pricing stratagy

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Pricing strategiesFrom Wikipedia, the free encyclopedia

Pricing strategiesforproductsorservicesencompass three main ways to improve profits. These are that the

business owner can cut costs or sell more, or find more profit with a better pricing strategy. When costs arealready at their lowest and sales are hard to find, adopting a better pricing strategy is a key option to stay

viable.

Merely raising prices is not always the answer, especially in a poor economy. Too many businesses have been

lost because they priced themselves out of the marketplace. On the other hand, too many business and sales

staff leave "money on the table". One strategy does not fit all, so adopting a pricing strategy is a learning curve

when studying the needs and behaviors of customers and clients.[1]

Models of pricing

Cost-plus pricing

Cost-plus pricing is the simplest pricing method. The firm calculates the cost of producing the product and adds

on a percentage (profit) to that price to give the selling price. This method although simple has two flaws; it

takes no account of demand and there is no way of determining if potential customers will purchase the product

at the calculated price.

This appears in two forms, Full cost pricing which takes into consideration both variable and fixed costs and

adds a % markup. The other is Direct cost pricing which is variable costs plus a % markup, the latter is only

used in periods of high competition as this method usually leads to a loss in the long run.

Creaming or skimming

In most skimming, goods are sold at higher prices so that fewer sales are needed to break even. Selling a

product at a high price, sacrificing high sales to gain a high profit is therefore "skimming" the market. Skimming

is usually employed to reimburse the cost of investment of the original research into the product: commonly

used in electronic markets when a new range, such asDVDplayers, are firstly dispatched into the market at a

high price. This strategy is often used to target "early adopters" of a product or service. Early adopters

generally have a relatively lower price-sensitivity - this can be attributed to: their need for the product

outweighing their need to economise; a greater understanding of the product's value; or simply having a higherdisposable income.

This strategy is employed only for a limited duration to recover most of the investment made to build the

product. To gain further market share, a seller must use other pricing tactics such as economy or penetration.

This method can have some setbacks as it could leave the product at a high price against the competition.[2]
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Limit pricing

A limit price is the price set by a monopolist to discourage economic entry into a market, and is illegal in many

countries. The limit price is the price that the entrant would face upon entering as long as the incumbent firm

did not decrease output. The limit price is often lower than the average cost of production or just low enough to

make entering not profitable. The quantity produced by the incumbent firm to act as a deterrent to entry is

usually larger than would be optimal for a monopolist, but might still produce higher economic profits than

would be earned underperfect competition.

The problem with limit pricing as a strategy is that once the entrant has entered the market, the quantity used

as a threat to deter entry is no longer the incumbent firm's best response. This means that for limit pricing to be

an effective deterrent to entry, the threat must in some way be made credible. A way to achieve this is for the

incumbent firm to constrain itself to produce a certain quantity whether entry occurs or not. An example of this

would be if the firm signed a union contract to employ a certain (high) level of labor for a long period of time. In

this strategy price of the product become limit according to budget.

Loss leader

A loss leader or leader is a product sold at a low price (i.e. at cost or below cost) to stimulate other profitable

sales. This would help the companies to expand its market share as a whole.

Market-oriented pricing

Setting a price based upon analysis and research compiled from the target market. This means that marketers

will set prices depending on the results from the research. For instance if the competitors are pricing their

products at a lower price, then it's up to them to either price their goods at an above price or below, depending

on what the company wants to achieve .

Penetration pricing

Setting the price low in order to attract customers and gain market share. The price will be raised later once this

market share is gained.[3]

Price discrimination

Setting a different price for the same product in different segments to the market. For example, this can be for

different ages, such as classes, or for different opening times, .

Premium pricing

Premium pricing is the practice of keeping the price of a product or service artificially high in order to encourage

favorable perceptions among buyers, based solely on the price. The practice is intended to exploit the (not
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Target pricing is not useful for companies whose capital investment is low because, according to this formula,

the selling price will be understated. Also the target pricing method is not keyed to the demand for the product,

and if the entire volume is not sold, a company might sustain an overall budgetary loss on the product.

Absorption pricing

Method of pricing in which all costs are recovered. The price of the product includes thevariable costof each

item plus a proportionate amount of thefixed costsand is a form of cost-plus pricing

High-low pricing

Method of pricing for an organization where the goods or services offered by the organization are regularly

priced higher than competitors, but through promotions, advertisements, and or coupons, lower prices are

offered on key items. The lower promotional prices are designed to bring customers to the organization where

the customer is offered the promotional product as well as the regular higher priced products.[5]

Premium decoy pricing

Method of pricing where an organization artificially sets one product price high, in order to boost sales of a

lower priced product.

Marginal-cost pricing

In business, the practice of setting the price of a product to equal the extra cost of producing an extra unit of

output. By this policy, a producer charges, for each product unit sold, only the addition to total cost resulting

from materials and direct labor. Businesses often set prices close to marginal cost during periods of poor sales.

If, for example, an item has a marginal cost of $1.00 and a normal selling price is $2.00, the firm selling the

item might wish to lower the price to $1.10 if demand has waned. The business would choose this approach

because the incremental profit of 10 cents from the transaction is better than no sale at all.

Value-based pricing

Pricing a product based on the perceived value and not on any other factor. Pricing based on the demand for a

specific product would have a likely change in the market place.

Pay what you want

Pay what you want is a pricing system where buyers pay any desired amount for a given commodity,

sometimes including zero. In some cases, a minimum (floor) price may be set, and/or a suggested price may

be indicated as guidance for the buyer. The buyer can also select an amount higher than the standard price for

the commodity.

Giving buyers the freedom to pay what they want may seem to not make much sense for a seller, but in some

situations it can be very successful. While most uses of pay what you want have been at the margins of the
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economy, or for special promotions, there are emerging efforts to expand its utility to broader and more regular

use.

Freemium

Freemium is a business model that works by offering a product or service free of charge (typically digitalofferings such as software, content, games, web services or other) while charging a premium for advanced

features, functionality, or related products and services. The word "freemium" is a portmanteau combining the

two aspects of the business model: "free" and "premium". It has become a highly popular model, with notable

success.

Odd pricing

In this type of pricing, the seller tends to f ix a price whose last digits are odd numbers. This is done so as to

give the buyers/consumers no gap for bargaining as the prices seem to be less and yet in an actual sense are

too high. A good example of this can be noticed in telephone promotions of some countries likeUgandawhere

instead of writing the price as sh. 40000, they write it as sh. 39999. This pricing policy is common in economies

using the free market policy.

Nine Laws of Price Sensitivity and Consumer Psychology

In their book, The Strategy and Tactics of Pricing, Thomas Nagle andReed Holdenoutline nine "laws" or

factors that influence how a consumer perceives a given price and how price-sensitive they are likely to be with

respect to different purchase decisions.[6][7]

They are:

1. Reference Price Effectbuyers price sensitivity for a given product increases the higher the

products price relative to perceived alternatives. Perceived alternatives can vary by buyer segment,

by occasion, and other factors.

2. Difficult Comparison Effectbuyers are less sensitive to the price of a known or more reputable

product when they have difficulty comparing it to potential alternatives.

3. Switching Costs Effectthe higher the product-specific investment a buyer must make to switch

suppliers, the less price sensitive that buyer is when choosing between alternatives.

4. Price-Quality Effectbuyers are less sensitive to price the more that higher prices signal higher

quality. Products for which this effect is particularly relevant include: image products, exclusive

products, and products with minimal cues for quality.

5. Expenditure Effectbuyers are more price sensitive when the expense accounts for a large

percentage of buyers available income or budget.
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6. End-Benefit Effectthe effect refers to the relationship a given purchase has to a larger overall

benefit, and is divided into two parts: Derived demand: The more sensitive buyers are to the price of

the end benefit, the more sensitive they will be to the prices of those products that contribute to that

benefit. Price proportion cost: The price proportion cost refers to the percent of the total cost of the

end benefit accounted for by a given component that helps to produce the end benefit (e.g., think CPU

and PCs). The smaller the given components share of the total cost of the end benefit, the less

sensitive buyers will be to the component's price.

7. Shared-cost Effectthe smaller the portion of the purchase price buyers must pay for themselves,

the less price sensitive they will be.

8. Fairness Effectbuyers are more sensitive to the price of a product when the price is outside the

range they perceive as fair or reasonable given the purchase context.

9. The Framing Effectbuyers are more price sensitive when they perceive the price as a loss rather

than a forgone gain, and they have greater price sensitivity when the price is paid separately rather

than as part of a bundle.

Individual pricing Strategies In Detail

Limit pricing

A limit priceis thepriceset by amonopolistto discourage entry into amarket,and is illegal in many

countries. The limit price is the price that a potential entrant would face upon entering as long as the

incumbent firm did not decrease output. The limit price is often lower than the average cost of production

or just low enough to make entering not profitable. Such apricing strategyis called limit pricing.[1]

The quantity produced by the incumbent firm to act as a deterrent to entry is usually larger than would be

optimal for a monopolist, but might still produce highereconomic profitsthan would be earned

underperfect competition.

The problem with limit pricing as strategic behavior is that once the entrant has entered the market, the

quantity used as a threat to deter entry is no longer the incumbent firm'sbest response.This means that

for limit pricing to be an effective deterrent to entry, the threat must in some way be made credible. A way

to achieve this is for the incumbent firm to constrain itself to produce a certain quantity whether entry

occurs or not. An example of this would be if the firm signed a union contract to employ a certain (high)

level of labor for a long period of time.[2]Another example is to build excess production capacity as a

commitment device.

Simple Example
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In a simple case, suppose industrydemandfor good X at market price P is given by:

Suppose there are two potential producers of good X, Firm A, and Firm B. Firm A has nofixed costsand

constantmarginal costequal to . Firm B also has no fixed costs, and has constant marginal cost

equal to , where (so that Firm B's marginal cost is greater than Firm A's).

Suppose Firm A acts as a monopolist. The profit-maximizing monopoly price charged by Firm A is then:

Since Firm B will never sell below its marginal cost, as long as , Firm B will not enter the

market when Firm A charges . That is, the market for good X is an effective monopoly if:

Suppose, on the contrary, that:

In this case, if Firm A charges , Firm B has an incentive to enter the market, since it can sell a

positive quantity of good X at a price above its marginal cost, and therefore make positive profits. In order

to prevent Firm B from having an incentive to enter the market, Firm A must set its price no greater

than . To maximize its profits subject to this constraint, Firm A sets price (the limit price).
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Cost-plus pricing

Cost-plus pricingis apricingmethod used by companies to maximize their profits.

The firms accomplish their objective ofprofit maximizationby increasing their production untilmarginal

revenueequalsmarginal cost,and then charging a price which is determined by thedemand curve.However,

in practice, most firms use cost-plus pricing, also known as markup pricing. There are several varieties, but

the common thread is that one first calculates the cost of the product, then adds a proportion of it asmarkup.

Basically, this approach sets prices that cover the cost of production and provide enough profit margin to the

firm to earn its targetrate of return.[1]It is a way for companies to calculate how much profit they will make.

Cost-plus pricing is often used on government contracts (cost-plus contracts), and has been criticized as

promoting wasteful expendisesdirect costs,indirect costs,andfixed costswhether related to the production

and sale of the product or service or not. These costs are converted to per unit costs for the product and then a

predetermined percentage of these costs is added to provide a profit margin.

Cost-plus pricing is used primarily because it is easy to calculate and requires little information. Information on

demand and costs is not easily available, managers have limited knowledge as far as demand and costs are

concerned. This additional information is necessary to generate accurate estimates of marginal costs and

revenues. However, the process of obtaining this additional information is expensive. Therefore, cost-plus

pricing is often considered the most rational approach in maximizing profits. This approach relies on arbitrary

costs and arbitrary markups.

Mechanics of cost-plus pricing

There are two steps which form this approach. The first step involves calculation of the cost of production, and

the second step is to determine the markup over costs.

1. Calculation of cost of production

The total cost has two components: Total Variable cost and Total fixed Cost.In either case,costs are computed

on an average basis. That is

AC = AVC + AFC

Where

AVC = TVC /Q

AFC = TFC /Q

AC= average cost

AVC=Average variable cost

AFC=Average fixed cost
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TVC=Total variable cost

TFC=Total fixed cost

Q=Quantity (the number of units produced)

In this approach, the quantity is assumed.In cost-plus pricing we use quantity to calculate price but price is the

determinant of quantity.To avoid this problem, the quantity is assumed.This rate of output is based on some

percentage of the firm's capacity.[1]

2. Determining the markup over costs

The objective of this approach is to set prices in a manner that a firm earns its targeted rate of return. Now, if

that return is Rs.X(Rs.= Ratio of the respective share) of total profit then the markup over costs on each unit of

output will beX/Qand then the price will be: P = AVC + AFC + X /Q[1]

Reasons for wide use

Firms vary greatly in size, product range, product characteristics etc. Firms also face different degrees of

competition in markets for their products. So, a clear explanation cannot be given for the widespread use of

cost-plus pricing. However the following points explain as to why this approach is widely used:[2]

Even if a firm handles many products, this approach provides the means by which fair prices can be found

easily

This approach involves calculation of full cost. Prices based on full cost look factual and precise and may

be more defensible on moral grounds than prices established by other means

This approach reduces the cost ofdecision-making.Firms which prefer stability use cost-plus pricing as a

guide to price products in an uncertain market where knowledge is incomplete

Firms are never too sure about the shape of their demand curve neither are they very sure about the

probable response to any price change.So, it becomes risky for a firm to move away from cost-plus pricing

Unknown reaction of rivals to the set price is a major uncertainty.When products and production processes

are similar competitive stability is achieved by usage of cost-plus pricing. This competitive stability is

achieved by setting a price that is likely to yield acceptable returns to other members of the industry

Management tends to know more about product costs than any other factors which can be used to price a

product Insures seller against unpredictable, or unexpected later costs

Ethical advantages (seejust price)

Simplicity

Ready availability

Price increases can be justified in terms of cost increases
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[edit]Usefulness

Cost-plus pricing is specially useful in the following cases:

Public-utility Pricing

Finding out the design of the product when the selling price is predetermined i.e. product tailoring.By

working back from this price,the product and the permissible cost is decided upon.This means that market

realities are taken into account as this approach considers the viewpoint of the buyer in terms of what he

wants and what he will pay

Pricing products that are designed to the specification of a single buyer-the basis of pricing is the

estimated cost plus gross margin that the firm could have got by using facilities otherwise

Cost-plus pricing is useful in cases like 'MonopsonyBuying' - here, the buyers have enough knowledge

aboutsuppliers'costs.Thus, they may make the product themselves if they do not comply with the offered

prices. So,relevant costwould be the cost which a buying company would incur if it made the product

itself

[edit]Disadvantages

Providesincentive for inefficiency

Tends to ignore the role of consumers

Tends to ignore the role of competitors

Uses historical rather thanreplacement value

Uses normal or standard output level to allocate fixed costs

Includessunk costsrather than just using incremental costs

Ignoresopportunity cost

Cost-plus pricing and economic theory

Cost-plus pricing might appear to be inconsistent with theeconomic theoryofprofit maximization.Analysis

based on marginal cost equals marginal revenue decision rule may appear to have become irrelevant due to

the wide use of cost-plus pricing.However, this conflict is more apparent than real. A comparison of the two

approaches to pricing starts with a consideration of costs. Cost-plus pricing is based on average costs and not

marginal costs.However, in economic theory long-run marginal and average costs are not very different. Thus,

it can be said safely that usage of average costs for pricing may be considered a reasonable approximation of

marginal cost decision making.[3]

Second step in comparison involves the target rate of return and the resulting markup. Determination of the

target rate of return depends on certain factors. Basically, the decision involves management's perception of

demand elasticity and competitive conditions. This can be explained with an example,consider grocery
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stores.Profits are held down to the intense competition that exists among these firms. Due to this intense

competition the markup for most food items is only about 12 percent over cost. If the markup over cost is based

on demand conditions,cost-plus pricing may not be inconsistent with profit maximization. This can be shown

mathematically.[1]

Marginal revenue is the derivative of total revenue with respect to quantity. Thus

MR = d (TR)/ dQ = d (PQ)/ dQ = P + dP*Q /dQ

(P + dP *Q /dQ)can also be written as P (1 + dPQ /dQP).Here, (dP /dQ) (Q /P) is 1/EP, where EPis price

elasticity of demand. Thus

MR = P (1 + 1/EP)(equation 1)

In order to maximize profit MR should be equal to MC.To simplify the assumption let MC=AC. Thus the profit

maximizing price is the solution to

P (1 + 1/EP) = AC

which can be written as

P (EP+ 1 /EP) = AC

Solving for P yields

P = AC (EP/EP+ 1)(equation 2)

Equation 2 can be interpreted as a cost-plus pricing or markup pricing scheme.That is the price of the product

is based on markup over average costs. (EP+ 1 /EP) which is the markup is a function of the price elasticity of

demand. From the equation we can see that the markup and the price elasticity of demand are inversely

related, as the demand becomes more elastic the markup becomes smaller.[
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Loss leader PricingFrom Wikipedia, the free encyclopedia

A loss leader, or simply a leader,[1]is a product sold at a low price (at cost or below cost)[2]to stimulate other

profitable sales. It is a kind ofsales promotion,in other wordsmarketingconcentrating on apricing strategy.Aloss leader is often a popular article. Sometimes leaderis now used as a related term and means any popular

article, in other words one sold at a normal price.[3]

Sales of other items in the same visit

One use of a loss leader is to drawcustomersinto a store where they are likely to buy other goods. The vendor

expects that the typical customer will purchase other items at the same time as the loss leader and that the

profit made on these items will be such that an overall profit is generated for the vendor.

Loss Leaddescribes the concept that an item is offered for sale at a reduced price and is intended to leadto

the subsequent sale of other items, the sales of which will be made in greater numbers, or greater profits, or

both. It is offered at a price below its minimum profit marginnot necessarily below cost. The firm tries to

maintain a current analysis of its accounts for both the loss lead and the associated items, so it can monitor

how well the scheme is doing, as quickly as possible, thereby never suffering an overall net loss.

An example is asupermarketsellingsugarormilkat less than cost to draw customers to that particular

supermarket.

Marketing academics have shown that retailers should think of both the direct and indirect effect of substantial

price promotions when evaluating their impact on profit.

[4]

To make a very precise analysis one should alsoinclude effects over time. Deep price promotions may cause people to bulk-buy (stockpile), which may

invalidate the long-term effect of the strategy. This is theassociation ruleanalysis.[5]

When automobile dealerships use this practice, they offer at least one vehicle below cost and must disclose all

of the features of the vehicle (including theVIN). If the loss leader vehicle has been sold, the salesperson tries

to sell a more upscale trim of that vehicle at a slightly discounted price, as a customer who has missed the loss

leading vehicle is unlikely to find a better deal elsewhere.

Characteristics of loss leaders

A loss leader may be placed in an inconvenient part of the store, so that purchasers must walk past other

goods which have higherprofit margins.

A loss leader is usually a product that customers purchase frequentlythus they are aware that its

unusually low price is a bargain.
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Loss leaders are often scarce, to discourage stockpiling. The seller must use this technique regularly if he

expects his customers to come back.

The retailer will often limit how much a customer can buy.

Some loss leader items are perishable, and thus can't be stockpiled

Some examples of typical loss leaders include milk, eggs,rice,and other inexpensive items that grocers

wouldn't want to sell without other purchases.

Examples

Therazor and blades business model,pioneered by American businessmanKing C. Gillette,is similar to the

loss leader business model.Razorhandles are given away for free or sold at a loss, but sales of disposable

razor blades are very profitable. Since the late 1990s, this model has proven very popular and successful

forinkjet printermanufacturers, where profit is derived from the sale of expensive ink cartridges.

In 1910, the City of Pasadena criticized the private Edison Gas and Electric Company for giving away free

electric lamps to solicit new electricity subscribers.[6]

In 1979, American businessmanEarl Muntzdecided to sell blank tapes andVCRsas loss leaders to attract

customers to his showroom, where he would then try to sell them highly profitable widescreen projection TV

systems of his own design. His success continued through the early 1980s.[7]

Inkjet andlaser printersare also often sold to retail customers below their margin price and could also be

viewed as loss leaders. Some of the printers, especially the entry-level models, are sold at a loss-leading price

which seems apparently affordable to most consumers, but they pay the regular price for ink cartridges or

toner, and specialty papers supplied by the manufacturer. The manufacturer also limits the customers' options

by not supporting third party ink, including refills. This analysis more closely parallels the strategies of tying and

bundling products, however. A disadvantage to this model is the waste caused when the printers are priced

below the refills, causing savvy consumers to treat their printers as disposable and replace them every t ime

they run out.

Loss leaders can be an important part of companies' marketing and sales strategies, especially

duringdumpingcampaigns.

Video game consoleshave often been sold at a loss while software and accessory sales are highly profitable to

the console manufacturer, a tactic first utilized in thesixth generation era.Sony and Microsoft, with

theirPlayStation 2andXbox,had prohibitively high manufacturing costs so they were forced to sell their

consoles at a loss, and these losses widened especially in 20022003 when both sides tried to grab market

share with price cuts.Nintendohad a different strategy with itsGameCube,which was considerably less

expensive to produce than its rivals, so it retailed at break-even or higher prices. In the current generation of

consoles; bothSonyandMicrosofthave sold their consoles, thePlaystation 3andXbox 360,respectively, at a
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loss and made up for it through game software and accessory profits (Nintendo again prices itsWiiat break-

even or higher prices, as it is cheaper to make). For this reason, console manufacturers aggressively protect

their profit margin against piracy by pursuing legal action against carriers ofmodchipsandjailbreaks.

Dangers

In recent years, loss leader pricing has been practiced with considerable success, especially by large national

discount retailers. The strategy is not without controversy, however. Indeed, many states have passed laws

that severely limit or explicitly forbid selling products below cost. Lawsuits alleging that some loss leader pricing

strategies amount to illegal business practices have increased in recent years, though the plaintiffs have not

always been victorious. Opponents of loss leading pricing practices argue that the strategy is basically

predatory in nature, designed to ultimately force competitors out of business.
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Penetration pricing

Penetration pricingis thepricingtechnique of setting a relatively low initial entry price, often lower than

the eventual market price, to attract new customers. The strategy works on the expectation that customers

will switch to the newbrandbecause of the lower price. Penetration pricing is most commonly associated

with amarketingobjective of increasing market share or sales volume, rather than to make profit in the

short term.

The advantages of penetration pricing to the firm are:

It can result in fastdiffusionand adoption. This can achieve highmarket penetrationrates quickly. This

can take the competition by surprise, not giving them time to react.

It can create goodwill among the early adopterssegment.This can create more trade throughword ofmouth.

It creates cost control and cost reduction pressures from the start, leading to greater efficiency.

It discourages the entry of competitors. Low prices act as a barrier to entry (seePorter's 5-forces

analysis).

It can create high stock turnover throughout thedistribution channel.This can create critically

important enthusiasm and support in the channel.

It can be based onmarginal cost pricing,which is economically efficient.

The main disadvantage with penetration pricing is that it establishes long term price expectations fortheproduct,and image preconceptions for thebrandand company. This makes it difficult to eventually

raise prices. Some commentators claim that penetration pricing attracts only the switchers (bargain

hunters), and that they will switch away as soon as the price rises. There is much controversy over

whether it is better to raise prices gradually over a period of years (so that consumers dont notice), or

employ a single large price increase. A common solution to this problem is to set the initial price at the long

term market price, but include an initial discount coupon (seesales promotion). In this way, the

perceivedprice pointsremain high even though the actual selling price is low.

Another potential disadvantage is that the low profit margins may not be sustainable long enough for the

strategy to be effective.

Price Penetration is most appropriate where:

Product demand is highlyprice elastic.

Substantialeconomies of scaleare available.
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The product is suitable for a mass market (i.e. enough demand).

The product will face stiff competition soon after introduction.

There is not enough demand amongst consumers to makeprice skimmingwork.

In industries where standardization is important. The product that achieves high market penetration

often becomes the industry standard (e.g. Microsoft Windows) and other products, whatever their

merits, become marginalized. Standards carry heavy momentum.

A variant of the price penetration strategy is the bait and hook model (also called therazor and blades

business model), where a starter product is sold at a very low price but requires more expensive

replacements (such as refills) which are sold at a higher price. This is an almost universal tactic in the

desktop printer business, with printers selling in the US for as little as $100 including two ink cartridges

(often half-full), which themselves cost around $30 each to replace. Thus the company makes more

money from the cartridges than it does for the printer itself.

Taken to the extreme, penetration pricing becomespredatory pricing,when a firm initially sells a product or

service at unsustainably low prices to eliminate competition and establish amonopoly.In most countries,

predatory pricing isillegal,although it can be difficult to differentiate illegal predatory pricing from legal

penetration pricing.
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Price discriminationFrom Wikipedia, the free encyclopedia

Price discriminationor price differentiation[1]exists when sales of identical goods or services are transacted

at differentpricesfrom the same provider.[2]In a theoretical market withperfect information,perfect substitutes,

and notransaction costsor prohibition on secondary exchange (or re-selling) to preventarbitrage,price

discrimination can only be a feature ofmonopolisticandoligopolisticmarkets,[3]wheremarket powercan be

exercised. Otherwise, the moment the seller tries to sell the same good at different prices, the buyer at the

lower price can arbitrage by selling to the consumer buying at the higher price but with a tiny discount.

However, product heterogeneity,market frictionsor high fixed costs (which make marginal-cost pricing

unsustainable in the long run) can allow for some degree of differential pricing to different consumers, even in

fully competitive retail or industrial markets. Price discrimination also occurs when the same price is charged to

customers which have different supply costs.

The effects of price discrimination onsocial efficiencyare unclear; typically such behavior leads to lower prices

for some consumers and higher prices for others. Output can be expanded when price discrimination is very

efficient, but output can also decline when discrimination is more effective at extracting surplus from high-

valued users than expanding sales to low valued users. Even if output remains constant, price discrimination

can reduce efficiency by misallocating output among consumers.

Price discrimination requiresmarket segmentationand some means to discourage discount customers from

becoming resellers and, by extension, competitors. This usually entails using one or more means of preventing

any resale, keeping the different price groups separate, making price comparisons difficult, or restricting pricinginformation. The boundary set up by the marketer to keep segments separate are referred to as a rate fence.

Price discrimination is thus very common in services where resale is not possible; an example is student

discounts at museums. Price discrimination inintellectual propertyis also enforced by law and by technology.

In the market for DVDs, DVD players are designed - by law - with chips to prevent an inexpensive copy of the

DVD (for example legally purchased in India) from being used in a higher price market (like the US). TheDigital

Millennium Copyright Acthas provisions to outlaw circumventing of such devices to protect the enhanced

monopoly profits that copyright holders can obtain from price discrimination against higher price market

segments.

Price discrimination can also be seen where the requirement that goods be identical is relaxed. For example,

so-called "premium products" (including relatively simple products, such as cappuccino compared to regular

coffee) have a price differential that is not explained by the cost of production. Some economists have argued

that this is a form of price discrimination exercised by providing a means for consumers to reveal their

willingness to pay.
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Types of price discrimination

First degree price discrimination

This type of price discrimination is primarily theoretical because it requires the seller of a good or service to

know the absolute maximum price (orreservation price)that every consumer is willing to pay. By knowing the

reservation price, the seller is able to absorb the entire market surplus, thus taking all of theconsumer's

surplusfrom the consumer and transforming it into revenues. From a social welfare perspective though, first

degree price discrimination is not necessarily undesirable. That is, the market is entirely efficient and there is

nodeadweight lossto society. In a market with first degree price discrimination, the seller(s) simply captures all

surplus. This type of market does not exist much in reality, hence it is primarily theoretical. Examples of where

this might be observed are in markets where consumers bid for tenders, though still, in this case, the practice

ofcollusive tenderingundermines efficiency.

Second degree price discriminationIn second degree price discrimination, price varies according to quantity sold. Larger quantities are available

at a lower unit price. This is particularly widespread in sales to industrial customers, where bulk buyers enjoy

higher discounts.

Additionally to second degree price discrimination, sellers are not able to differentiate between different

types of consumers. Thus, the suppliers will provide incentives for the consumers to differentiate themselves

according to preference. As above, quantity "discounts", or non-linear pricing, is a means by which suppliers

use consumer preference to distinguish classes of consumers. This allows the supplier to set different prices to

the different groups and capture a larger portion of the total market surplus.

In reality, different pricing may apply to differences in product quality as well as quantity. For example, airlines

often offer multiple classes of seats on flights, such as first class and economy class. This is a way to

differentiate consumers based on preference, and therefore allows the airline to capture more consumer's

surplus.

Third degree price discrimination

In third degree price discrimination, price varies by attributes such as location or by customersegment,or in

the most extreme case, by the individual customer's identity; where the attribute in question is used as a proxy

for ability/willingness to pay.

Additionally to third degree price discrimination, the supplier(s) of a market where this type of discrimination

is exhibited are capable of differentiating between consumer classes. Examples of this differentiation are

student or senior discounts. For example, a student or a senior consumer will have a different willingness to

pay than an average consumer, where the reservation price is presumably lower because of budget
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constraints. Thus, the supplier sets a lower price for that consumer because the student or senior has a more

elasticPrice elasticity of demand(see the discussion ofPrice elasticity of demandas it applies to revenues

from the first degree price discrimination, above). The supplier is once again capable of capturing more market

surplus than would be possible without price discrimination.

Note that it is not always advantageous to the company to price discriminate even if it is possible, especially for

second and third degree discrimination. In some circumstances, the demands of different classes of consumers

will encourage suppliers to ignore one or more classes and target entirely to the rest. Whether it is profitable to

price discriminate is determined by the specifics of a particular market.

Fourth degree price discrimination

In fourth degree price discrimination, prices are the same for different customers, however costs to the

organization may vary. For example, one may buy a plane ticket, but call ahead to order a vegetarian meal,

possibly costing the company more to provide, but your ticket has no greater cost to you. This is also known as

reverse price discrimination, as the effects are reflected on the producer.

Combination

These types are not mutually exclusive. Thus a company may vary pricing by location, but then offer bulk

discounts as well. Airlines use several different types of price discrimination, including:

Bulk discounts to wholesalers, consolidators, and tour operators

Incentive discounts for higher sales volumes to travel agents and corporate buyers

Seasonal discounts, incentive discounts, and even general prices that vary by location. The price of a flight

from say, Singapore to Beijing can vary widely if one buys the ticket in Singapore compared to Beijing (or

New York or Tokyo or elsewhere).

Discounted tickets requiring advance purchase and/or Saturday stays. Both restrictions have the effect of

excluding business travelers, who typically travel during the workweek and arrange trips on shorter notice.

First degree price discrimination based on customer. It is not accidental that hotel or car rental firms may

quote higher prices to their loyalty program's top tier members than to the general public. [citation needed]

Modern taxonomy

The first/second/third degreetaxonomy of price discrimination is due to Pigou (Economics of Welfare, 4th

edition, 1932). See, e.g.,modern taxonomy of price discrimination.However, these categories are not mutually

exclusive or exhaustive. Ivan Png (Managerial Economics,2nd edition, 2002) suggests an alternative

taxonomy:

Complete discrimination-- where each user purchases up to the point where the user's marginal benefit

equals the marginal cost of the item;
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Direct segmentation-- where the seller can condition price on some attribute (like age or gender)

that directlysegments the buyers;

Indirect segmentation-- where the seller relies on some proxy (e.g., package size, usage quantity,

coupon) to structure a choice that indirectlysegments the buyers.

The hierarchycomplete/direct/indirectis in decreasing order of

profitability and

information requirement.

Complete price discrimination is most profitable, and requires the seller to have the most information about

buyers. Indirect segmentation is least profitable, and requires the seller to have the least information about

buyers.

Two part tariff

the two part tariff is another form of price discrimination where the producer charges an initial fee then a

secondary fee for the use of the product, an example of this is razors, you pay an initial cost for the Gillet razor

and then pay for the replacement blades, this pricing strategy works because it shifts the demand curve to the

right since you have already paid for the initial blade holder you will buy the blades which are now cheaper than

buying a disposable razor, the formulea for profit from a two part tariff is =PQ+nT-C1(Q)-C2(n) where is

profit P is price Q is quantity n is number of customers (who pay tariff) C is cost

so re written it is = (price x quantity + number of people x tariff) - the cost of producing that quantity - the cost of

producing the tariff (blade holders)

Explanation


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Sales revenue without and with Price Discrimination

The purpose of price discrimination is generally to capture the market'sconsumer surplus.This surplus arises

because, in a market with a single clearing price, some customers (the very low price elasticity segment) wouldhave been prepared to pay more than the single market price. Price discrimination transfers some of this

surplus from the consumer to the producer/marketer. Strictly, a consumer surplus need not exist, for example

where some below-cost selling is beneficial due to fixed costs or economies of scale. An example is a high-

speed internet connection shared by two consumers in a single building; if one is willing to pay less than half

the cost, and the other willing to make up the rest but not to pay the entire cost, then price discrimination is

necessary for the purchase to take place.

It can be proved mathematically that a firm facing a downward sloping demand curve that is convex to the

origin will always obtain higher revenues under price discrimination than under a single price strategy. This can

also be shown diagrammatically.

In the top diagram, a single price (P) is available to all customers. The amount of revenue is represented by

area P, A, Q, O. The consumer surplus is the area above line segment P, A but below the demand curve (D).

With price discrimination, (the bottom diagram), the demand curve is divided into two segments (D1 and D2). A

higher price (P1) is charged to the low elasticity segment, and a lower price (P2) is charged to the high
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elasticity segment. The total revenue from the first segment is equal to the area P1,B, Q1,O. The total revenue

from the second segment is equal to the area E, C,Q2,Q1. The sum of these areas will always be greater than

the area without discrimination assuming the demand curve resembles a rectangular hyperbola with unitary

elasticity. The more prices that are introduced, the greater the sum of the revenue areas, and the more of the

consumer surplus is captured by the producer.

Note that the above requires both first and second degree price discrimination: the right segment corresponds

partly to different people than the left segment, partly to the same people, willing to buy more if the product is

cheaper.

It is very useful for the price discriminator to determine the optimum prices in each market segment. This is

done in the next diagram where each segment is considered as a separate market with its own demand curve.

As usual, the profit maximizing output (Qt) is determined by the intersection of the marginal cost curve (MC)

with the marginal revenue curve for the total market (MRt).

Multiple Market Price Determination

The firm decides what amount of the total output to sell in each market by looking at the intersection of

marginal cost with marginal revenue (profit maximization). This output is then divided between the two markets,

at the equilibrium marginal revenue level. Therefore, the optimum outputs are Qa and Qb. From the demand

curve in each market we can determine the profit maximizing prices of Pa and Pb.

It is also important to note that the marginal revenue in both markets at the optimal output levels must be equal,

otherwise the firm could profit from transferring output over to whichever market is offering higher marginal

revenue.

Given that Market 1 has aprice elasticity of demandof E1 and Market of E2, the optimal pricing ration in

Market 1 versus Market 2 is .

Examples of price discrimination
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Retail price discrimination

In certain circumstances, it is a violation of theRobinson-Patman Act,(a 1936 Federal U.S. antitrust statute) for

manufacturers of goods to sell their products to similarly situated retailers at different prices based solely on the

volume of products purchased.

Travel industry

Airlinesand other travel companies use differentiated pricing regularly, as they sell travel products and services

simultaneously to different market segments. This is often done by assigning capacity to various booking

classes, which sell for different prices and which may be linked to fare restrictions. The restrictions or "fences"

help ensure that market segments buy in the booking class range that has been established for them. For

example, schedule-sensitive business passengers who are willing to pay $300 for a seat from city A to city B

cannot purchase a $150 ticket because the $150 booking class contains a requirement for a Saturday night

stay, or a 15-day advance purchase, or another fare rule that discourages, minimizes, or effectively prevents a

sale to business passengers.

Notice however that in this example "the seat" is not really always the same product. That is, the business

person who purchases the $300 ticket may be willing to do so in return for a seat on a high-demand morning

flight, for full refundability if the ticket is not used, and for the ability to upgrade to first class if space is available

for a nominal fee. On the same flight are price-sensitive passengers who are not willing to pay $300, but who

are willing to fly on a lower-demand flight (say one leaving an hour earlier), or via a connection city (not a non-

stop flight), and who are willing to forgo refundability.

On the other hand, an airline may also apply differential pricing to "the same seat" over time, e.g. bydiscounting the price for an early or late booking (without changing any other fare condition). This could present

an arbitrage opportunity in the absence of any restriction on reselling. However, passenger name changes are

typically prevented or financially penalized by contract.

Since airlines often fly multi-leg flights, and since no-show rates vary by segment, competition for the seat has

to take in the spatial dynamics of the product. Someone trying to fly A-B is competing with people trying to f ly

A-C through city B on the same aircraft. This is one reason airlines useyield managementtechnology to

determine how many seats to allot for A-B passengers, B-C passengers, and A-B-C passengers, at their

varying fares and with varying demands and no-show rates.

With the rise of the Internet and the growth of low fare airlines, airfare pricing transparency has become far

more pronounced. Passengers discovered it is quite easy to compare fares across different flights or different

airlines. This helped put pressure on airlines to lower fares. Meanwhile, in the recession following the

September 11, 2001, attacks on the U.S., business travelers and corporate buyers made it clear to airlines that

they were not going to be buying air travel at rates high enough to subsidize lower fares for non-business
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travelers. This prediction has come true, as vast numbers of business travelers are buying airfares only in

economy class for business travel.

There are sometimes group discounts on rail tickets and passes. This may be in view of the alternative of going

by car together.

Coupons

The use of coupons in retail is an attempt to distinguish customers by their reserve price. The assumption is

that people who go through the trouble of collecting coupons have greater price sensitivity than those who do

not. Thus, making coupons available enables, for instance, breakfast cereal makers to charge higher prices to

price-insensitive customers, while still making some profit off customers who are more price-sensitive.

Premium pricing

For certain products, premium products are priced at a level (compared to "regular" or "economy" products)

that is well beyond theirmarginal costof production. For example, a coffee chain may price regular coffee at

$1, but "premium" coffee at $2.50 (where the respective costs of production may be $0.90 and $1.25).

Economists such asTim Harfordin theUndercover Economisthave argued that this is a form of price

discrimination: by providing a choice between a regular and premium product, consumers are being asked to

reveal their degree of price sensitivity (or willingness to pay) for comparable products. Similar techniques are

used in pricing business class airline tickets and premium alcoholic drinks, for example.

This effect can lead to (seemingly)perverse incentivesfor the producer. If, for example, potential business

class customers will pay a large price differential only if economy class seats are uncomfortable while economy

class customers are more sensitive to price than comfort, airlines may have substantial incentives to purposely

make economy seating uncomfortable. In the example of coffee, a restaurant may gain more economic profit

by making poor quality regular coffeemore profit is gained from up-selling to premium customers than is lost

from customers who refuse to purchase inexpensive but poor quality coffee. In such cases, the net social utility

should also account for the "lost" utility to consumers of the regular product, although determining the

magnitude of this foregone utility may not be feasible.

Segmentation by age group and student status

Manymovie theaters,amusement parks,tourist attractions,and other places have different admission prices

per market segment: typical groupings are Youth, Student, Adult, and Senior. Each of these groups typically

have a much different demand curve. Children, people living on student wages, and people living on retirement

generally have much lessdisposable income.

Discounts for members of certain occupations
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Many businesses, especially in theSouthern United States,offer reduced prices to activemilitarymembers. In

addition to increased sales to the target group, businesses benefit from the resulting positive publicity, leading

to increased sales to the general public. Less publicized are discounts to other service workers such aspolice;

off-duty police customers in high-crime areas are said to constitute free security.[citation needed]

Employee discounts

Most people feel that discounts businesses give to their own employees are an employee benefit (and is often

listed as such in the employee handbook). However, some might construe this as a form of price discrimination.

Retail incentives

A variety of incentive techniques may be used to increase market share or revenues at the retail level. These

include discount coupons, rebates, bulk and quantity pricing, seasonal discounts, and frequent buyer d iscounts.

Incentives for industrial buyers

Many methods exist to incentivize wholesale or industrial buyers. These may be quite targeted, as they are

designed to generate specific activity, such as buying more frequently, buying more regularly, buying in bigger

quantities, buying new products with established ones, and so on. Thus, there are bulk discounts, special

pricing for long-term commitments, non-peak discounts, discounts on high-demand goods to incentivize buying

lower-demand goods, rebates, and many others. This can help the relations between the firms involved.

Sex-based examples

Many sex-based price differences are held to be illegal but still occur often in countries such as theUnited

Statesand theUnited Kingdom.

Ladies' n ight"

Many North American and Europeannightclubsfeature a "ladies' night" in which women are offered discount or

free drinks, or are absolved from payment ofcover charges.This differs from conventional price discrimination

in that the primary motive is not, usually, to increase revenue at the expense of consumer surplus, but to

increase the club's attractiveness to the market side more willing to pay (men), for the benefit of the other

(women). (See alsotwo-sided market)

Dry cleaning

Dry cleaners typically charge higher prices for the laundering of women's clothes than for men's. Some US

communities have reacted by outlawing the practice. Dry cleaners justify the price differences because

women's clothes

pricing stratagy

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