product versioning

Channel pricing

• Barns and Noble has different prices online than at its outlets• Airlines web-only fares are not available through travel agencies

– Continental Airlines – a $325 ticket costs $43 to distribute through a travel agent and $18 through company web site – ONLY ONE OF THE REASONS

• Fashion and home furnishing merchants have different prices in mail-order catalogs

• THE MAIN DIFFERENCE is price sensitivity: e.g. personal loans through internet vs call center client vs retail branch customer; and if you tend to use bot’s or consolidator web sites, you are usually even the most price sensitive

Regional pricing, extremely common

• In Latin America, McDonalds prices burgers differently according to zip code, says The Economist

• Flying between the US and Estonia, usually has a higher price, when you are coming from the US

• There is a difference between a price of a beer, when you are (a part of a captive market) at an airport bar or at a corner bar

• Every example therein explores differences in price sensitivity

Couponing and self-selection• Group pricing is often both difficult and unpopular

– As a seller must categorize customers on the basis of sensitivity before quoting them a price

– It often seems unfair to customers• Both list price and discounted price are available to all customers• It must take time, effort or cost in terms of flexibility, if you want to

obtain a discount– Retailers have discount coupons in newspapers, direct mail and magazines– Retailers often offer mail-in rebates for purchasers of a good – Movie theaters charge lower prices for a weekday matinee than for a

Saturday night show– Brand name retailers, e.g. Ralph Lauren, the Gap, Liz Claiborne operate

outlet stores in out-of-the-way locations; such as Lasnamäe

Couponing and self-selection

• The seller has chosen a mechanism, that allows customers to self-select, depending on the value they place on time and flexibility

• Reseach has shown, that coupon users are more flexible than nonusers of coupons (Narasimhan, 1984)

• Peak-load, day-of-week, time-of-day pricing segments the market as some customers are flexible to change their plans

Product versioning

• Inferior goods– Mobil/Exxon and Shell sell excess gasoline in bulk at low prices to

„off-brand“ independent dealers– A well-knows premium wine producer sells some of its production

under a different label, at about half the price– Brand-name vegetable canners sell their product to retailers as a

„house brand“ • Damaged goods (Deneckere and McAfee, 1996)

– Bizarre?!?– The 486SX processor ($333) and the 486DX processor ($588)– Enterprise resource planning (ERP) software is often installed with

the full set of options, and the non-purchased items are configured not to start

Production versioning

• Superior goods– Spendrups brewery in Sweden; medium- or low-priced lagers aimed

at the mass market, came out with Spendrups Old Gold, which… was not good, but still priced 25% to 50% above its other brands – an obvious complement to the inferior-good strategy, creating a superior good in order to extract a higher price from less price-sensitive customers

– Proctor-Silex, in 1985, priced the top-of-the-line iron at $54.95, and the next best model at $49.95; the only difference being a red light, indicating when the iron is ready to use: „There is a segment of the market that wants to buy the best, despite the cost“

– It enabled the less price sensitive segment to self-select and extracted additional $4.00 in contribution margin from each high-end buyer

Product versioning

• Product lines– Vertical product lines – a hotel charges more for

an ocean-view room, than for a parking-lot-view room; Dell brands its computers vertically, as well, with higher priced product having progressively better features; this is in contrast to the horizontal product lines, such as one consisting of „Classic“ Coke, Diet Coke, Cherry Coke, Diet Cherry Coke, etc., all with simply different features

• Pro – „all the features of Basic plus advanced tools and customization options to boost efficiency and accuracy“

• Premier – „all the features of Pro and comprehensive tools for greater insight into your business“

• Enterprise – „our most comprehensive business management tool for growing businesses, with all the features of Pro and Premier“

• Very small businesses need less functionality, have fewer users, are more price sensitive than large businesses – again a self-selection mechanism

• Expedia – a Hertz one-day rental from the Seattle airport on a midweek day in May; or NY

• Not driven much by cost differences as e.g. life-cycle costs do not vary much among models; no difference in daily incremental cost

• The small cost differences create the possibility of upgrading (also practiced in e.g. cruise lines)

• When compared to group pricing, „paying more to get more“ is widely accepted– The pricing menus offered by Intuit and Hertz are openly

communicated

Time-based differentiation• Amazon offers 5-9 day „super-saver“ shipping free while $3.97 for „standard

shipping“, again, not only cost based, but also time of delivery is used as a segmentation variable

• Passenger airlines offering cheaper tickets earlier– Time of booking, but also factors such as ability to have a Saturday night stayover

are used for segmenting travellers into business and leisure segment, considered separately

• Software and hardware support contracts for „two-hour response“ and „two-day response“

• Fashion goods mark down later in the season– The ability of customers to wait and purchase later on a discount is the basis of

markdown management, considered separately• Of course, the higher price charged by Amazon also relfects the incremental

costs, but the company is also using time of delivery as a segmentation variable

Product versioning or group pricing

• A roundtrip ticket from San Francisco to Chicago, costing 250$ when purcased a week in advance and including a Saturday night stay-over vs. 750$ if purchased at the last minute, without restrictions: group pricing or product versioning?

• Customer: group pricing • Airline: distinct product – flexibility of being able to purchase

late and return without staying over at a Saturday night • Viewed one way, we could say that the airlines created an

inferior product as the most efficient and least controversial way to institute group pricing

Volume discounts, „buy more to save more“

• A six-pack and a single beer• Large bottle of laundry detergent costs less

per ounce• A cellular operator had price packages, where

you get more minutes per buck, when you buy more minutes

In b2b and wholesale, volume discounting is at least as prevalent

Price jumps, newspaper orders, the numerous schemes of volume discounting are called nonlinearpricing

• 250 copies - $562.50• 260 copies - $455.00

Volume discounts• Transaction and order costs

– A software seller – a fixed cost of $1000 per installation and a variable cost of $40 per user; 10 users - $140/user; 100 users - $50/user

• Decreasing marginal utility– A cold drink on a hot day– A demand function for a financial analysis software, for a number of

employees of the client, calculating the monetary gain for the client– The demand curve within the company: d(p) = 500-2p; For a fee 125$,

250 licenses sold for revenue of 31250$, however for a two-tier pricing, the second price of 75$ would sell 100 additional copies for 75000$

• Increasing price sensitivity– A corporate customer, who spends millions on galvanized pipe

annually, has more time to ponder the decision

Incremental discounting – „buy one, get the second at half price“*

• Discounts at the total volume of business • frequent flyer programs• a local cofee shop offering every 10th cup free – not only for loyality, but also deals with

the higher price sensitivity of those purchasing frequently• b2b quarter sales volume discounts – electronics sales – 0.5% rebate for $1M-$1.499M

sales; 0.75% for <$2M; 1% for >$2M sales; the same essentially true for freight transportation

• In freight transport, a higher discount, if a shipper commits to a higher volume over a time period

• Combining different terms and discount structures leads to a very wide variety of volume discount schemes (Nagle and Holden, 1994) (Wilson, 1993), in order to capture maximum contribution

• Software companies require registering, not only to fight with piracy, but to also to avoid arbitrage

• Some bulk and volume purchasers are required to sign a contract, that they do not resell• A magazine, on the other hand, is interested in as many sales as possible

Volume discounting and oligposony/monopsony

• Historically, the „big three“ US automakers were a oligopsony

• Very large freight consolidators or e.g. Wal-Mart can use its status as the biggest retailer of the world, to extract very low prices from business partners

• Branches of US goverment require in their procurement contracts the supplier to provide them „most favored buyer“ status

Calculating differentiated prices

• In case the market segments are independent – no cannibalization

• Unit cost for a portable MP3 player - $200• Additional cost per sale – Internet, incl.

shipping: $35 (price elasticity is 2.5); retail store: 70$ (price elasticity is 2.2)

• Contribution-maximizing price: (2.5/1.5)*($200+$35)=$392 and (2.2/1.2)*($200+$70)=$495

Optimal pricing with arbitrage

• A situation to avoid, except when arbitrageur has lower transportation cost – in which case which it could become the distributor

• If the price-response curve is continuous and downward sloping, there exists a single optimum

• Often, the prices are determined for major markets (e.g. North America, Western Europe, Japan) and price bands are used for smaller markets

• We are dealing with the members of the triad, but could just as well consider regions or cities

• Transportation costs do not have to be symmetric – e.g. taxes imposed on imports

Optimal pricing with cannibalization

• The more the low-price product cannibalizes the high-price product, the higher we need to price the low-price product

• At alpha=0.36, no more low-w.t.p. customers are buying and the only low-price customers are cannibalized high-w.t.p. customers

• Breakeven point at alpha=0.13, at that point we are better off without segmenting – even low rates of cannibalization can outweigh the benefits of price differentiation

Finding the optimal market segments

• A seller needs to identify groups with differing wtp. and to be able to price differently

• If the widget maker could choose the ideal way to divide the market into two segments, how should he do it, in order to maximize contribution?

• The ideal would be to segment the market at wtp. 10$, whereas the prices would be 10$, for the higher wtp. group, and 7.5$, for the lower wtp. group, resulting in total contribution of 15000$, which is 33% higher than in the unsegmented case – although substantially lower than the 22500$ for the third degree pricing