Price Discrimination is All Around You
This is the first in a series of articles that will show how we’re at a turning point in the history of price discrimination and discuss the consequences. This article presents numerous examples of traditional price discrimination that you see today, many of which are funny, sad, or downright devious.
Price discrimination, more euphemistically known as differential pricing and dynamic pricing, exploits the fact that in any transaction each customer has a different “willingness to pay.”
What is “willingness to pay,” and how does the seller determine it? To illustrate, let me quote a hilarious story by Steve Blank on selling enterprise software. The protagonist is one Sandy Kurtzig.
Since it was the first non-IBM enterprise software on IBM mainframes, [when] she got her first potential order, she didn’t know how to price it. It must have been back in the mid-’70s. She’s [with] this buyer, has a P.O. on his desk, negotiating pricing with Sandy.
So, Sandy said she goes into the buyer who says, “How much is it?”
And Sandy gulped and picked the biggest number she thought anybody would ever rationally pay. And said, “$75,000″. And she said all the buyer did was write down $75,000.
And she realized, shit, she left money on the table. … And she said, “Per year.”
And the buyer wrote down, “Per year.”
And she went, oh, crap what else? She said, “There’s maintenance.”
He said, “How much?”
“25 percent per year.”
And he said, “That’s too much.”
She said, “15 percent.”
And he said, “OK.”
Sadly, not all transactions are as much fun as pricing enterprise software ;-) The price usually has to be determined without meeting the buyer face to face. There are three types of price discrimination based on how the price is determined:
- Each buyer is charged a custom price. (Traditionally, there has never been enough data to do this.)
- Price depends on an attribute of the buyer such as age or gender.
- Different price for different categories of buyers, with the seller somehow getting the buyer to reveal which category they fall into. As we’ll see, hilarity frequently ensues.
Additionally, each buyer may be sold the same product, or it could be customized to each segment—in the extreme case, to each buyer. This is called product differentiation.
Alright. Time to dive into some examples.
1. Student discounts at movies, museums, etc. are one of the simplest types of price discrimination. Students are generally poorer and more price sensitive, so the business hopes to attract more of them by making it cheaper.
Why museums and movies, and not say grocery stores? Two reasons: first, if the grocery store tried it, they’d quickly run into the problem of resale by the group that qualifies for the lower price. (It could manifest as parents sending their kids to get groceries.) The museum doesn’t have this problem because they ask for a student ID.
Second, grocery stores set prices pretty close to their marginal cost anyway, so there’s not as much of a scope for variable pricing. With museums, on the other hand, it costs them next to nothing to admit an extra visitor. All of their costs are fixed costs.
2. Ladies’ night at bars is another simple example of price discrimination based on an attribute (gender). Rather than women having a lower willingness to pay, it is perhaps more accurate to say that men are more desperate to get in :-)
Interestingly, this is one of the few examples whose legality is questionable. Wikipedia has a good survey. Also, it is not a “pure” example since the point of ladies’ night is not just to get more women through the door but also, indirectly, to get more men through the door.
3. A less obvious example is the variation of gas prices (and other commodities) within the same chain across locations. This is because people in richer ZIP codes are willing to pay more on average.
An important caveat: some of the variation is typically explainable by differences in marginal cost (such as rent) between different locations, but not all of it.
4. Financial aid at universities is a rather complex case of price discrimination. Instead of charging different rates to different students, the seller has a base rate and gives discounts (aid) to qualifying students.
You can see aid programs in humanitarian/political terms or in economic terms; the two paradigms are not in conflict with each other. In the economic view, students with higher scores receive aid because they have more college options and are therefore more price-sensitive. Poorer students and minorities receive aid because they are less able/willing to pay.
In the examples so far, the attribute(s) that factor into discrimination are either obvious (gender, race, location) or it is in the buyer’s interest to disclose them to the seller (student status, financial need). Now let’s look at examples where the seller has to be crafty in getting the buyer to disclose it.
The same principle applies to numerous other product categories like wine and coffee. But at least you’re getting at least a nominally superior product for a higher price. Let’s look at examples where buyers voluntarily pay more for the same product.
6. Dell.com used to ask customers if they were home users, small businesses, or other categories. The prices for the same products varied according to the category you declared. There was no legally binding reason to be honest about your disclosure, and no enforcement mechanism.
Now for a more devious example.
7. “Staples brazenly sends out different office supply catalogs with different prices to the same customers. The price-sensitive buyers know which to buy from. The inattentive ones pay extra.” [source]
A similar example: restaurants with long menus sometimes highlight some popular choices on the first page. The same items are available in the long-form menu for cheaper, if only you knew where they’re buried.
These examples illustrate an extremely common form of price discrimination:
This theme is so fundamental that it has been practiced for thousands of years in the form of haggling.
8. The jumping-through-hoops principle suggests that it makes economic sense for the seller to make discounts hard to get. Nowhere is this more apparent than with Black Friday deals—stand in ridiculously long lines all night to get fabulous discounts. Wealthier customers who don’t bother doing so will get much less of a discount during regular store hours, even on Black Friday.
9. More examples of hard-to-get discounts: woot.com, mailing-list deals and Southwest Airlines DING. Many of these involve artificial scarcity and time-limitations to make them more difficult to get, thus ensuring that those who take advantage are buyers who might otherwise not buy at all.
10. Perhaps the most extreme example of roping in buyers who might otherwise not buy is deliberately crippling your own product, known in economics as damaged goods.
IBM did this with its popular LaserPrinter by adding chips that slowed down the printing to about half the speed of the regular printer. The slowed printer sold for about half the price, under the IBM LaserPrinter E name.
It is not because of the few thousand francs which would have to be spent to put a roof over the third-class carriages or to upholster the third-class seats that some company or other has open carriages with wooden benches. What the company is trying to do is to prevent the passengers who can pay the second class fare from traveling third class; it hits the poor, not because it wants to hurt them, but to frighten the rich. And it is again for the same reason that the companies, having proved almost cruel to the third-class passengers and mean to the second-class ones, become lavish in dealing with first-class passengers. Having refused the poor what is necessary, they give the rich what is superfluous.
These examples should make clear that:
11. There are endless examples of clever tricks to learn the customer’s price-sensitivity in the airline industry. The price for the same seat can vary greatly depending on a variety of factors. The most well-known one is that you get lower prices if your trip spans a weekend, because it probably means you’re not a business traveler.
12. First class and business class seating on airlines is also price discrimination, but of a very different kind. Here it’s not different prices for the same product but different prices for slightly different products. Buyers segment themselves due to product differentiation, a phenomenon we’ve seen before with cars.
The first class/economy price spread can often be as high as 10x, which illustrates the wide range of customers’ willingness to pay. For a variety of reasons, most other markets haven’t managed to attain such a high price spread.
Aaaaaand we’re done with the examples!
Note that this is far from a complete list—I haven’t covered clearance sales, loyalty programs and frequent flyer miles, hi-lo pricing, drug prices that vary by country, and so forth, but I hope I’ve convinced you that price discrimination in some form already happens in nearly every market.
But here’s the kicker: I’ve deliberately left out what I consider the most important class of examples, because I’m going to devote a whole article to it. I will argue that this emerging form of price discrimination is going to explode in popularity and dwarf anything we’ve seen so far. Feel free to guess what I’m thinking about in the comments, and stay tuned!
Many thanks to Justin Brickell, Alejandro Molnar and Adam Bossy for useful discussions and comments. Thanks also to my Twitter followers for putting up with my ‘tweetathon’ on this topic two months ago and providing feedback.