When Apple Computer priced its new Power Macintosh line of computers in 1994, it grossly underestimated the level of demand and was consequently unable to supply enough computers and parts.
Mercury One-2-One offered a promotion around the same time that entitled new buyers of mobile phones to free long-distance telephone calls on Christmas Day. The promotion backfired when the response was so large that many customers were unable to gain access to the network.
The question "How should a product be priced?" is of enormous importance to businesses, and most companies allocate substantial budgets to market research both before launching a new product and, once launched, through the different stages of the product's life cycle.
Economists will argue that the level of demand for a product at any price is the sum of what all the individual consumers in the market would be willing to purchase. This demand, or willingness to pay, for any product will be affected by three key factors:
individual consumers' preferences for the different characteristics of the product
the price of close substitutes to the product and the price of goods that must be used in conjunction with it
the level of each individual consumer's income.
This will apply to any product, be it cans of cola, automobiles or computers.
To forecast demand for, say, a new Apple Power-Mac, market researchers need to know the answer to questions such as: What portion of consumers want a new computer with the extra power and speed offered by the Power-Mac? How do consumers view the Apple Macintosh brand name relative to other brands such as IBM, Dell, Compaq, Hewlett-Packard and so on?
How will Apple's new computer compare in price to that of rival brands of equivalently powered computers and also to the price of computers that are slightly more or less powerful than the Power Mac?
Will there be a need for new software and/or peripheral equipment and if so what are the costs of purchasing these?
How well off are consumers (or companies) and will they be able to afford to purchase these new machines, either to meet expanding business requirements or to replace older machines and improve productivity?
Even if sellers know the maximum amount that different customers are willing to pay, developing a pricing scheme that makes each customer pay that amount, a practice know as first degree price discrimination, can be difficult.
Under first degree price discrimination, the full benefit from the trade between buyer and seller accrues to the seller. At the same time, business is not lost by charging too high a price to customers who would not be willing to pay as much.
One strategy to achieve first degree price discrimination is to sell to the highest bidders through sealed bid auctions. The auction approach is best suited for situations where the volume of sales are low (usually due to scarcity of the product), where there are many potential buyers who are unable to co-operate among themselves and where buyers all have access to the same information about the product's characteristics.
The auction approach would enable the seller to identify those buyers with the highest willingness to pay and would yield the highest possible revenues for the same production costs. This is a common strategy for the sale of very special types of products such as art objects, antique furniture or the rights to the mining and exploration of plots of land. It is not suitable for most bulk-produced products such as cans of cola or computers.
Where the auction approach is not feasible, the company must do its best to approximate the first degree outcome using its pricing structure. There are two broad approaches to doing this.
The first is based on the notion that any individual consumer derives diminishing satisfaction from each successive unit of any product consumed. Thus a thirsty cola-loving consumer may get great satisfaction from the first can consumed and high satisfaction from the second.
But gradually the incremental value of each successive can will be lower and lower. Thus, this same consumer may be willing to pay a lot for the first can but not much for the sixth.
If the price per can is very high, the cola-loving consumer will only buy one can; other consumers may not buy any. So instead, the seller packs some of its cans into six-packs and sells them at a lower unit-price than the individual cans. But the consumer can only qualify for the lower price if she or he buys all six cans.
Thus the consumer who only wanted one can and gets a high satisfaction from that one can, will pay the higher price. At the same time, the business of the consumer who would have bought more at a lower price is not lost to the company either.
This form of price discrimination, which is based on the volume of consumer purchases, is very common and is known as second degree price discrimination.
Other forms of second degree price discrimination include two-tier tariffs, i.e. prices where the consumer must pay a flat fee for access and then a separate fee (which may be zero) for usage.
This is typical of many sports clubs, amusement parks and transport facilities offering monthly or annual access passes.
The idea in the case of a travel pass, for example, is that the traveller who travels infrequently pays on average a higher price per trip because the fixed access cost is spread over fewer trips. On the other hand, the high volume user spreads this fixed cost over so many trips that he or she may actually sit next to the infrequent traveller, consume the exact same services (meals, fuel and so on), but end up paying a lower average price for any given trip.
A second way sellers approximate first degree price discrimination is where, rather than pricing according to the volume of purchases, the company prices according to the characteristics of the buyer.
Pricing based on what type of consumer is doing the purchasing rather than the volume of purchase is an approach known as third degree price discrimination.
This is very common in the sales of air and rail travel, subscriptions to newspapers and magazines, theatre tickets and other products where consumers can be segmented into different groups who are likely to differ greatly in their willingness to pay based on certain easily identifiable attributes.
Students are one of the main beneficiaries of third degree price discrimination schemes, since they are known as a group to be much more price sensitive than the population at large. Other often identified groups include pensioners and the young, both of whom also tend to be more price sensitive, and business purchasers, who are often less price sensitive and may be willing to pay a lot for small quality improvements.
Suppose, for example, there are only two types of travellers: students and businessmen. Students pay for their travel out of their own pockets, while businessmen charge their travel to their employers who in turn deduct these expenses from their taxable income.
Since a typical student is likely to be willing to pay less for a travel ticket, all else being equal, than a typical businessmen, it makes sense for the company selling travel services to price higher to the businessman and lower to the tourist to get the largest possible volume of business out of each customer group.
Pricing schemes can be quite complex and may combine elements of second and third degree price discrimination: for example, discounted travel passes for students and pensioners. In any case, the main danger to the seller is that customers have an incentive to get together and trade among themselves to benefit from existing price differentials.
Thus, a student may try to purchase a ticket she or he does not plan to use for the express purpose of selling it to a business traveller and sharing the difference between the prices. Or, a holder of a travel pass may offer the pass to a friend to use, enabling the friend to benefit from the high volume of the holder's travel. If this were allowed to happen, the seller would lose the business of the high-price paying customer and would be better off offering a single profit-maximising price.
The seller engaging in price discrimination must therefore take measures such as passport checks at the departure gate and photos on rail passes to make sure consumers are not able to engage in arbitrage, i.e. profit from their access to a lower price by selling to someone to whom such access is precluded.
The other danger the price discriminating seller faces is that a rival firm may enter with a single price that undercuts the incumbent's higher price. Then the rival will draw away the most profitable market segments and the original company will only be left with the low-margin discount buyers.
That is why price discrimination is only possible in imperfectly competitive markets, where direct competition by rivals is made difficult by entry barriers such as established brand names (computers), differentiated products (magazines), scale economies in production (air and rail travel), technology patents (pharmaceuticals) or where access to a key input is limited (fine art).
Summary
Demand for any product at a given price will be affected by individual preferences for the product's characteristics, the price of substitutes, and the level of individual consumers' incomes. Developing a pricing scheme based on the maximum amount different customers are willing to pay - known as first degree price discrimination - is difficult. One way of doing this is by auction, but that is only suitable for special and low volume products like art objects or mining rights.
Price discrimination based on the volume of consumer purchases (such as a lower unit price for a six pack and for an individual tin) is known as second degree price discrimination. This approach is often practised by sports clubs or transport providers who charge consumers a flat fee for access and a separate fee for usage. Pricing based on what type of consumer is doing the purchasing rather than the volume of purchasers is known as third degree price discrimination. Here customers can be segmented into different groups, e.g. students and businessmen, defined by their different willingness to pay. Sellers engaged in price discrimination must take steps to ensure that customers do not engage in arbitrage.
Signpost
Applied Microeconomics
The Module resumes with a section on price discrimination. Further sections are scheduled for Parts 15,16,18 and 19. Topics to be covered will include: cartels, monopolies and regulation, entry barriers, R&D and market failure and vertical integration. Previous sections appeared in Parts 9 and 11 and have covered profits, costs and demand, and pricing Related topics can be found in the International Macroeconomy & Competitiveness, Finance and Accounting modules.
Kimya M. Kamshad
Dr. Kimya M. Kamshad is assistant professor of economics at London Business School and research fellow at the Centre for Business Strategy