Should Firms Price Discriminate - Essay Example

?Should Firms Price Discriminate, Why or Why Not? In the contemporary setting of the world, manifold modern business organisations in divergent formsof industries have attempted to develop a tactic to gain competitive advantage in the dynamic market. One type that has received significant recognition in the business world is associated to the companies’ use of price related approaches to deal with the fluctuating demand in the market. Particularly, firms tend to use a pricing tactic, such as price discrimination, in the hope of gaining high competitive advantage. However, pundits argue whether firms must use or not such a pricing technique because of its nature. This notion brings interesting arguments, which may be used to provide firms with salient reasons about when to use it and when they should not. Such concerns will be depicted in this paper and each will be discussed in detail. Price Discrimination Evolution is not only associated to management practices of business organisations, but also to what these organisations are operating for--those are stakeholders. Consumers, being a predominant external customer of companies, have also evolved in terms of their preferences. They collate different prices of similar products offered in different market environments and decide whether or not to buy such a good or service (Turow, 2005, p.125). For instance, consumers can now demand certain attributes of products that these companies produce resulting the market to become dynamic and diversified (Poynor Lamberton & Diehl, 2013, p.394). With such a smart choice, companies also conduct an investigation on their target market and decide whether such a segment is or not a profitable market (Turow, 2005, p.125). In this notion derived the company’s implementation of the so-called “dynamic pricing” or ”tiered pricing,” otherwise known as price discrimination technique, which is a pricing tactic used by firms to charge a different price to different market segments for similar good or service without reasons associated to cost (Elegido, 2011, p.633; Krugman, 2000, p.1; Smith, 2009, p.1). Requirements for Price Discrimination to Work Differences in Price Elasticity of Demand. For price discrimination to work, firms must consider the different price elasticity of demand for each market segment. From this point, companies can charge a maximum price to the market segment with a more price inelastic demand and a minimum price for the market segment with a more elastic demand. With this kind of technique, companies can achieve a higher level of producer surplus from the increase in their total revenue and profits. To increase the profit, the company should exert effort to balance marginal revenue and marginal cost in each group of market (Stigler, 1987, cited in Elegido, 2011, p.635). Barriers to Prevent Consumers Switching. Consumer switching is significant in the theory of consumer preferences wherein the combined effect of their budget constraint and choices can affect the entire decision making process of customers, leading them to switch from one supplier to another (Elegido, 2011, p.637). For price discrimination to work, companies must prevent consumer switching--a method in which lower-priced products that are sold to customers can be resold by the latter to those customers who are willing to pay for its premium price. It must be noted that companies must not use price discrimination if they cannot eliminate the threat of consumer switching as they cannot compete for both types of consumers: “high and low willingness to pay” (Corrocher & Zirulia, 2010, p.150). Paradigms of Price Discrimination First-Degree or Perfect. First-degree or perfect price discrimination is a pricing tactic whereby companies charge each customer a different price for similar products purchased with no cost relation. Three results are prevalent when it comes to using this tactic: an increase of profits, a decrease in the level of consumer surplus, and an increase in the level of producer surplus (Mankiw, 2012, p.316). Meaning to say, there is no deadweight loss in the equation (see Figure 1.1). However, this may be difficult to achieve as (monopolist) companies must have full information about the consumers’ individual preferences and their willingness to pay (Corrocher & Zirulia, 2010, p.151). Given this notion, it can be said that companies must not use price discrimination technique if it cannot accumulate the exact information regarding the choices and budget constraints of all its customers. However, if ever the company chooses to research the market, the transaction costs involved in doing this is the greatest barrier that will impede the company from using the said pricing tactic. Source: adapted from (Mankiw, 2012, p.316) Second Degree. Second degree price discrimination, otherwise known as “volume discounting,” or ”quantity discounting,” is a pricing tactic wherein companies charge lower unit prices for larger quantities of similar products purchased by customers (Barrows & Smithin, 2009, p.105). This tactic is the most widely used in terms of retail businesses (Corrocher & Zirulia, 2010, p.151). While first degree price discrimination charges different prices for individual units of products, second degree price discrimination tends firms to charge different prices for clusters of units. Firms can get higher total return in charging a higher price for each cluster of units than charging a single price for each unit. The salient thing about second degree price discrimination is that it does not require companies to research the individual preferences of the market (Barrows & Smithin, 2009, p.105). As shown in Figure 1.2, a company charges $24 for every 6 blocks of units of the product and $18 for every 6 blocks of units. From this point, there is an increase of consumer surplus, which means that firms generate lower profits than it would have gained it had able to discriminate price perfectly. However, the company would have gained higher profit if it would price all the products similarly. In this respect, customers who purchase small quantities of products will have to pay more than those who buy in bulk (Barrows & Smithin, 2009, p.105). Therefore, in summing this up, firms can discriminate price without any relative transaction cost, but it is better to research the market in order to fathom well the characteristics of the target market. Source: adapted from (Barrows & Smithin, 2009, p.106) Third Degree. Third degree price discrimination, otherwise known as “differential pricing,” is the most common form of pricing tactic in which companies produce different forms of market segments and charges each segment with different prices for similar products they purchased (Barrows & Smithin, 2009, p.106). This can only be possible when firms segment the market according to divergent attributes, such as geographic location, income, types of uses for the good or service, individual preferences, etc. After segmenting the market, firms then charge different prices for each group in spite of the similar transaction costs. Therefore, as long as the company perceives the different elasticity of demand in each of the target segment, the company will gain considerable high returns by grouping such target markets into different groups and charging them with prices in accordance to their elasticity. This approach is the so-called market segmentation (Barrows & Smithin, 2009, pp.106-107). As shown in Figure 1.3, two markets (A and B) have different characteristics. Market A is willing to pay premium prices than those in the market B. In this respect, it can be said that there is less competition in the given market. An incremental result, such as a profitable business operations (MR), usually comes when the market is less competitive. On the contrary, in the market B whereby lower price signifies that firms operating in the market have considerable lower profitability level (MR) because of tough competition. Source: adapted from (Barrows & Smithin, 2009, pp.106-107) Recommendations / Conclusion Altogether, the use of price discrimination strategy heavily depends on the nature of the market and the capacity of the company to combat with the uncertainties in the market. For instance, the company can use price perfect or first degree price discrimination if it operates alone in the market. Thus, it is advisable for firms not to use such a strategy when the competition is very tough. Moreover, second degree price discrimination also posits that companies do not have to understand consumer preferences in pricing the products. From this point, the price of the products must be above the marginal revenue of the company. Therefore, firms will have to charge prices above the marginal cost, which can affect its profitability. On the other hand, the nature of the business must be considered in this type of strategy, leading, therefore, to a conclusion that such a strategy is best applicable for retailers. Lastly, third-degree price discrimination must consider the demand elasticity of the different market segments and the absence of consumer switching in order for the tactic to succeed. Therefore, firms can only use such a tactic when the market is price conscious. It will be difficult for smaller firms to use this kind of strategy because of the transaction cost involved in segmenting the market. To sum up, price discrimination technique is not applicable to all business environments, especially when the market posits no trace of differences in price elasticity of demand and the barriers to prevent consumer switching are vulnerable because of market competition. References Barrows, D. & Smithin, J., 2009. Fundamentals of Economics for Business. 2nd ed. Ontario, Canada: Captus Press Inc. Corrocher, N. & Zirulia, L., 2010. Switching cost, consumer heterogeneity and price discrimination. Journal of Economics, 101 (2), pp.149-167. Elegido, J.M., 2011. The ethics of price discrimination. Business Ethics Quarterly, 21 (4), pp.633-660. Krugman, P., 2000. What price fairness?, viewed November 21, 2013, . Mankiw, N.G., 2012. Principles of Economics. 5th ed. Mason, USA: South-Western Cengage Learning. Poynor Lamberton, C. & Diehl, K., 2013. Retail choice architecture: the effects of benefit- and attribute-based assortment organisation on consumer perceptions and choice. Journal of Consumer Research, 40 (3), pp.393-411. Smith, T., 2009. The case for price discrimination, viewed November 21, 2013, . Turow, J., 2005. Have they got a deal for you: it’s suspiciously cozy in the cybermarket. Washington Post, pp.122-127. Read More