3.6 Price Discrimination and Price Differentiation

It is a fundamental economic principle that the way to maximize profits is to charge a price that equates to the value of the product to each consumer, instead of selling at a uniform price to all consumers. This is the idea behind price discrimination.As noted in the last reading, the terms price discrimination and price differentiation can, in general, be treated as synonymous. Companies use price discrimination to differentiate prices. Pure price discriminationInvolves selling the same good at different prices to different consumers. involves selling the same good at different prices to different consumers. Flat pricingThe producer starts at the top price of the demand curve and then ratchets the price down. The flat price selected is a function of how the fixed costs and variable costs lead to the highest profit. can have perverse consequences, because it encourages the producer to sell to the high end of the market.Varian (1996). The producer simply starts at the top price of the demand curve and then ratchets the price down. The flat price selected is a function of how the fixed costs and variable costs lead to the highest profit. Producers who understand differential pricing have a strong incentive to supply several versions of a product because they will usually make more money. Rather than sell the same exact good at different prices, the goal should be to modify a product and sell a differentiated product at different prices. This could be accomplished using the following strategies:

• Adding and subtracting product features
• Adding and subtracting convenience
• Adding and subtracting durability
• Adding and subtracting design appeal
• Adding and subtracting speed of delivery and processing
• Changing the level of customer service
• Advertising and branding and perhaps generating a cool factor and snob appeal

There are two situations that lead to very high demand for products. The first involves scarcity. When a product is scarce, it is usually in demand. Price discrimination is easy for scarce products, even though such situations are sometimes transitory (e.g., snow blowers during extended winter storms, games consoles at launch, and oil consumption in the winter). The other approach to generating high levels of demand is to design products that make people and their kids look smarter or more attractive. Products that give kids an academic edge are always in demand. Parents will flock to such products because they may be able to differentiate their children from the competition.