Have you ever searched for an airfare only to find that the price for a particular flight has increased significantly compared to when you searched a few days later?
Or have you noticed that some people pay less to access the same subscription service you pay for? What about that time when you could have bought the same pair of jeans a day later than when it was special at the semi-annual sale?
These are all examples of price discrimination, where a company charges different groups of people different prices for the same product or service. There are three classic forms of price discrimination:
- First degree discrimination is when a company calculates the maximum possible price for each unit sold based on each individual customer’s ability to pay
- Second degree discrimination is when a company charges a different price for different quantities purchased by a customer
- Third degree discrimination is when companies charge different prices to different groups of customers
There are some conditions for a company to apply first-degree discrimination.
First, it is ideal for the company to operate in a monopoly market where it controls the supply. If there are multiple suppliers, the customer may switch to another provider.
Second, the company needs to know the maximum amount the customer is willing to pay for its product or service. A good understanding of the customer is essential.
Third, the company must prevent the resale of products or services by the customer to other customers, otherwise there may be cases where their customer makes a profit through resale.
Fourth, each customer reacts differently to price changes that reflect their willingness to pay and preferences.
Examples of second-degree discrimination including buying three items and getting the fourth for free or buying six items to get 20% off the entire order. While second-degree discrimination is often associated with e-commerce companies to achieve economies of scale through bulk purchases, it can also be applied to software companies.
Have you ever committed to subscribing a year in advance instead of paying the regular price monthly because you get 20% off? Or how about paying a little more to get access to the family edition so that instead of one user account you can now give four users from your household the same access?
Compared to other forms of price discrimination, second-degree discrimination does not require detailed segmentation of customers. It is also effective at boosting demand as bulk discounts can encourage customers to buy more than usual. Tools such as coupons, loyalty cards, and bulk offers are often associated with second-degree discrimination.
You have experienced third-degree discrimination if you go to the cinema where the adult ticket is $20, the child ticket is $10, the youth ticket is $14, and the senior ticket is $16.
All people see the same movie in the same theater at the start and end times, but the theater operator has decided that in order to maximize their revenue, it should charge its customers different prices and discriminate based on age.
How to segment customers
There are many ways to segment customers.
In Australia, the banks are known for this, where the customer has to pay a premium for loyalty! When banks are eager to take out new home loans, they offer discounts on their standard interest rates to attract new customers. As these new customers become loyal and long-term, the discounts decrease, with the better rates being offered to the bank’s new customers.
That’s why it pays to shop around every few years for a better deal.
While price discrimination is technically based on a company selling the same product or service to different customers, it is often used in conjunction with product differentiation to maximize the economics of the business unit. Product differentiation describes how companies differentiate their product or services from competitors.
Horizontal product differentiation occurs when, for the same price, only a few customers will choose one product and the rest will choose other products. Vertical product differentiation occurs when all customers prefer one product over another for the same price.
Add product differentiation
A classic combination of price discrimination and product differentiation can be seen when purchasing different software.
For its classic sales and service product, Salesforce has four product versions: essentials, professional, enterprise, and unlimited. All products are sold per user per month and are billed annually. The essentials product costs $35 per user per month and has three main features. The professional product costs $140 with five key features. That’s a step up from $105!
The enterprise product costs $245 with the same five key features, but is highly customizable. The unlimited product is $455, with seven key features that are an increase of $210.
Salesforce has cleverly segmented its customers into different groups (small, medium, and large enterprises) and provided differentiated offerings (the mid-range products have pipeline and forecast management features, but only the top product has 24/7 support and configuration services) that set them apart and their competitors.
By using both price discrimination and product differentiation, Salesforce maximizes the revenue they generate from their customers.
How could you use price discrimination and product differentiation to deliver better products to your customers and increase your revenue?
- Benjamin Chong is a partner at venture capital firm Right click on capital letterinvestors in bold and visionary tech founders.