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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*
Impact of market segmentation
Unsegmented Segment 1 Segment 2 Total
Change %
Average price
4800 31050
Gross contribution
800 12050
• 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
Group pricing, exactly the same
• 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
• 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
• 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; RobinsonPatman 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
• Airlines web-only fares are not available through travel
– Continental Airlines – a $325 ticket costs $43 to distribute
through a travel agent and $18 through company web site –
• 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
• 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
– 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
– 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
• 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. lifecycle 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
• 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
• 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
A magazine, on the other hand, is interested in as many sales as possible
Volume discounting and
• Historically, the „big three“ US automakers
were a oligopsony
• Very large freight consolidators or e.g. WalMart 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)=$392 and
Optimal pricing with arbitrage
• A situation to avoid, except when arbitrageur has lower
transportation cost – in which case which it could
become the distributor
• If the price-response curve is continuous and
downward sloping, there exists a single optimum
• Often, the prices are determined for major markets
(e.g. North America, Western Europe, Japan) and price
bands are used for smaller markets
• We are dealing with the members of the triad, but
could just as well consider regions or cities
• Transportation costs do not have to be symmetric –
e.g. taxes imposed on imports
Optimal pricing with cannibalization
• The more the low-price product cannibalizes the
high-price product, the higher we need to price
the low-price product
• At alpha=0.36, no more low-w.t.p. customers are
buying and the only low-price customers are
cannibalized high-w.t.p. customers
• Breakeven point at alpha=0.13, at that point we
are better off without segmenting – even low
rates of cannibalization can outweigh the benefits
of price differentiation
Finding the optimal market segments
• A seller needs to identify groups with differing
wtp. and to be able to price differently
• If the widget maker could choose the ideal way to
divide the market into two segments, how should
he do it, in order to maximize contribution?
• The ideal would be to segment the market at
wtp. 10$, 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