Three Degrees of Price Discrimination

Mohit mentioned in his comment yesterday that it is all about pricing. Takes me back to B-School where the economics Prof. explained the three degrees of price discrimination. Price discrimination is the process of charging different prices to different customers for the same goods, and getting away with it. Better still, if you can get your customers to thank you for charging them higher.

Price Discrimination is not a new concept. It happens at the subji-mandi all the time. I have vivid memories of the time when I was about 8 years old, I haggled the heck out of the vendor, getting him to drop the price of a watermelon to 12 rupees. I remember the smile on his face as I handed over the money. I thought he was admiring how this little kid was negotiating hard. I puffed up my chest nearly to the size of the watermelon, when I showed it off to my mother and asked, "How much do you think I paid for this?" I deflated rapidly at her guess, 10 rupees.

There's price discrimination for you. The vendor charged me the amount that I was willing to pay. This was not perfectly executed though, for I begrudged the seller for 'cheating' me of 2 rupees. How does a company engage in price discrimination and get away with it? That's where the savvy of the marketing blokes comes in.

Essentially, there are three different levels or degrees of price discrimination.

The third degree involves selling the same goods to different segments of customers at different prices, even though the cost of delivering that product or service is essentially the same. Consider the fact the electricity is sold at different rates to industrial customers, households and farmers.

The second degree is when there is a volume discount. Often however, the volume in question is not really large enough to enable savings due to economies of scale at the transaction level. When you buy a pack of ten pens at a stationery store, the unit price might be lower by about 10%. However, at the factory, the change in volume from 1 unit to 10 units has not really caused any change in economies of scale. So also at the fruit vendor, we ask for a drop in price if we are buying 24 oranges instead of the one.

First degree price discrimination is where things get really interesting. This is where the seller actively tries to extract the maximum price that each buyer is willing to pay. This happens all the time in the service industry. Airlines, after deregulation, charge different prices to different customers for the same service. Students willing to book 2 months ahead can fly from say Bangalore to Delhi paying Rs 2400. The businessman who buys the ticket a couple of days before the date of travel could end up paying as high as Rs 20,000. And yet, both of them are traveling the same route at the same time on the same aircraft, arriving at the same time and served the same crew. Crucially, both of them are likely happy with the transaction. If not, they were free to not buy at that price.

The really good marketing companies have learned to sell not just services but even products under first degree price discrimination, i.e. sell the same product to different customers at different prices purely on the basis of the customers willingness to pay . The key is to make the product appear sufficiently different to these different customers. In my post yesterday, I wrote about how the Skoda Octavia, the VW Jetta and the Audi A4 are essentially the same car under the skin. Yet different segments of customers are happily willing to pay vastly different prices, because the product appeals to them at that price.

So the next time you think you are making a statement by buying an Audi instead of a Volkswagen, or a Louis Philippe instead of a Peter England, remember, they love customers like you.