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.