Because most philosophies that frown on reproduction don't survive.

Friday, August 26, 2011

All About Pricing: Price Discrimination

I thought it might be interesting to do an occasional series on how pricing works -- since it's what I do all day and I (clearly a biased source) find it interesting. I flatter myself this might also be educational in that many people don't think much about how pricing works in making a business successful.

One of the important-but-illusive concepts that I deal with a fair amount as a pricer is price discrimination. This is a term which different people use in different ways, and on its own it sounds a bit scary (we don't normally think of "discrimination" as something we want a business to be doing) so I'll define it roughly here at the beginning and then discuss some examples: Price discrimination consists of selling similar or identical products or services to different customers for different amounts of money.

Why would you want to do that?

To be successful, a business needs to meet both its fixed costs and the cost of the goods it sells. Take a restaurant. The fixed costs include rent, the kitchen and wait staff, utilities, advertising, etc. The costs of the goods it sells are the costs of the food ingredients used to make meals for its customers.

If the restaurant gets really, really busy, it might need more staff, but most of the time the cost of keeping the restaurant open for business are the same whether 100 people or 150 people come in for lunch.

So, you're running Egan's Irish Pub and right now your business is just breaking even. It's worth it to you to offer lower prices to new customers if that would increase your traffic, because your fixed costs are already met. But you don't necessarily want to discount all the business that you already have, because then you might find yourself no better off. What do you do?

Well, you could offer a coupon. If you get the coupon mostly to people who aren't already your customers, you increase your sales and the lower price those additional customers are paying is okay because you only have to meet your cost of goods on those sales: your fixed costs are already covered.

You could also offer time dependent discounts. The "happy hour" is a classic example of price discrimination. You pick of a time of day when not many people normally come to your business and offer people who come at that time a special discount. People who really care about getting a good deal will come at that time, while customers who care more about convenience will come at their usual times.

While not a classic example of price discrimination, certain types of product differentiation can be motivated by price discrimination-type thinking. The idea here is to offer one version of your product for value conscious customers, at a lower price, in order to win their business, while steering other customers to a very similar, higher priced product.

In addition to helping businesses make money, there's an odd sort of social justice angle to price discrimination as well. While the purpose of the strategy is to help companies make more money, the result can end up being that those who are truly short of money (and willing to make certain trade-offs as a result) get to pay less for virtually the same product, while those with more money pay more.


Foxfier said...

That's the theory behind store brands that are made by the same folks who make name brands, isn't it? Part of the value of a product is the reputation and presentation, yes?

RL said...

Yes foxfier. However, I have found that there's very little of that practice found anymore. I'm guessing there's two reasons for it.

Consumers knowing, or at least thinking, that it's really the same product make the choice to purchase the store brand at the lower price. There is likely less margin in the store brand for manufacturer. So while you could say the manufacturer gets the sale no matter what, one is more profitable and builds their brand's market share, the other is less profitable and does nothing for the brand.

The other thing I think happened there (this is only a hunch, I have no information on it) is that third party manufacturers offered clone type products to the stores at much lower costs. I'm thinking the model could be based on low cost imports and perhaps handling a large chunk the distribution piece for the stores as well.

John Beegle said...

Hi Darwin,

Thanks for the discussion of pricing, it's an interesting topic. I'm curious -- what type of methods/tools would you use to attempt to optimize pricing?

Bayesian techniques (and tools like SAIC's Causeway)?
Or other statistical methods?
Or Game Theory approaches?

Darwin said...


Given that we're pretty much always dealing with less data than we should in order to be really statistically rigorous, pricers tend to have a bit of a jumbled tool bag.

In my current and recent jobs, I've typically used a mix of basic test, control and extrapolation techniques and statistical regressions on price elasticity for individual products, combined with the cross elasticities of related products.

I try to establish what the relation between product price and daily or weekly unit volume is, and then solve for the profit or revenue maximization point given the product cost.

Commercial pricing software takes this a step further by reading all the cross effects into the model and allowing you to solve for profit or revenue or unit maximization (or specific change targets) across a whole category. (Accounting, for example, that if I put Tide on sale at the super market, then other brands will sell less as some customers switch over to the cheaper product.)