ORGANIZATIONS, MARKETS AND
FINANCE ASSIGNMENT
PRICE DISCRIMINATION – A STRATEGY FOR
COMPETITIVE ADVANTAGE
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CONTENTS
INTRODUCTION........................................................................................................2
PRICING STRATEGY..............................................................................................2
PRICE DISCRIMINATION....................................................................................2
Factors In Price Discrimination....................................................................................3
TYPES OF PRICE DISCRIMINATION.............................................................3
FIRST DEGREE PRICE DISCRIMINATION............................................................4
Use of First Degree Discrimination...........................................................................4
British Airways – Uses First-Degree Discrimination................................................5
SECOND DEGREE PRICE DISCRIMINATION........................................................5
Panasonic – Second-Degree Discrimination.............................................................6
THIRD DEGREE PRICE DISCRIMINATION...........................................................6
British Telecom – Example of Third-Degree Discrimination...................................6
OVERLAPPING OF PRICE DISCRIMINTION............................................6
MARKET STRUCTURE..........................................................................................7
ADVANTAGE OF PRICE DISCRIMINATION..............................................8
COMPETITION COMMISSION..........................................................................8
CONCLUSION..............................................................................................................9
REFERENCES............................................................................................................10
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INTRODUCTION
The competitive atmosphere prevalent in business world has made organizations to look
at different innovative ways to maximize returns on their investment. Every move an
organization makes is calculated with not only customers in mind but also competitor’s
retaliatory moves that one might have to encounter. The ability of organizations to
differentiate in as many forms as possible from their competitors in the eyes of the
customers will decide the amount of competitive advantage an organization might
successfully attain. In order to sustain competitive advantage one factor that customers
will always be enticed to – the price of the products or services sold is very often used by
organizations. This essay will focus on various methods adopted by organizations to use
the price of their products as a method of gaining competitive edge.
PRICING STRATEGY
Every service or product has a perceived value in the mind of the customers. How well
organizations can convince customers that the value offered and price paid are
appropriate will depend on product quality and attributed price when compared with
other similar products offered by competitors in market. Pricing strategy is used by
organizations when there is compromise made on quality of the product (Porter, 1998).
This is normal in essential commodities like food items and in markets which is crowded
with competitors and profit margins are fiercely fought for due to the low margin of
profits. One such pricing strategy used by organizations is “Price Discrimination”.
PRICE DISCRIMINATION
The policy of organization to sell the same goods or services to different groups of
customers at different prices is called Price Discrimination (Wilkinson, 2005). The
organization is able to exploit customers need for products, so much that it is
discriminating one group of customers from another by means of the price it sells it
products in market. In an open market with many competitors, this may not be possible as
customers can easily switch their choice of buyers easily. However in a market where
organizations wield more power like a monopolistic market, or a market the goods sold
are extremely rare and difficult to get, the organizations can use price discrimination as a
strategy to gain enormous profits and market share.
However, there is a misconception that price discrimination is there only in selling.
However, there have been instances where price discrimination is practiced in buying,
leasing and hiring. Nevertheless, the principles behind all of them are very similar. i.e. to
discriminate based on price over different customers for wide range of reasons. (Machlup,
1995)
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Factors In Price Discrimination
For an organization to price discriminate other than their market power one important
factor, which has to be considered, is the price elasticity of demand (E d) of that particular
market. The ability or responsiveness of customers to variations in price is called as price
elastic of demand.
Ed = % change in demand quantity Mankiw (2008)
% Change in price
The other factor organizations using price discrimination strategy should watch out for is
the presence of customers in market who can buy the product at a lower price, sell it at a
higher price, and in effect become potential competitors. For this, organizations must
ensure that different price groups have an adequate opaqueness between them and any
possible transactions between them are never gone unnoticed. This is usually achieved by
making price comparison difficult or information about price availability in different
markets difficult to access or by restricting sharing of price information by creating what
is called a rate fence (Kimes, 2002)
TYPES OF PRICE DISCRIMINATION
Price discrimination is the process of transferring the existing consumer excess or surplus
to the producer. Price discrimination is broadly classified as Direct and Indirect price
discrimination. The direct price discrimination is further classified as first and third
degree price discrimination, whereas the indirect price discrimination is also know as
second-degree price discrimination (McAfee, 2008).
PRICE DISCRIMINATION
Direct Discrimination Indirect Discrimination
(Or)
Second Degree
First Degree Third Degree
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FIRST DEGREE PRICE DISCRIMINATION
This is usually referred to as the perfect or balanced type of price discrimination. In this
case, the entire surplus is transferred to the producer (Armstrong, 2007). This necessitates
the producer to have complete knowledge of customers, with regard to many factors and
like the expected curve for demand and the maximum price, any customer might be
willing to pay at any given point of time. The use of first degree of price discrimination is
entirely subjective and depends on the price elasticity of customers. For example, a
customer with high elasticity is deterred easily by the high price when compared with a
customer with low price elasticity. Hence as mentioned, earlier this type of discrimination
is dependent entirely on the customer. Nevertheless, elasticity of price is not an easy
parameter to be calculated, as this would mean knowing each customers individual
willingness.
Another form of mutually exclusive first-degree discrimination is where customers’
reservations with regard to the maximum price are found and thereby fixing the price as
close as possible to that reservation price. The excess customer in the market is absorbed
and converted in to revenues for the organization (Wilkinson, 2005).
This type of price discrimination is not very common in society nowadays, as customer
tastes vary greatly and hence due to customization it is difficult to sell similar products to
many customers. In addition, the fact that customers have enough knowledge about the
products they intend to consume and that sufficient research into the price and other
related issues are carried out before decision is made on purchase, thus completely
avoiding any shortage of information between different groups. However, in rarity this
type of price discrimination can be spotted.
Use of First Degree Discrimination
As the technological advances make data availability easy, so does the technology and
methods to collect and acquire data. The biggest challenge in first degree price
discrimination is that the price is determined for each and every customer individually,
which means that there is a specific price that each individual is willing to pay and that
should be identified and used to generate revenues.
This kind of price discrimination is very common in airline industries. By monitoring
individual customers for flying hours they have flown, the company is able to give
discounts exclusive to that customer alone, although he is being offered the same facility
as his fellow passenger who might not have had the same price offered to him. To
monitor this requirement of minimum number of flying hours, various data like hours
travelled, frequency of travel in a given specified period of time are all analyzed to offer
this exclusive facilities. For this, as mentioned earlier enormous amount of data mining
and analysis is required and can be done only if sufficient technology is available. This is
actually a trade off which the organization will have to decide upon between the
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enhanced surplus extraction and the ability to win over the intense competition prevalent
in the markets (Ulph, 2000)
British Airways – Uses First-Degree Discrimination
One organization in this industry that has used this form of price discrimination is British
Airways (BA), which has been a leading airway in the world for a very long period. They
track each customer’s number of flying hours and their personal tastes and offer them
specific discounts and special facilities when they have flown for a specific number of
hours with either BA or one of their alliance partners (Gupta, 1999). This type of
approach is an ideal example of first-degree price discrimination where different prices
are offered to different customers to absorb customer surplus and generate revenues. This
method has both advantages and disadvantage. The disadvantage being the fact that
customer due to their increase attachment to the organization might feel uncomfortable
to shift their loyalty even if services are not satisfactory, but at the same time get
advantage of getting the same services for a lesser price when compared to other
customers.
Even though the argument is, first-degree price discrimination is not practicably possible
due to the price information being shared between passengers, in this particular industry
it does exist. Even if the information on price difference is shared between customers,
they do realize that the difference is due to them belonging to different levels as far as
customer loyalty is concerned.
SECOND DEGREE PRICE DISCRIMINATION
This is the type of price discrimination, which takes place depending on the quantity of
product or service consumed by the customer. This might resemble the first-degree
discrimination as in the example above flying hours is also the quantity of service. But
the subtle difference is that in second-degree discrimination the price difference takes
place depending on the quantity sold in each transaction, unlike in first degree, which
takes past record also into consideration. Also in first degree, each customer has the same
demand curve (Fisher, 2002) i.e. each customer will occupy only one seat, even though
he might book additional tickets for his family or friends, his demand or personal
requirement is one seat, whereas in second degree discrimination the demand between
customer varies and is uneven.
This type of price discrimination is non-linear price discrimination, and is very dependent
on a particular parameter like quantity of goods or service sold. An ideal example for this
kind of discrimination would be a sports club where the customer pays an initial amount
of deposit and then pays according to his usage or the number of hours used
(Chakravarty, 2005). Even though for different customer the amount will vary, for two
customers using the same number of hours the price will remain same. This is also called
two-part tariff, where an initial amount is paid and then an amount in accordance with
consumption is paid (This is in complete contrast to first degree where even different
customers using the same facility (like economic class seat in airline industry) might be
charged differently.
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Panasonic – Second-Degree Discrimination
Panasonic cameras are sold individually at a particular price, and their memory stick with
different storage capacity is stored at an entirely different price (Timothy, 2002). When a
customer buys the camera he pays a lump sum for the product, but depending on his
usage of memory (read as quantity used) his memory stick consumption will vary from
another customer, which is an ideal example of second-degree price discrimination.
THIRD DEGREE PRICE DISCRIMINATION
This is the most widely spread and common type of price discrimination. In this method,
the differentiation in the price is made by identifying differences in market segments like
age group or geographical location (Fisher, 2002). The needs of people in different
categories are easy to identify due to their larger numbers and products need not be
customized individually. Also marketing is lot easier in this type of discrimination.
There is a systematic difference in demand for the products such that different customers
in different demographic locations pay a different price for the same product. This is
often referred to as market segmentation based on price, where a single large market is
sub-divide into a number of smaller markets based on demand. This is profitable only as
long as the price elasticity of different groups remain different. Once the price elasticity
becomes similar then there is little difference between the two groups, that it might make
sense to consider them as a single group and make pricing strategies accordingly.
British Telecom – Example of Third-Degree Discrimination
This type of strategy is very common in industries as electricity charges for industries per
unit are much higher when compared to that used in households (Barrows, 2009). This is
due the difference in their geographical location (industries are usually located in
outskirts of city, or their usage is twenty-four hours, unlike households). As can be seen
this price discrimination is not because of the quantity of electricity consumed but
because of their segmentation based on geographic locations or time of usage. The same
principle is used by British Telecom, which charges different rates to phone line usage
during peak hours than when compared to usage during normal hours (Butterworth,
2010). In addition, BT charges different rates to students than it does to professionals so
again discrimination based on their occupation.
OVERLAPPING OF PRICE DISCRIMINTION
Sometimes there is a possibility of overlapping of price discrimination i.e. same customer
might be discriminated in more than one ways. For example, a student who is trying to
start a garment business on his own, purchases garments in bulk quantities of thousand,
and hence might be discriminated on both quantity and segment. As he will be
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discriminated on price for buying bulk quantities (Second Degree discrimination) and
also his position as a student (Third Degree discrimination) in a particular segment.
MARKET STRUCTURE
Price discrimination as a strategy can be successful only in certain markets and different
markets will need different forms of price differentiation. It is usually assumed that if an
organization is practicing monopoly then it can discriminate price in a way they want to
and as much as they want to. However, this is not always the case. Even a monopoly
market can survive only if there is product demand. The monopolistic organizations
ability to differentiate price will depend on the demand curve for the products or services
it offers. Even if the organization is a price setter, they cannot sustain themselves in a
market where their product is not in demand.
In a monopolistic market the maximum profits is obtained when the quantity where MC
and MR intersect is produced. For demand (Di) the point where MC and MRi meets is Qi
and for demand (De) the point where MRe and MC meets is Qe. So when quantities are
sold as per demand (the point of intersection of MC and MR in the TOTAL MARKET
being extended to meet the Demand lines in individual markets 1 and 2) the price at
which they are to be sold can be obtained.
MARKET 1 MARKET 2 TOTAL MARKET
MC
Pe
Pi
PRICE
Di
De MR
MR i MR e
Qi Qe Q
QUANTITY PER PERIOD
(Adapted from Nowsell)
As the product is manufactured in the same place MC will be constant and only MR will
vary as per the revenue obtained from the sale. The key is to keep a higher price where
the elasticity is less i.e. the demand is less responsive to price, which is the steeper of the
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two demand curves (De) and as seen in the graph D e is set at a higher price of P e. Thus,
price discrimination can fetch higher profits provided
The market has difference price elasticity of demand and monopolistic so that
competition is non-existent to prevent customer switching loyalty and the
organization is the price setter.
No seepage of product from lower priced to higher priced market (i.e. no cross
trading)
ADVANTAGE OF PRICE DISCRIMINATION
The following could be said as advantage that could be gained from price discrimination
Increase revenues for the organization
Larger market share due to attracting more customers
By discriminating prices some portions of markets will be at a lower price, this
could prove to be a marketing strategy in the form of price differentiation, instead
of price discrimination by which customer loyalty could be enhanced.
It could cater to different segments of society, like people who cannot afford the
product at a very high price could still be able to use the product from a different
segment where prices are comparatively lower. (Fisher, 2002)
COMPETITION COMMISSION
Competition Commission in general is the authority to investigate all mergers,
acquisitions and market related activities like pricing and demand. Their main job is to
ensure that no activities in these domain take place that are illegal or in a manner that
could affect the balance of the market in a negative manner. They usually conduct inquiry
based on a complaint or after an issue that is raised by appropriate regulators.
One of the main duties is to ensure that the price demand balance in market is maintained
and is not disturbed by any inappropriate corporate activities. They are more dominant in
markets that sell essential items like food products, petroleum products or the items used
for household activities. This is mainly to prevent any unfair pricing polices that might
be taken by organizations operating in certain market.
In markets that sell essential household items like grocery it is necessary the commission
interventions is present so as to regulate the prices of these items as sudden acquisition or
mergers between major players could lead to monopolistic market thereby giving
hardship for consumers.
One of the recent actions taken by the European Competition Commission was to put the
Sun Microsystems, Oracle deal on hold during a recent probe they conducted in to the
deal before it took place (Neate, 2009). As these two are big players in the field of IT
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solutions and the merger could have resulted in reducing the competition further thereby
giving a near monopolistic market.
Thus, the markets that are very important and those that could have quick and large
impact on the daily life of a country’s people are the ones that could be more likely to be
investigated by competition commission.
CONCLUSION
Price discrimination is a very important strategy that is used by many organizations in
today’s competitive business environment. However, there need to be a careful analysis
of the market and the situation that the organization might have to encounter in future
before using this as a primary strategy to gain competitive advantage. As price is a very
important factor and one that could very easily attract customers more than any other
factor it must be very carefully approached.
With the type of product and the segment, varying so does the impact of price
discrimination on the revenues of the organization. Hence, it is necessary for
organizations to use the correct discrimination policy for the correct product in the
correct market to the correct customer.
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