Price Discrimination and Market Segmentation - Case Study Example

PRICE DISCRIMINATION AND MARKET SEGMENTATION Client Insert Name Client Insert Institution Client Insert Date Price Discrimination and Market Segmentation Introduction The concept of price discrimination, which is also called price differentiation, is a situation where service providers charge different prices for the same quantity and quality of goods or services sold to its clients. It is a business strategy that helps a business to establish competitive advantage within the market. According to Frank (2010), this strategy is very instrumental for organizations trying to settle within a market by optimizing profit margins based on the different supply and demand developments among consumers. It is a market segmentation strategy that identifies different consumer categories within the market to apply this pricing strategy where prices of products and services are charged to those consumers who are not only able to pay for the services and products but also willing to do so. This strategy eliminates consumer surplus within the market but Frank (2010) contends that it is usually very difficult to determine the exact level of pricing that is sufficient for each market segment identified. This paper provides a discursive analysis of the economic theory of second and third degree price discrimination providing conditions that are necessary for these strategies to be applied in a real life experience. The theoretical Basis of Price Discrimination Concept in Market Segmentation There is a theoretical basis that defines price discrimination as a strategy for business development especially in dealing with changing market trends and dynamism. According to McCloskey & Ziliak (2013), markets that have perfect information, substitutes and lacking any form of transaction costs aimed at preventing arbitrage, the concept of price discrimination remains a central feature of oligopolistic and monopolistic markets. Here, there is room for exercising market power since any other form of market dynamisms would not allow this strategy to thrive. For instance, in any event that a service provider tries to sell the same product or service to buyers at different prices, the buyer who buys the product or service at a lower price can easily arbitrate by selling the same product/service to the buyers buying them at a higher price but with a small discount for their own benefit (Whaples 2006). This notwithstanding, various attributes of the market such as market friction, product heterogeneity and high fixed costs which collectively make it unsustainable to have marginal-cost pricing in the market make it possible to have a certain level of degree of differentiation in pricing of goods and services sold to consumers (Frank 2010). This can happen in fully competitive industrial and retail markets and depend on the creativity that is employed in ensuring that the strategy is well implemented. With the different approaches that are taken in enforcing this strategy within the market, there have been studies that have sought to determine its effects on social efficiency and the findings have been inconclusive in this regard. In the cases where the pricing discrimination strategy is very efficient in its implementation, it is possible to expand output of units sold which is good for profit optimization and effective business growth (Frey, Werner, Pommerehne & Gilbert 2008). In addition to this, for price discrimination to be fully implementable, it is important that there be market segmentation allowing a means to discourage discount consumers from becoming sellers of the very products/services sold to them to other buyers in the market just as there is a level of restraint on what competitors can do as regards becoming resellers of merchandises sold (Shapiro 2012). In order to achieve this, Frank (2010) indicates that there are different strategies that can be used to as follows: Attempts should be made to ensure that the price groups are separated and maintained differently Attempts should be made to ensure that price comparisons are made difficult Attempts could also be made to ensure that pricing information is restricted and held in confidence These efforts are made to establish what is called the Rate Fence, the boundary that the marketer sets to keep the segments to which the different prices are implemented separate. This means that this strategy works well in situations where resale is not easily possible in such cases as student discounts at museums and theaters. This means that by virtue of someone being a student, they are allowed discounted rates on payments of some services and it is not possible to resell such offers since the services paid for can only be enjoyed by the person(s) themselves (Vernon 2012). This strategy can also be used in areas of intellectual property which is governed by the law and technology which has requires that DVDs for instance be produced with special hardware and software that prevents copying of their content at lower prices elsewhere around the world (Shapiro 2012). This restricts prices for the products in a manner reminiscent to what price discrimination strategy does to the general market. Different Types of Price Discrimination There are three different price discrimination strategies that are applied in different situations based on the prevailing market trends and these are as follows: 1. First degree price discrimination – this is also called perfect price discrimination and it occurs when an organization, charges different prices for merchandises based on the units consumed (Kennedy 2003). 2. Second degree price discrimination – this refers to the case where an organization charges a different price for different quantities as is the case in providing discounts for bulky purchases (Jean-Baptiste 2010). 3. Third degree price discrimination – this refers to the process where buyers charge different prices for goods and services to different consumer groups as is the case of commercial flights where different consumer groups pay different amounts to fly in different consumer categories such as economy class and business class (Pesaren 2010). This paper focuses on second and third degree price discrimination as economic theories that are important in price discrimination strategy of business development and focus will also be on how the different market segments in which these strategies exist are maintained. Second Degree Price Discrimination Economic Theory As has been described above, second degree price discrimination charges different prices for different quantities of products or blocks of outputs from an organization. In this case, buyers pay one price for a given product and a subsidized price for any additional unit that they consumer or buy in forms of discounts that are levied on the extra units that are consumed (Krugman & Obstfeld 2010). Using this strategy, there is no need to gather information about the potential of every buyer to purchase the goods being sold but instead the prices are provided for different products based on the preferences that are observed in the market among different consumer groups (Tobin 2014). The clearest way of application of this strategy usually is in what is referred to as quantity discounts where customers are allowed to purchase products at a relatively lower price when they do so in bulk and these prices are not offered to those customers that purchase single items (Samuelson 2010). It is a strategy that is largely used in warehouse retailers and in more recent times, the strategy has been used in organizations that offer loyalty cards to frequent customers allowing them discounted purchases when they attain a certain level of points (Blaug 2007). As indicated by Krugman & Obstfeld (2010), second degree price discrimination does not entirely eliminate consumer surplus but it does allow organizations to increase their profit margins based on its consumer base. For example, electric companies all over the world use this strategy in charging for services for its clients where they charge a given amount for units consumed and subsidizes the amount for subsequent units consumed. For instance, a company may charge 10 cents per kilowatt hour for the first 200 kilowatt hours of electricity that is consumed every month. Any additional units between 201 to 1000 kilowatt hours are charged 5 cents per unit and 3 cents is charged for any additional units used over 1000 kilowatt hours. What does this mean from a purely economic point of view? Organizations that use second degree price discrimination has a marginal revenue curve which presents itself as a series of steps. It is has a horizontal line that corresponds to the given price identified for a given block of output as shown in figure 1 below. Fig 1. Second Degree Price Discrimination Graphical Representation Source: (Krugman & Obstfeld 2010, p. 232). From the figure, the Average Total Cost (ATC) and Marginal Cost (MC) have the typical shape that is common to them. From this example, the market demand curve is downward sloping corresponding to the organization’s demand curve, D=d and in order to derive the Marginal Revenue Curve (MRC), it is important to observe from the curve that PA is charged for each unit in block output from 0 to qA. This means that for every unit above qA (from qA to qB), a lower price of PB is charged and from this the marginal revenue steps down to a lower unit price, PB. The same process of lowering prices for additional units happens from qB to q0 charging P0 and the marginal revenue reduces further to P0 and the process continues as long as there are additional units above those set at a given level and the Marginal Revenue (MR) represents this series of steps depicting the second degree price discrimination graph (Samuelson & Nordhaus 2004). For organizations seeking to use this strategy for the purposes of ensuring profit optimization, organizations usually seek to produce their output levels in a way that it is at a point where MR = MC which corresponds to the q0 output on figure 1 above. In this way, such organizations the company instead of charging single price, it charges price PA for the block output units purchased from 0 to qA, and PB for units obtained from qA and qB and then price P0 for the remaining block of units obtained and the process continues with newer prices for extra block of units obtained (Belleflamme & Peitz 2010). In doing this, the profit obtained from each of the bulk units sold is obtained by getting the difference in price and average total cost and from the graph; the shaded area in figure 1 above represents the profit that the organization gets (Howitt 2000). Third Degree Price Discrimination Economic Theory As has been defined above, third degree price discrimination refers to the case where a seller charges different prices to buyers based on differentiated groups in which they find themselves in the market. These different groups may be demarcated by location, age, ethnicity, sex, or socio-economic standing in the society (Brody 2000). Given its wide application and convenience it causes for both buyers and sellers, third degree price discrimination is the commonest price discrimination strategy that is used by organizations around the world. In other words, this strategy is used to charge different prices for consumer groups that have different demand elasticities which are further differentiated based on intrinsic characteristic that define them locally, gender-wise, among other characteristics. This means that there are many examples that provide situations where this strategy is used in pricing products and services within the market and the commonest of these examples is the children and senior citizen discounts that are provided in the market for different services and products. This is based on the fact that the market of children and families that have smaller children naturally tend to have their demand elasticities being slightly lower than the rest of the market especially for eateries and accommodation services (Jordan 2008). An example of how this strategy can be applied is in organizations offering movie services to the general public. When such an organization is big enough to command a considerable amount of the market, it is able to institute price discrimination in its business operations by offering different price options for different groups within its target market (Pride & Ferrell 2011). In most cases, the prices are usually discriminated based on age where younger movie goers may be offered lower prices as compared to older movie goers. Figure 2 shows a graph depicting this strategy where the overall goal is to maximize profits which is achieved by equating Marginal Revenue (MR) and Marginal Cost (MC) as shown in the figure below. Fig. 2: Three Degree Price Discrimination Graphical Representation Source: (Frank 2010, p. 54) Conditions Necessary for Price Discrimination to be Possible There are three conditions that are important and necessary in order to ensure that price discrimination is attained in the market and these include the following: 1. Market Control – this condition requires that a company that would like to implement this strategy should have a level of monopoly so as to determine prices in the market. This means that monopolistic and oligopolistic organizations have the capacity to undertake price discrimination to the extent to which they are able to control the price level in their respective markets (Milgate & Newman 2005). 2. Different Purchasers – this condition requires that the seller clearly identifies different buyers in the market with specific differences that make them discretely different from each other which requires that these groups have differing price and demand elasticity (Samuelson & Marks 2010). This makes it possible for the buyers to have the capacity to pay for service and products different prices and it is this flexibility that makes it possible for price discrimination (Baumol 2007). 3. Segmented Purchasers – this is the third condition that requires that the buyers are made discretely different and contained in their respective market segments at all times. 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