Have you ever searched for airfare only to find that the price of a particular flight has increased significantly compared to when you searched a few days later?
Or have you noticed that some people are paying less for the same subscription service you are paying? What did you do during those semi-annual clearance specials where you could buy the same pair of jeans one day later?
These are all examples of price discrimination, where a business charges different prices for the same product or service to different groups of people. There are three classic types of price discrimination:
- Primary discrimination When a business charges the best possible price for each unit sold based on each customer’s ability to pay.
- Secondary discrimination When a business charges different prices for different quantities purchased by a customer.
- Tertiary discrimination When businesses charge different prices to different groups of customers.
There are certain prerequisites for applying primary discrimination to a business.
First, it is best to operate in a monopoly market where the business controls supply. If there are multiple providers, the customer may switch to another provider.
Secondly, the business must know the maximum amount the customer is willing to pay for their product or service. A deep understanding of the customer is key.
Third, the business must prevent the customer from selling products or services sold by the customer to other customers, otherwise there may be opportunities for the customer to profit from reselling.
Fourth, each customer has a different response to price changes that reflects their willingness and preferences to pay.
Examples of secondary discrimination include buying three items and getting the fourth free, or buying six items to get 20% off the total order. While second-degree discrimination is associated with ecommerce businesses thanks to bulk purchases, it can also apply to software businesses.
Do you commit to signing up for a year instead of paying the regular monthly price because you’ll get 20% off? Or pay a little more to get access to the family edition, so instead of a single user account, you can now have four users from your family have the same access?
Compared to other forms of price discrimination, secondary discrimination does not require segmentation of the customer list. Bulk discounts are also effective in stimulating demand as they encourage customers to buy more than usual. Tools such as coupons, loyalty cards, and bulk discounts are often associated with secondary discrimination.
When you go to the movies where adult tickets are $20, child tickets are $10, youth tickets are $14, and senior tickets are $16, you are facing third degree discrimination.
Everyone is watching the same movie when it starts and ends at the same theater, but the theater operator decides to charge customers different prices and discriminate based on age to maximize revenue.
How to segment customers
There are many ways to segment customers.
Banks are famous for this reason in Australia where the customer is paid a premium for loyalty! When banks want to write new home loans, they offer discounts on regular interest rates to attract new customers. As these new customers become loyal and long-term, the discounts will be reduced, giving the bank better value for new customers.
That’s why it pays to shop around every few years for a better deal.
Although price discrimination is technically based on 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 a business differentiates its products or services from its competitors.
Horizontal product differentiation occurs when at the same price only some customers choose one product while the rest choose other products. Vertical product differentiation occurs when all customers at the same price choose one product over the others.
Increasing product diversity
A classic combination of price discrimination and product differentiation occurs when buying different software.
For its typical sales and service product, Salesforce has four product versions: Essentials, Professional, Enterprise, and Unlimited. All products are sold per user per month and billed annually. The essential product is $35 per user per month and has three key features. The professional product is $140 with five key features. That’s an increase of $105!
The Enterprise product is $245 with the same five key features but is more deeply customizable. The unlimited product is $455, with seven key features at the $210 level.
Salesforce cleverly divided its customers into different groups (small, medium and large enterprises) and offered different offerings (mid-range products have pipeline and forecast management features, but the highest range has 24/7 support and configuration services) that distinguish them from each other and from their competitors.
By using both price discrimination and product differentiation, Salesforce is increasing the revenue they generate from their customers.
How can you use price discrimination and product differentiation to offer better products to your customers and increase your revenue?
- Benjamin Chong is a partner at Right Click Capital, an investor firm of bold and visionary tech founders.
