The Complete Guide to Price Discrimination for Entrepreneurs

Stewardess assisting a passenger with ticket in airport

In business, discrimination of any kind towards potential or existing customers is considered a strict no-no – and rightly so. But the concept of price discrimination is a departure from this norm of sorts; it is a legitimate practice studied extensively in microeconomics.

It is also an important and widely utilised pricing strategy, meaning that budding entrepreneurs and small business owners should have a clear understanding of what it is and what it entails. To illustrate the various benefits and disadvantages, we've compiled a breakdown of the basic concept behind this strategy, its variations, and how it can be employed effectively by various kinds of businesses.

What is Price Discrimination?

You may have noticed businesses selling the same product or service at different rates to different customers. Take the case of educational software or subscription to online research journals; these are usually available at a discount to schools and universities, while you would have to pay a premium as an individual customer.

Another common example is the price of airline tickets. If you purchase a seat three months in advance, you will likely secure it at a far cheaper rate than a person who buys the same ticket a few hours before the flight. Other examples include restaurants, theme parks, and other entertainment-based establishments offering discounts to children, families, students or senior citizens.

These are all cases in point of price discrimination in action, and are based on the concept that not all customers possess the same level of demand or purchasing power for a product or service. Some consumers may be willing to pay a premium, while others may require a discount to encourage them to buy. 

Types of Price Discrimination

To this end, there are three primary forms of price discrimination: 

First Degree

First-degree price discrimination involves a business varying the price of a product on a case-by-case basis for each individual customer. For instance, an expert salesperson in a luxury boutique may gauge the purchasing power of a customer just by looking at their appearance, and quoting a premium price as a result. In a more modern setting, large online businesses often gather and analyse sophisticated data on consumers that allows them to employ this type of pricing strategy. 

Second Degree

This model refers to the practice of businesses offering differential pricing based on the number of goods a consumer buys. At many consumer goods stores, for instance, buying in bulk can gain you significant discounts. This approach is fairly common in both the B2B and B2C segments; a classic example is discounts on annual internet or telephone plans, encouraging customers to commit to longer-term contracts rather than paying on a monthly basis. 

Third Degree

Third-degree price discrimination is most common in the retail and consumer areas of the market. It involves dividing consumers into various segments based on age, gender, or occupation of the buyers; it is also the most accessible type of price discrimination for smaller businesses. Perhaps surprisingly, this is one of the most accepted forms of price discrimination among buyers.

For the remainder of this article, we will focus on third-degree price discrimination and how it can work for your organisation.

How to Execute Third-Degree Price Discrimination 

As touched upon, this is a strategy where your business should take into consideration how much an individual customer may be able to pay. In some cases, you may be able to charge a premium, while in others you may be compelled to give a discount.

For price discrimination to work, you will usually need to categorise buyers into various categories based on certain shared features or attributes. This could be the gender of the customer; ladies’ nights are quite common at nightclubs, for instance, and this can be considered as a form of price discrimination.

Age could also be a key factor, with restaurants often offering discount pricing for children's' meals. Senior citizens and retired individuals regularly pay less for public transport, while students, who don't have a regular income, are often given discounts by publishers, restaurants, and other businesses. Even a customer's occupation can be relevant; many organisations offer concessions to military personnel or healthcare workers, a practice that can tie into the promotion of their core brand values.

These various forms of discounts, coupons, and other incentives are common types of price discrimination, with industries such as travel, software, hospitality and leisure commonly deploying such strategies. 

Essential Factors

For your business to be in a position to execute price discrimination successfully, two conditions are absolutely essential:

1. Knowledge About Buyers 

It is essential that you possess an extensive knowledge and understanding of your target market and its consumers. You should have the necessary intelligence in place to divide buyers into clear-cut categories based on their price sensitivity. 

Take the example of airline customers. Business-class travellers, for instance, have inelastic demand, meaning that they are more willing to pay a higher price for a ticket. Airlines often charge this segment accordingly. Tourists, on the other hand, have elastic demand, meaning that they are usually more sensitive to spikes in prices. Therefore, airlines usually offer discounted prices to this segment.

The ability to continuously differentiate between these two groups is an important aspect of employing a price discrimination strategy. Without this capability, you will likely under or overcharge many of your potential customers.

2. An Ability to Enforce the System

If left to their wits and devices, buyers will usually find a way to abuse these price discrimination systems. Indeed, in keeping with the example of airlines, there are companies committed to exploiting pricing loopholes or errors and passing on the subsequent savings to their customers (for a fee, of course). Alternatively, consumers may take matters into their own hands; a tourist may purchase a discount ticket and attempt to sell it at a profit to a business traveller, for instance.

To combat such occurrences, companies usually implement various policies and conditions within the purchasing agreement. The most popularly adopted one is that airline tickets cannot now be resold to another customer, while airlines also enforce advance booking requirements for discounts that are not practical for business travellers.    

The Benefits of Price Discrimination

At its core, price discrimination has a simple objective: to optimise revenue. In any given marketplace, both buyers and sellers are in pursuit of the perfect price – where both parties derive maximum value. 

However, the reality is that businesses have to deal with a wide range of customers. One static pricing strategy may only appeal to one section of your target market, while other buyers may be put off by the price of the product. In other instances, there may be buyers who would be willing to spend more on that product.

Therefore, a price discrimination strategy allows you to target these segments that would otherwise have been missed by the default or normal price of your product or service. When done judiciously, it has the potential to bring in more sales and profits.

Is Price Discrimination Legal? 

Finally, it is pertinent to consider the ethical and even legal ramifications of price discrimination. Fairness is a fundamental concept for most people, with discrimination of any guise contraindicating this universal human principle. In a business context, this sentiment is no different, with the majority of consumers having a negative attitude towards price discrimination (especially first-degree).

That said, second and third-degree price discrimination is more tolerated, especially if your business is able to provide ample justification for the price variation. For instance, most people understand and accept the reasoning behind price discounts for students, seniors, and children.

What is certainly unacceptable – and, indeed, in many jurisdictions, illegal – is any pricing strategy that discriminates based on race, religion, or nationality. Gender is a more complex case, as it is illegal to discriminate based on this factor in some places; that viewpoint is not universal, though, and as we have seen, there is a perceived acceptance in this regard in certain industries.

Price discrimination may also be considered illegal if it falls foul of antitrust laws, or legislation that is designed to combat illegal or unfair price-fixing. For instance, if a wholesaler sells at a discount to one particular chain of retail shops while charging a premium for other individual businesses, then this is considered price-fixing as it negatively affects the concept of a free market based on supply and demand.

However, in all other instances, price discrimination is a legal, effective and widely adopted pricing strategy that, when properly researched and implemented, can yield maximum revenues for your organisation. It may be worth considering in your own niche, especially if you are operating in a sector that is conducive to the practice.

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